3 Financial Covenants to Consider in Your Acquisition Loan Agreements

If you are a lender providing funds for a borrower’s acquisition of a company, unit trust or key business assets, there are a few things you’ll want to factor into the drafting of your loan agreement and the circumstances overall. For example, you’ll likely need to consider whether the acquisition will generate more profits for the borrower, which will allow it to repay its loan (with interest). As a lender, you will also require some certainty that the borrower will be able to service its repayment obligations, even if the post-acquisition business does not perform as planned. 

After all, a lender does not simply assume that the borrower will be profitable and not overburdened with debt. Instead, lenders rely heavily on information in the financial statements of the borrower, which the lender analyses and tests before, at the time of making, and during the life of the acquisition loan. These financial tests are usually captured in the form of financial covenants or undertakings that are set out in the acquisition loan agreement. 

While the exact type and terms of a financial covenant will depend upon the particular transaction, there are three financial covenants that are commonly included in acquisition loan agreements in the current Australian market. Wondering what those three financial covenants are? All will be revealed in this article, so you can consider them next time you draft up an acquisition loan agreement for your client.  

The interest cover ratio 

The Interest Cover Ratio (usually abbreviated in finance documents to ICR) is a financial covenant that measures the borrower’s ability to meet its interest payment obligations to the lender from its earnings.  

The idea behind the ICR is to give the lender insight into whether (and by how much of) the borrower’s earnings for a particular period of time are available to pay interest on all of the borrower’s debts. The lender sets a minimum ICR that the borrower must satisfy; the higher the ratio, the more difficult it will be for the borrower to comply with it, but the better (read: less risky) the loan is from the lender’s perspective. The most common calculation for an ICR is the ratio of the borrower’s EBITDA to its total interest expense for a given period. For example, an ICR covenant of 2:1 means that the borrower must have twice as many earnings in a period than its interest payments on its debts for that same period.  

As is expected, a borrower that acquires a new company may need some time to get going and generate increased earnings from the acquisition. Therefore, many deals include a shifting ICR covenant, where the ICR increases over the life of the loan. For example, the lender may set an ICR covenant of 1.5:1 for the first year of the facility, then increase this to 2:1 for the second year and 2.5:1 for each financial year after that. Or alternatively, it may not test ICR until a certain period after initial drawdown.  

The debt service cover ratio 

Sure, a lender can look to the ICR for an indication of how well its borrower can meet its interest payment obligations, but for many lenders that information is not enough for them to really gauge how successful the acquisition was for the borrower. Lenders that require an ICR covenant in the facility agreement often insist on including a second financial covenant known as a Debt Service Cover Ratio or, you guessed it, a DSCR.  

The DSCR is almost always included in a facility agreement if the borrower has amortising loans that have scheduled and other mandatory prepayments during their term, as the DSCR calculation looks at the borrower’s ability to service both interest and scheduled principal payments, whereas the ICR only looks at the borrower’s ability to service its interest payments. The DSCR is tested in a similar manner to the ICR. 

The Gearing Ratio 

Knowing about a borrower’s earnings compared to its interest obligations or even its overall debt is very useful for a lender. But what if the lender is more concerned with the big picture? A borrower can incur all sorts of debts in its ordinary course of business. And it will almost inevitably incur a range of one-off transaction costs as part of the acquisition (for example, adviser fees). A company that has incurred multiple debts does not necessarily have a greater credit risk, but a company that has debts that far outstrip its net assets (being its total assets less its total liabilities) is at a higher risk of not being able to service those debts from its available equity (being what is left over once the borrower’s total liabilities have been subtracted from its total assets).  

A lender providing acquisition funding will be interested in knowing the ratio of the borrower’s total debts to its net assets and will include a financial covenant known as a Gearing Ratio (no abbreviation for this one) or Debt to Equity Ratio in the facility agreement to find this out. The lower the ceiling for this ratio, the better for the lender, as that means the borrower has a lower level of liabilities compared to its net assets.  

When funding an acquisition, lenders are usually prepared to accept a higher Gearing Ratio early in the life of the loan (when acquisition costs may temporarily increase the borrower’s debt) but will expect that ratio to fall steadily over time, particularly if the borrower makes mandatory prepayments on an amortising loan.  

There is no market standard ceiling level for this covenant; the ratio is industry specific and a function of the level of credit risk the lender is willing to assume. 

Now that you are up-to-date on the three financial covenants to consider in your acquisition loan agreements, consider reading my piece on syndicated facility agreements that are worth revisiting. For more information on Practical Law’s suite of acquisition financing documents and practice notes, register your interest in a complimentary trial.  

Justin writes for Practical Law’s Banking and Finance practice area. He joined Practical Law after 13 years in practice at Clayton Utz, Herbert Smith Freehills and Dentons Australia, where he advised on real estate financing, aged care and retirement village development funding solutions, and corporate financing transactions. Justin has acted for all major Australian financial institutions and a range of corporate clients on both domestic and international financing transactions.

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