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Deal Structuring: 5.

1
Overview of Deal Structuring and
Monitoring
Introduction
A credit assessment provides the lender with a prospective view of the borrowers probability
of default (PD), loss given default (LGD) and exposure at default (EAD). A positive credit
assessment indicates a favorable outlook of the PD and LGD. This means that the lender can
expect to be repaid or serviced on time.
However, that favorable outlook does not always become a reality. Unexpected events can
occur that change the risk profile of the client. Lenders manage uncertainty by mitigating risk
with deal structures and dynamic internal monitoring.
This lesson discusses four key concepts:

WHY lenders rely on deal structures

WHAT components form a deal structure

HOW deal structures are created and implemented

WHEN dynamic internal monitoring is essential to enhance the mitigation from a


deal structure

What You Need to Know


Risk assessment is a dynamic process. When a credit approval decision is made, the lender is
making a prospective view of the future PD and LGD. However, the lender has to manage the
risk during the whole term of the exposure. Changes in circumstances may affect the original
expected outlook of the clients risk profile.
Credit management begins with making a good initial credit assessment. It then continues
with ongoing control of the risk that the future PD and LGD may deteriorate following the
latest credit approval. Deal structuring and internal monitoring are a critical part of that
process.

WHY LENDERS RELY ON DEAL STRUCTURES


An effective deal structure protects the lender from the negative impact of future events by
providing two important services:

An early warning signal (EWS) of an increase in the expected PD, caused by a


deterioration in business and financial risk or natural mitigation

Protection against an increasing LGD, by preventing an increase in structure risk or


mitigation, through increased subordination and dilution

Good deal structuring and monitoring do not make bad deals an acceptable risk. Good risk
analysis, and the assessment that the borrower can service debt from operational cash flow,
are the foundation of deal structuring and monitoring. The lender must be satisfied that the
transaction meets acceptable risk criteria on a judgment of the future. The deal structure and
monitoring are then required to mitigate the risk that the lenders initial view of the future
may change.
WHAT COMPONENTS FORM A DEAL STRUCTURE
A deal structure is a unique mix of different components, often negotiated on a case-by- case
basis.
The deal structure always includes three key items:

Tenor
The tenor reflects the duration of the asset being financed.

Repayment schedule
The schedule aligns with the projected cash flow.

Pricing
Pricing reflects market conditions. It is a key determinant in the risk-adjusted return to
the lender.

Before disbursement of funds:


The key deal structure components are conditions precedents (CP) and representations and
warranties (R&W). These components ensure several requirements:

PD and LGD have not changed in the period between negotiation and drawdown
(because of external or internal client events).

Misrepresentation of critical facts has not taken place during negotiations.

All the agreed components of the deal structure are in place.

The client is in compliance with covenants upon drawdown.

EAD is controlled when drawdown is allowed in stages (e.g., project or construction


finance)

After disbursement of funds:

Some deal structure components are designed solely to prevent LGD and EAD from
increasing during the tenor of the exposure. The most common components for this purpose
are:

Collateral
Collateral provides a security interest in critical assets and cash flows (discussed in
detail in the next lesson).

Guarantees
Guarantees provide the lender with an unsecured claim on the guarantor (discussed in
detail in the next lesson).

Assignment of contracts
This provides the lender with a legal assignment (pledge) of a clients commercial
contract. In some legal jurisdictions (subject to notice of the assignment to the
contract counterparty), this gives the debt provider the right to oblige the contract
counterparty to fulfill their obligations under the contract.

Other components of the deal structure either provide an EWS of deteriorating PD or prevent
an increase in LGD. Some components provide joint protection. The most common of these
components include:

Covenants
Covenants provide an EWS of deteriorating business and financial risk, or prevent
subordination and dilution (discussed in detail in later lessons).

Transactional control
Using trade finance and cash management products, transaction control provides an
EWS of a problem with transaction flows, or protects LGD by controlling the assets,
cash flows and contracts on one or more transactions.

Information undertakings
These provide the lender with the right to access information required to monitor PD
and LGD on an ongoing basis.

HOW A DEAL STRUCTURE IS CREATED AND IMPLEMENTED


There are three main phases to consider in implementing a deal structure:

Design phase

Negotiation phase

Drawdown and monitoring phase

Design Phase
The design phase establishes several important elements:

Who is included in the deal structure?

Which legal counterparties will provide collateral or guarantees? For example, which
credit bases can be indirectly included in the deal structure by taking covenants on a
consolidated basis?

Why does the lender need the structure?


It is essential to prioritize the business, financial and structure factors most likely to
have an adverse future impact on PD and LGD. The deal structure should mitigate the
negative impact of these factors as much as possible. The negotiating power of the
client can lead to a gap in protection from the deal structure, on a deal that otherwise
meets the risk criteria of the lender. This must be compensated by robust and dynamic
internal monitoring.

