Brief analysis of the importance of covenant clauses in loan agreements in the light of corporate finance theory.

1. Why are financial covenants so important? Agency costs and the risk of over/under risk
taking
By Luis Felipe Vidal Arellano
In a frictionless world, financing alternatives should not alter the value of a company, say
corporate finance theorists. How the company finances its projects should not be relevant.
Whether financed by equity or by debt, the enterprise value (EV) should not change, even if the
return on equity (ROE) might.
In the real world, in contrast, the decision between debt and equity changes the EV,
mainly due to the existence of tax-shields on payment of interests to lenders and due to market
frictions such as bankruptcy costs, information asymmetry and agency costs. In fact, specific
capital structures have only two types of value consequences that must be take into account by
the company when deciding between equity or debt: a financial structure may create more real
costs than others may; or a financial structure may lead managers not to take all positive-NPV
projects and reject all negative-NPV projects.
As an important stakeholder, the lender of the company must be aware of these frictions
and be able to design agreements that prevent sub-optimal actions taken by managers and equity
holders of the firm. With this purpose in mind, the so-called “covenant clauses” on loan
agreements comes to hand.
The covenant clauses are contract clauses that define an obligation to do or not to do
something, commonly in parallel to the financial clauses of a loan agreement. The covenants may
be affirmative or negative. An affirmative, or positive, covenant is a clause in a loan contract that
requires a borrower to perform specific actions, such as requirements to maintain adequate levels
of leverage, to furnish audited financial statements to the lender, and maintenance of proper
accounting books and credit rating. Negative covenants, on the other hand, are set to make
borrowers refrain from certain actions that could result in the deterioration of their credit standing
and ability to repay existing debt. Common forms of negative covenants are financial ratios that a
borrower must maintain as of the date of the financial statements. For example, frequently loan
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2. agreements require an authorization of the lender for the company to sell specific assets or to
engage in specific agreements.
Now, let us see through an example, how covenants can prevent sub-optimum decisions
by management and equity holders, in disregard for the lenders interests.
Suppose that a company has a market value of 100 and a debt of 120 due to the next day.
In this scenario is easy to notice, that the market value of the debt can not be 120, but only 100,
since this is the only part of the debt that can be recovered in our example by the firm’s assets.
Let us now suppose that the CFO of the company has before him a project proposal that generates
a sure free, after taxes, cash flow of 120, after one year, with an investment of 100 to be financed
entirely with the shareholders pockets. The discount rate for the firm is of 10%. Should the
company accept the project?
To answer that question, we have, first, to calculate the NPV for the project, which is
9.09, since NPV = -100 + [120/(1+0.1)]. Considering the fact that the NPV is positive, the
conclusion is that the company should accept the project.
If the company accepted he project, the company value would raise to 209.09, which is
simply the sum of the inicial 100 plus the 100 invested by shareholders and the extra 9.09 NPV.
The debt value would also raise from 100 to 120, since, now, all the value of the debt is expected
to be repaid by the company. In other words, the lender would be very pleased if the company
made the investment.
But, will the company accept the project?
That really depends on the equity holders’ independence to decide on that. The reason is
that, in the shareholders perspective, the NPV of the project is negative, since it has to invest 100,
but, only captures 89.09 of the 109.09 present value of the project. The other 20 (109.09 - 89.09)
is captured by the debtholder.
Well, if that is the case, wouldn’t it be nice if the debtholder could have influence in some
investment decisions of the company? That is when covenant clauses really come in useful! The
loan agreement could set, for example, a veto faculty for the lender in some decisions.
Let us now think of a different example.
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3. Suppose, the same company, but a different project appears before the CFO: a project in
which the company invests all its assets, tangible and intangible, and have an expected return of
1,000, with a probability of 1%, and of 0, with a probability of 99%.
Should the company accept the project? Of course not, since the expected NPV is
negative (-90.91). But, will the shareholders be tempted to take the project?
Well, if the shareholders do not take the project, we already know that the EV for them is
the same as 0, since all the firm’s value (100) will be used to pay for the debt. But, if they accept,
their NPV is positive (9.09 = 1,000 x 1% + 0 x 99%), and that happens because, in their
perspective, they have nothing to lose, they are just risking someone else's money.
In conclusion, it is possible to see that different capital structures bring different issues.
If, on one hand, debt raises EV through tax-shield and raises equity holder’s return, on the other
hand, it raises the expected cost of bankruptcy and may cause an adverse selection of projects
inducing risk taking behaviour from management and shareholders that may not have enough
“skin in the game” when working in high levels of leverage. To prevent this, careful writing of
covenant clauses, that align all the incentives, is a very important measure.
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