Covenants in an asset-based facility, and the ones that only appear when you are struggling

Asset-based lenders generally impose fewer financial covenants than cash-flow lenders, for a straightforward reason: they are already measuring the business every week through the collateral. The covenants that survive are the ones that catch what the borrowing base cannot see, and several of them are dormant until a threshold is crossed.

The covenants that are always there

The springing kind

A springing covenant is one that is not tested at all until a trigger is hit, and the usual trigger is availability.

Illustrative only. Suppose a 5,000,000 facility with a springing fixed charge coverage test set at the greater of 12.5% of the commitment or 500,000. Twelve and a half per cent of 5,000,000 is 625,000, so the trigger is 625,000. While availability stays above that figure, no coverage ratio is tested and you never think about it. The month availability closes at 590,000, the ratio is tested — usually on a trailing twelve-month basis, so it is being measured against a year you cannot go back and change.

That is the trap in springing covenants. The test arrives at the moment you are least able to pass it, and it is calculated from history rather than from the month in question.

Two other points to settle at closing. First, how availability is defined for the trigger — the raw calculated availability, or availability net of past-due payables and other suppressed amounts, which is a lower number. Second, whether the test stops applying once availability recovers, and after how many consecutive days. Without a written unspringing provision, a single dip can turn a dormant covenant into a permanent one.

What a breach actually triggers

Rarely foreclosure. The first response is almost always economic and administrative:

1. A new or increased reserve against the borrowing base, which lowers availability immediately.
2. A cut to an advance rate, or a tightening of the eligibility definitions.
3. More frequent reporting — weekly certificates instead of monthly.
4. An additional field exam or appraisal, at your cost.
5. Default interest, and a fee for the waiver you will be asked to sign.
6. Cash dominion springing, where the documents allow it.

Each of these reduces the cash available to the business, which makes the next test harder. That sequence is worth understanding before you sign, because it is the real consequence of a breach in this product, not the acceleration clause everyone reads.

Cure rights worth asking for

• A stated cure period for reporting failures, with notice, rather than automatic default.
• An equity cure: the ability to cure a coverage shortfall with a cash contribution from ownership, with limits on how often it can be used.
• A materiality qualifier on representations that would otherwise be breached by an ordinary business dispute.
• The right to a copy of any field exam or appraisal you are paying for, so you can argue with the conclusions that drive reserve decisions.

The question to ask your lender

Ask directly what the last three borrowers who tripped this trigger experienced, and what the bank did first. You will not get names, and you should not expect a number. You may get a description of process, and process is what you are buying. An asset-based facility is a relationship with a monitoring department, and the covenants are the schedule on which that department is allowed to change your terms.

Illustrative only — how a reserve trips a test you were passing

A field exam lands and the lender takes a $250,000 reserve against slow-paying accounts at one customer. Availability falls to $520,000. Your sales did not change, your margins did not change, and you did not miss a payment. The springing fixed charge coverage covenant is now live, and it will be measured on the trailing twelve months.

Now run that test on the same business. Illustrative only — EBITDA of $1,450,000, less unfinanced capital expenditure of $210,000, less cash taxes of $145,000, less owner distributions of $180,000, gives $915,000. Divide by fixed charges of $777,000 — $430,000 of scheduled principal, $295,000 of interest, $52,000 of capital lease payments — and the ratio is 1.18. A 1.10 test passes with room.

Change one input. Take $300,000 of distributions instead of $180,000 and the numerator falls to $795,000, the ratio to 1.02, and the test fails. The covenant that springs on availability is frequently failed on a decision about your own pay that you made eight months before anyone measured it.

That is the practical argument for modelling the ratio quarterly even while it is dormant. A dormant test is still accruing its own history.

The calendar to build before the first draw

Put four things in a shared calendar on the day you close, not the day someone chases you:

• Every reporting deadline in the credit agreement, with a reminder three business days earlier and the name of the person who produces each item.
• A monthly self-calculation of availability, using the lender's definition rather than your own, so you see a dip forming instead of learning about it from a certificate.
• A quarterly dry run of every springing test, whether or not it is live.
• The date each field exam and appraisal is due, and a note of who pays for it.