Learn more about Dynamic Internal Monitoring


A weak deal structure on an acceptable loan may not provide EWS of deteriorating business
and financial risk or prevent an increase in structure risk. In this case, the lender relies on
internal monitoring to identify a change in the expected outlook of the client and exposure.
A lenders internal monitoring system is normally based on three factors:

Analysis of historical financial data provided by the client

Time based review ranging from quarterly to annually, depending on risk levels

Monitoring trends in the transactions related to the bank account

This approach has a number of weaknesses:

Warning signals are identified too late. There is usually a time lag between when a
problem occurs in business operations and when it is reflected in the financial data.
There is also a time gap between the reporting date and when the lender receives the
financial information. Depending on the type of business and market practice, the
delay could be as short as a few months or years. For example, a business dependant
on an order book will not reflect immediately a declining order book in declining
sales.
In a typical situation of this example, the order book declines in quarter 3 or 4, but the
annual sales at the end of quarter 4 still show growth because they reflect quarters 1
and 2 of the order book. The decline in the order book does not show up until the next
years order book.

In some situations, there are no formal projections. Historical data is compared


against historic trends only, not against the expected outlook at the time of credit
approval.
Assume that a lender approves a credit on the expectation that sales in the next year
will grow by 10%. After a year, however, sales grow only by 4%. The temptation is to
analyze the 4% historic growth with little reference to reasons for the missed expected
outlook of 10% sales growth. Clearly, however, the risk profile of the client is worse
than previously expected. The original credit decision was based on an expected
outlook of 10% growth.

Late warning signals on deteriorating business and financial risk delay the lender
taking action against the potentially larger increase in structure risk. However, other
stakeholders may be taking action to improve their debt priority position.
Bank account monitoring is effective only when the client is not multi banked, and the
majority of the clients transactions are routed through the bank.

To compensate for these weaknesses in traditional internal monitoring, lenders are


increasingly requiring additional internal monitoring actions. These actions are set at the time
of credit approval:

Focus on business operations to provide EWS.


Previous lessons discussed how the key business drivers of the operation have a major
impact on profitability and cash flow. Early identification of a change in the business
drivers is a strong indicator of a change in reported future profit and cash flow.

Include internal triggers to measure the variance between reality and expected
outlook (where possible).
This sets a clear standard at the start of the exposure that if the internal trigger is
broken, a change in risk profile is likely.

Be dynamic and ongoing in normal client relationship management.


An experienced relationship manager discusses the business in depth with the client,
to identify more revenue opportunities for the bank. This discussion also helps
identify changes in the expected outlook on the business operations since the latest
credit approval.

In practice, internal triggers should be set on the business operations. Issues like delays in
events or changes in market prices can easily be measured. For example, a credit decision
may include an internal monitoring trigger around the delay of completion of a new plant by
more than one month, or perhaps an increase in raw material costs of over 10%. In both of
these examples, if the trigger is broken this will strongly indicate that future profits and cash
flow will be less than expected, with a potential negative impact on PD.
In many cases, however, it is difficult to measure the expected outlook in a non-financial way.
The necessary information may not be available. In such cases, the credit approval would
normally indicate the areas of the business operations that relationship management should
discuss during regular client contacts.
Historical financial data generally provides a late warning signal. However, internal triggers
can easily be set to identify when a potential change in risk profile has occurred. If the lender
is relying on projections, it should be clear how much variance will be allowed before a full
review takes place. For example, the internal trigger could be a 10% negative variance with
the projections. Similarly, if the expected outlook of the lender is that historic good
performance will continue, an internal trigger could be set on historic financial trends. For
example, the internal trigger may be set to identify a decline in historic profit margins by
more than a percentage that would trigger a review.
Setting exact internal triggers on structure risk can also be difficult. In general, however, any
unexpected increase in guarantees, debt or collateral given to other lenders should trigger an
immediate review.

The process of internal dynamic monitoring can be difficult. Lenders need to allocate
resources to the monitoring effort for risks that are not sufficiently mitigated by the deal
structure.
Competitive market conditions often lead to internal dynamic monitoring being the lenders
most effective mitigation to identify change in the expected outlook and increased risk levels.
The trade-off for the lender is between receiving internal monitoring warning signals that are
too early, with limited negotiation power, versus receiving warnings from the deal structure
too late, with stronger negotiation power:

Internal triggers may provide early warning signals. However, if they are not legally
enforceable, the lender relies on the clients cooperation to resolve the problem.

A deal structure may provide a late warning signal. However, the covenant breach is
legally enforceable, giving the lender more negotiating power to resolve matters if the
client is not cooperative.
o

What range of possible deal structure components could be used?


The required components depend on two factors, in order of preference:

How effectively do they provide an EWS for the critical business or


financial factors identified, and protect against structure risk increasing
the lenders LGD and EAD?

What is the expected level of negotiating power? For example, a


borrower may only raise debt on an unsecured basis. In this case,
collateral may not be included in the range of possible deal structure
components. If this takes the deal outside the acceptable risk criteria,
the lender may have to walk away from the deal.

What are the negotiating options or key issues for each of the selected deal
structure components?
Several items are necessary for negotiation:

Create a range of negotiation options based on the protection afforded.


For example, to restrict debt the range of options may include a no
further debt clause (strong) or a leverage clause (weaker).

Consider client specific improvements to any market standard


definitions, such as the Loan Markets Association (LMA), for example.

Set the level of covenants to make them as effective as possible. In


particular, question whether the level set gives the borrower too much
flexibility before triggering a covenant breach. On the other hand, the
borrower needs enough room to make sure the business can function
normally. The lender should not be viewed as being in control of the
business.

Consider the need and possibility of creating a protective deal structure


(ring fence). This provides the lender with more control and

protection, by preventing other stakeholders access to critical assets,


cash flow and contracts.
Negotiation Phase
The balance of negotiation power between the debt provider and the client has
a major impact on the deal structure effectiveness. The more effective the deal
structure, the tighter the conditions will be on how the client conducts future
business.
Clients with strong negotiating power (low risk profile) will only agree to
loose conditions, which make the deal structure less effective. If the deal still
meets an acceptable level of risk, the debt provider relies on internal
monitoring to provide a warning signal of increasing PD, and protection from
increasing LGD. (Internal monitoring is discussed in more detail below.)
The level of the clients negotiation power is determined by several factors:

Financial strength

Terms and conditions in existing or past credit agreements

Local market practice (depending on competition of lenders)

There are five steps in the negotiation phase:

Negotiate and agree the deal structure components with the client.

Assess the effectiveness of the deal structure in the stress scenario. If it


does not adequately provide an EWS for deteriorating PD, and protect
against increasing LGD and EAD, dynamic internal monitoring will be
required.

Instruct lawyers on documentation and key clause or covenant


definition issues.

Sign the documentation.

Set up internal monitoring to meet the shortfall in protection from a


less than ideal structure.

Drawdown and Monitoring Phase


Prior to disbursement of funds (in full or in stages), the lender needs to ensure
that all risk control measures are in place. In particular, two items should be
completed:

All conditions precedent (CPs) must be completed before any


drawdown (partial or full) of funds including compliance with
covenants.

Internal monitoring must be ready and in place to enhance loose deal


structures.

Once disbursement of funds has taken place, the lender takes several important
steps:

Monitor the clients compliance with information requirements and


covenants as per the facility agreement.

Dynamically monitor the client and the facility structure to spot signs
of a deterioration in the risk profile.

Take action upon a deterioration of the risk profile, which can lead to a
breach of internal monitoring parameters or covenants.

Consider the sale, transfer or assignment of the loan asset, depending


on the portfolio management requirements of the lender.

What You Need to Do


High quality risk analysis is the foundation for effective deal structuring (DS) and internal
monitoring plans (IMP).
Identification of the key parties to be included in the deal structure is the starting point.
Ideally, all key parties should be legal counterparties (borrowers or guarantors). Otherwise,
credit bases should be included indirectly into the structure through group or consolidated
covenants.
Prioritization of the business and financial factors that impact PD reveals the early warning
signs that need to be included in either the DS or IMP. Similarly, a priority list of structure
factors that affect LGD will set out clearly where the DS and IMP need to protect against
subordination and dilution.
Once it is clear which parties to include, and why the DS is required, check the common deal
structure components:

Tenor
Does the funding tenor match the asset being financed?

Repayment schedule
Does the schedule align with projected cash flow?

Pricing
Is pricing in line with market conditions, and does it provide an acceptable return to
the lender?

Other deal structure components may apply, depending on several factors:

Type of business
Collateral is an unlikely option for a borrower that only raises unsecured debt, for
example. A lack of trade finance transactions does not allow transactional control.

Current deal structures in place for the borrower

Evidence of increased risk is needed for the borrower to agree to additional deal
structure components.

Negotiating power
The stronger the lenders position, the more likely the borrower is to agree to a DS
that imposes more control on the business. On the other hand, the weaker the lenders
position, the more likely a borrower is to resist a DS that imposes more control on the
business.

When planning for negotiations with the client, follow the two steps outlined below:

Create a range of options for each deal structure component likely to be used. For
example, if collateral applies, the strong option is security over all assets; the weak
option is a minimum of security over fixed assets.

Design internal triggers that can be included in an IMP to compensate if the optimal
structure cannot be negotiated. For example, a lender may wish to negotiate a Debt
EBITDA covenant of 3.5, but may have to agree to a level of 4 because of the clients
negotiating power. The underlying credit may still be good. However, this makes the
DS weaker, which can be compensated by including an internal trigger of 3.5. If this
trigger is broken, it becomes an EWS leading to a review of the credit when the Debt
EBITDA ratio reaches 3.5, before the covenant is breached at 4.

During the negotiations, it is in the lenders interest to make sure that the borrower
understands why the lender needs the deal structure. This helps ease the natural resistance of
the client to give away any future control of the business, reducing flexibility in the future.
After the negotiations, check that the documentation accurately reflects the critical deal
structure components. Then, design an IMP that compensates the weaknesses in the DS.
When the client asks for the funds, the lender must ensure that all conditions precedent have
been met. After the drawdown, the lender needs to control the risk of changes in the expected
outlook. The lender does this by monitoring the clients compliance with the information
requirements, checking that covenants remain as per the loan agreement and checking that all
internal triggers and key factors are included in the IMP.

How This is Useful


The future is uncertain. The lender must manage the risk that unexpected events increase
losses and destroy value for the client.
The earlier the lender becomes aware of the clients unexpected problems, the more options
and time will be available for corrective action, before the cash flow of the borrower comes
under stress.
If the situation cannot be fully corrected, or if the client is uncooperative, the lender is faced
with a higher PD than originally expected. Limiting expected losses can be done by
improving LGD and exerting pressure on a client who is unwilling to change. This requires
good access to the clients assets and cash flows, which is not possible if subordination and
dilution risk is high.

An effective deal structure and internal monitoring plan protects the lender from the negative
impact of future events. The deal structure should provide two key services:

An early warning signal of an increased PD, caused by a deterioration in business and


financial risk or natural mitigation

Protection against increasing LGD, by preventing an increase in structure risk or


mitigation through increased subordination and dilution

Questions You Should Ask


The questions listed below are based on the assumption that a good risk analysis has been
undertaken. The questions are arranged in four groups. The first two groups relate to before
and after an agreement with the client. The last two groups fall before and after the drawdown
of funds.
Before Client Negotiations (Design Phase)

Which parties should be included in the DS and IMP?

What are the key business and financial factors affecting PD for which an EWS is
required in the DS or IMP?

What critical structure factors affecting LGD should the DS mitigate?

Is the proposed tenor appropriate for the financing need?

Does the proposed repayment schedule match the projected cash flow?

Is the anticipated pricing at market level, and does it give the lender an adequate
return?

What type of deal structure components are most suitable for the type of business and
transaction?

What is the negotiating power of the client?

Which deal structure components are in current loan agreements with the client?

What are the range of negotiation options for each of the deal structure components
that the client is likely to accept?

Which weaknesses in the DS are likely to need to be compensated by the IMP?

After an Agreement with the Client

To what extent does the agreed DS provide an early warning sign of a deteriorating
PD (business and financial factors)?

Do the triggers in the IMP compensate for the shortcomings in the EWS provided in
the DS?

Does the DS control the critical assets or cash flows, and does it prevent
subordination or dilution?

If not, how is subordination and dilution risk monitored internally?

Before Drawdown

Have all the conditions precedent been met?

Are all the DS compliance and internal monitoring procedures in place?

After Drawdown

How does reality compare with the expected outlook at the time of credit approval?

If it differs, what action should the lender take?

Knowledge Check
Question 1
Which statement about effective deal structuring is most accurate?

An effective deal structure should provide an early warning signal of an increase in


the expected probability of default.

An effective deal structure should provide protection against increasing probability of


default an increase in structure risk through increased subordination and dilution.

An effective deal structure should provide an early warning signal of an increase in


the expected exposure at default

An effective deal structure should provide protection against increasing exposure at


default by preventing an increase in structure risk or mitigation through increased
subordination and dilution.

An effective deal structure should protect the lender from the negative impact of future events
by providing an early warning signal of an increase in the expected PD, caused by a
deterioration in business and financial risk or natural mitigation. It should also offer
protection against increasing LGD by preventing an increase in structure risk or mitigation
through increased subordination and dilution.
Question 2
Which phase of deal structure implementation seeks to establish who, what, why and key
issues?

Negotiating phase

Design phase

Drawdown phase

Monitoring phase

In the design phase, it is important to establish who should be included in the deal structure,
why the lender needs the structure, what range of possible deal structure components could
be used and which negotiating options or key issues are required for each of the selected deal
structure components.

Question 3
Generally, what does not determine the level of a clients negotiation power with a lender?

Clients financial strength

Clients management quality

Intensity of competition between debt providers

Terms and conditions in the clients past credit agreements

The level of the clients negotiation power is determined by financial strength, terms and
conditions in existing or past credit agreements, local market practice and the intensity of
competition between debt providers.
Question 4
In the final phase of deal structure implementation, what should be done prior to the
disbursement of funds?

Ensure all conditions precedent are completed.

Check the clients compliance with covenants as per the facility agreement

Ensure an internal monitoring plan is agreed and in place to spot signs of a


deterioration in the risk profile

All of the above

Prior to disbursement of funds (in full or in stages), the lender needs to make sure that all risk
control measures are in place, particularly that all conditions precedent (CPs) are completed
prior to any drawdown (partial or full), a dynamic internal monitoring is in place to enhance
loose structures and check that covenants are being complied with to ensure no unexpected
deterioration in PD has already taken place.
Question 5
What can lenders use to compensate for weakness in traditional internal monitoring systems?

Analysis of historical financial data provided by the client

Time based review, ranging from quarterly to annually depending on risk levels

Perform an annual check on transactions in the clients the bank account

Set internal triggers with specific focus on business operations to provide early
warning systems

To compensate for weaknesses in traditional internal monitoring, lenders are increasingly


setting out required internal monitoring action and internal triggers. These triggers will focus
on business operations to provide EWS, measure the variance between reality and expected
outlook and be dynamic/ongoing as part of normal client relationship management.
2016 Moody's Analytics

Deal Structuring: 5.2


Collateral and Guarantees
Introduction
Collateral and guarantees are commonly used to reduce loss given default (LGD), which is an
element of structure risk. This lesson focuses on various types and values of collateral and
guarantees for loans. It also defines acceptable collateral and guarantees, and explains how to
assess the extent to which they protect you from structure risk.

What You Need to Know


Lenders use collateral and guarantees for loans to all but the strongest, most creditworthy
borrowers.
Collateral reduces LGD in the event that a loan becomes uncollectible for one of several
reasons:

The more a lender controls critical assets and cash flows, the lower the exposure to
subordination or dilution risk, and the more power the lender has in negotiations with
other parties. This is enhanced when the legal system allows efficient and quick
enforcement.

Collateral prevents the borrower from raising cash from asset disposals without the
lenders agreement.

Depending on the asset type, collateral can provide an eventual repayment source.
This is determined by the correlation between the value drivers of the collateral and
the business operations. The less the value of the asset relies on the success of the
business, the more substantial the amount to be collected from the sale proceeds of
collateral. For example, if the value of a general warehouse is driven by the local
property market, specialized inventory for a manufacturer will have little value if the
business fails.

Guarantees reduce LGD by including another legal counterparty in the deal structure.
Guarantees give the lender an unsecured claim to the guarantors assets. This can be
improved by taking collateral from the guarantor to convert an unsecured guarantee to a
secured guarantee.

Collateral and guarantees do not make a marginal loan a good loan. Generally, a loan that
cannot be repaid from cash generated from normal operations, should not be made, regardless
of the quality or amount of the collateral.
Even if the loan is fully secured by a savings instrument, the deal should not proceed if the
borrower can never repay the debt and the primary repayment source is collateral or a
guarantee. Such a loan would increase reputation risk for the lender and in some countries,
could lead to legal action against the lender as funds loaned irresponsibly.
Learn more about the rules for Collateral and Guarantees
Collateral
Dealing with collateral generally requires that some basic rules are observed:
1. Collateral must be specifically identified and designated.
2. Collateral value must be properly and independently appraised.
3. Title to the proposed collateral must be investigated to ensure that a clear title can be
obtained.
4. Lenders must achieve a first position, unless upper management makes an exception.
Approval for an exception is usually required, regardless of the loan amount.
5. Collateral must be properly documented. For example, the lender and the borrower
must sign documents (principally, a collateral agreement) giving the lender a formal
interest in the collateral.
6. Collateral interests in assets must be perfected properly and in a timely manner.
Usually, the lender files formal documentation with government authorities, within
the required time limits, to provide public notification of its appropriate position or
rights to the collateral.
7. Collateral must be monitored throughout the term of the loan being secured to help
ensure that it is locatable, insured and in good condition.
8. When it is applicable for a lender to establish loan-to-value (LTV) ratio for a
particular type of collateral, the collateral must hold its value sufficiently to ensure
that the prescribed LTV ratio is maintained throughout the term of the loan.
Guarantees
Dealing with guarantees generally requires that some basic rules are observed:
o

The guarantors should have the legal capacity to enter into a guarantee. With
some legal entities, such as limited companies and government agencies, this
power can be removed.

The commercial benefit to the guarantor should be clear.

Legal enforceability of the guarantee is confirmed. In some jurisdictions,


upstream guarantees from subsidiaries are difficult to enforce. This can also be
the case when the guarantor and beneficiary are in different countries.

The amount, and conditions under which the guarantee can be called should be
clear. Ideally, the lender is seeking a guarantee that is payable on first demand.

Regular monitoring should be in place to review the financial position of the


guarantor. Guarantors should be notified on a regular basis that the lender is
relying on their guarantee.

An institutions loan policy establishes acceptable types and guidelines for collateral
and guarantees. Commonly-acceptable collateral types include:
o

Accounts receivable (trade debtors)

Inventory (stock)

Machinery and equipment

Furniture and fixtures

Commercial real estate

Intangible assets

Single-family residence

Shares and bonds

Savings instruments

Cash surrender value of life Insurance

Learn more about Types of Collateral


Below is a list and description of collateral types that are generally considered acceptable.

Accounts Receivable (Trade Debtors)


Accounts Receivables are normal sales made and recorded, but not yet collected in
cash. These accounts are expected to be liquid and not subject to dispute or
performance risk. In taking these fairly liquid assets as collateral, lenders frequently
subtract all non-eligible receivables. Normally, the definition of non-eligible includes
receivables that are over 30-60 days past due, related-party, in dispute or with set off.
In the case of a few large debtors, concentration limits may be set. In many countries,
acknowledgement by the debtor is required to perfect the collateral. When taking
accounts receivable as collateral, every reasonable effort must be taken to understand
the quality (i.e., collectability) of those accounts. They are then assessed as to what
extent the loan amount is covered by the borrower's best base of eligible receivables.

Inventory (Stock)
It can be important for the lender to control inventory. However, the value can be
highly questionable in a stress scenario. Inventory may realize some value only if it
can be easily tracked, insurable, readily marketable as is and is not susceptible to
radical market changes or prior claims from suppliers. However, if it consists of many
items in different stages of production, or if the goods are not easily marketable in
their present state, inventory value is dependent on the borrower remaining a going

concern. Under these conditions, inventory control is the main benefit of the collateral
to the lender, in the stress scenario.

Machinery and Equipment


These types of collateral may be used as the sole collateral for loans made to purchase
the equipment. They may also be used as collateral for other loans, but only if the
lender can get a first charge on the equipment. In all cases, some standards apply
when considering these types of collateral:
1. The collateral must be insurable.
2. The risk of obsolescence impacts the value. Equipment that is based on
technology that is subject to rapid change will be of little benefit to the lender
in the stress scenario.
3. If the equipment is subject to heavy maintenance and upkeep, it must be
demonstrated that this maintenance can be carried out and financed without
undue down time, diminishing the value of the collateral or shortening its
useful life, and without decreasing its insurability.
Specialized equipment typically re-sells in the stress scenario for less than generalpurpose equipment. This is because value is dependent on the borrower remaining a
going concern. This category of equipment can include:
4. Machinery and non-mobile equipment
5. Mobile equipment and heavy trucks
6. Light trucks, automobiles, boats and aircraft
The location and condition of mobile types of collateral must be carefully monitored.

Furniture and Fixtures


Typically, furniture and fixtures are relatively small, movable and easily breakable.
They are not usually attractive as collateral. They are difficult to monitor and do not
retain value well.

Commercial Real Estate/Construction


If the loan purpose is construction or acquisition of real property, that property must
always be taken as collateral for the loan. Commercial real estate may also be used as
collateral for loans made for other business purposes, as long as basic collateral rules
are followed. For more specialized commercial property, the value depends mainly on
the borrower continuing as a going concern, rather than on market conditions of the
property.

Intangible Assets
These assets are usually of a highly specialized nature, such as intellectual property,
patents or quotas. In general, their value depends on the business continuing as a
going concern. Therefore, lenders take intangible assets as collateral for control

purposes, rather than for their minimal forced sale value. The legal perfection of the
collateral can be complex. It may not even be possible in emerging legal systems.
On a few occasions, there can be a recognized market in intangible assets such as
trade quotas. In these exceptional circumstances, there may be value in the stress
scenario.

Single Family Residence


The use of a single-family residence as collateral for a business loan is somewhat
limited. Typically, this type of collateral is used only to give strength to a loan made
to a small partnership or sole trader, or to support a personal guarantee given by the
owner of a company. This may be appropriate where the business appears to be
successful, but it is very new or the accounting information is inadequate to fully
understand the risk.
When taking a residence as collateral for a business loan, great care must be taken to
ensure that all those with an interest in the property (family, tenants, etc.) are aware of
the situation and have been correctly involved in the legal process. The value of a
private residence is much easier to value than many other types of collateral.
However, realizing the security can expose lenders to high reputation risk, especially
when the private residence is the main family home.

Shares and Bonds


Shares and bonds are generally acceptable as the sole collateral on a loan if they meet
a number of requirements:
1. The shares or bonds are from publicly held companies quoted on a recognized
stock exchange, represent a small percentage of the number of shares issued
and can be liquidated with reasonable ease.
2. The borrower has clear title to the collateral, or a third-party owner consents in
writing to give the lender a first position on the collateral. The authority to sell
the bond or shares, if the borrower is in payment default (known as bond or
share power), is also necessary if the instrument is registered in the name of
the owner.
3. The lender does not already have a loan outstanding to the company whose
shares are being considered as collateral. Although this may give the lender
some control, the double exposure would not protect against increasing LGD.
4. The value of the shares or bonds is both high enough and stable enough to
ensure that a proper loan-to-value ratio can be maintained.
5. The shares or bonds are re-valued periodically throughout the term of the loan
it is securing.
6. The borrower agrees in writing to pledge additional collateral if a future
reassessment shows that the value of the collateral has declined to a point
where the loan-to-value ratio is out of the prescribed range. The additional
collateral must be available and acceptable to the lending institution. It must

be at least as liquid as the original collateral and must be able to be delivered


to the lender in a short time frame, after the loan-to-value ratio is breached.
7. The borrower accepts that, if the additional collateral is not made available in
the required time, the lender will sell the shares or bonds. This may lead to a
loss for the client. Otherwise, the lender may be taking a legal risk, if the
realization of the collateral leads to losses for the client, especially if the value
improves after realization.
8. Where possible, a variety of shares or bonds make up the collateral package to
help insulate the loan-to-value ratio from a decline in any one collateral or
financial market.
9. The lender takes physical possession of the shares.
Loans to purchase the shares being offered as collateral often require a legal review
before any commitment is made by the lender. This is to help ensure that regulations
related to this type of transaction are not violated. If the purpose of the proposed loan
is not the purchase of shares, the borrower must sign a statement to that effect.
Care must be taken that the borrower can generate the cash to repay the loan, and is
not relying on increased market values. Otherwise, the lender is doubly exposed to
market riskon the prime repayment source and on the collateral.

Savings Instruments
A savings instrument can be the sole collateral on a loan if it meets certain
requirements:
1. The amount of the instrument is in the same currency as the loan, and greater
than or equal to the principal balance of the loan plus accrued interest.
2. The term of the instrument is greater than or equal to the term of the loan.
Otherwise, the borrower agrees in writing that an instrument with a shorter
term will be rolled over as many times as necessary to keep the loan
completely secured throughout its term.
3. The name of the savings instrument and the name on the loan are identical.
Ideally, the savings instruments should be deposited with the lender, who will also
control withdrawals. The liquid nature of the security does not, as previously
mentioned, reduce the lenders responsibility to ensure than the loan can be repaid
from the projected cash flow.

Cash Surrender Value of Life Insurance


Cash Surrender Value of Life Insurance (CSVLI) can be used as the sole collateral on
a loan. However, several steps must be taken before accepting CSVLI as collateral,
including:
1. The financial condition of the insurance company must be assessed and
deemed sound.

2. The insurance policy must be read and understood in its own light. Further, it
must be clear that the insurer, the insured, the beneficiary and the lender all
interpret the terms of the policy the same way.
3. The beneficiary must join in the assignment of the policy to the lending
institution.
4. Both the insured and the beneficiary must sign a separate contract setting forth
the lender's rights.
5. Payment of premiums on time should be monitored.
6. In many countries, an acknowledgement is required from the insurance
company.
Guarantees can be given by most legal entities, including individuals, partnerships
and limited companies. There are two commonly acceptable types of guarantee:
o

Limited or unlimited
For a limited guarantee, the amount is capped; whereas an unlimited guarantee
depends on the amount of lenders exposure plus interest, at the time of
default.

Secured or unsecured
This depends on whether or not the lender has collateral from the guarantor.

Collateral and guarantees are generally taken to lower expected loss. Much of the
enhancement depends on the control and the cushion maintained between the value of
the collateral or guarantee and the loan amount.

Certain types of collateral, such as property or equipment, can be valued at an


estimated market price. With other kinds of collateral, such as accounts receivable
(trade debtors) or inventory (stock), book values can be taken from financial accounts.
However, it is very important to remember that in the stress scenario the value of
collateral will be at its lowest. The value of guarantees will depend on the financial
strength of the guarantor, the legal enforceability and debt priority of the guarantee
claim.

Learn more about Valuations


If the asset being considered as collateral has to be valued prior to the closing of the
corresponding loan, the completion of a valuation acceptable to the lender should be a
condition precedent in the deal structure. Subsequent valuations are done according to lenderspecified timetables.
Some lenders have formal valuation capability in-house for a variety of types of collateral.
Others have very little expertise internally, and therefore contract out virtually all of their
valuation work. Still others provide borrowers with a list of valuers that have been approved
by the lending institution and require that one from the list be used. The borrower signs a
contract with the valuer and pays for the valuation.
The valuation instructions by the lender are critical to understanding the valuation report.
They often also conform to any applicable governmental regulations and to trade standards.

The valuations should be addressed to the lending institutions and done in consideration of
the specific loan being requested by the borrower. If a lender relies on a valuation addressed
to another party, in most legal jurisdictions, the lender will not have any redress against the
valuer in case of negligence.
In many countries, market value is interpreted as being on a willing buyer/willing seller
basis. The asset being valued is advertised for sale for a number of months. Clearly these
conditions would not apply in the event of a forced sale when the collateral is realized. The
difference between forced value and "market value" can be considerable. In addition, a
lender can become liable to many extra costs (e.g., security, maintenance, repairs, etc.) during
the process of realizing collateral. This should be kept in mind when the collateral valuation
is based on market price.
The value of a guarantee is primarily determined by the financial strength of the guarantor
and the lenders assessment of their continuing ability to repay the borrower's debt during the
term of exposure.
Structure risk on the guarantee claim is also relevant for two reasons:

In some countries, legally enforcing guarantees is not possible in certain situations,


such as where there is no commercial benefit to the guarantor, for example.

The weaker the guarantor is, the greater the risk of subordination and dilution. This is
especially true if the guarantee is unsecured, and the guarantor has issued other
guarantees and given collateral to other parties.

Lenders have specific policies that determine coverage rates on different types of
collateral, and what overall loan-to-value ratios should be. The coverage rate is
described as the percent of the collateral value. It determines the maximum exposure
that a lender is willing to take.

Learn more about Loan-To-Value Ratios


The loan-to-value (LTV) ratio compares the amount of a loan with the value of the collateral
that secures it. Low LTVs are better than high LTVs. This is because they indicate that the
loan is backed by an asset of relatively higher value. LTV is calculated as:
Loan Amount Collateral Value
= Loan-to-Value Ratio (expressed as a Percentage)
For example, if the loan amount is 100,000, and the collateral value is 125,000, the equation
would be:
100,000 125,000
= 0.80 (expressed as 80%)
LTV is important because it measures the cushion between the loan amount and collateral
valuations that may not be so exact. These values often fluctuate with market forces, and are
therefore usually only estimates. In some cases, as with accounts receivable (trade debtors),
the actual aggregate volume of accounts being taken as collateral may be measurable to the
penny. However, it is rare for all of the business's receivables to be collected. Therefore, even
the true value of this type of collateral is never precisely known.
If the LTV improves beyond the agreed level, a client will often request a release of some of
the security. If the asset value improvement is due to volatile conditions or an asset bubble
(e.g., stock exchange bull market), the lender takes a risk if collateral is released. The cushion

is smaller. The value of the remaining collateral may just as easily reduce in value after an
erratic increase. Obtaining additional collateral from a client is more difficult than releasing
existing collateral.
When relying on an LTV, the lender must be clear on two key issues:

Does the regularity of monitoring the LTV match the potential volatility in the asset
value?

What action is the lender entitled to take if the LTV is breached?

There are three likely actions to take:

Call default (only likely in high risk or recovery situations).

Give a period of time to provide additional or acceptable collateral before calling


default.

Restrict further lending if the LTV relates to a revolving facility.

Examples of LTV ratios are listed in the table below. Next to the LTV ratio is an explanation
of the maintenance usually required to ensure the LTV is not being eroded. These standards
are set by institutions to protect the lender from undue risk. They also reflect the ease with
which the collateral can be realized in the local legal system. Exceptions to these rules
typically require approval by upper management, regardless of the loan amount.
You should check your institutions LTV policy to ensure that you are abiding by the rules
governing your performance.
Note: The LTV ratios quoted below are illustrative only. The lender needs to make an
assessment depending on local market conditions, quality of the asset and the probability of
default of the borrower. The potential collateral maintenance outlines a range of possibilities.
The amount of resources the lender decides to spend on this will depend on the level of risk
and the importance of the collateral to the lender.
Collateral
Type

Collateral Value

LTV Ratio

Potential Collateral
Maintenance

Financial accounts value minus


all accounts past due 30 or more
days
Accounts must be true receivables
Aging of accounts
Accounts
arising from the normal sales of
receivable reviewed at
Receivable
60%
the company to non-related
least quarterly by the
(Trade Debtors)
parties, and should not include
loan officer or auditor
disputed amounts. Maximum
exposure for sole debtors will be
set to reduce concentration risk.
Inventory
Lower of book or market value. 0% to 25%,
Annual confirmation of
(Stock)
depending on
physical inventory;
Inventory must be easily
whether finished quarterly breakdown
identified, easily repossessed,
goods, raw
between raw materials,
readily marketable as is and not materials or work work in process, and
subject to radical market changes in process
finished goods

and claims from suppliers.

Industry type is
also a factor.

New: Invoice purchase price


Machinery and minus delivery and installation New: 80%
Non-mobile
Equipment
Used: Lower of replacement cost Used: 50%
or market value

Mobile
Equipment and
Heavy Trucks

New: Heavy truck loan value (if


applicable), or invoice purchase
New: 90%
price minus delivery
Used: Lower of replacement cost
or market value

Used: 75%

Amortizing: Visual
inspection at least
annually by the loan
officer
Non-amortizing: Annual
appraisal by an industry
expert
Amortizing: Visual
inspection at least
annually by the loan
officer
Non-amortizing: Annual
appraisal by an industry
expert

New: 100% of
dealer price
Location, usage and
Used (less than 3
general condition of the
years old): 80%
vehicle reviewed at least
of listed value
Used: Red Book loan value
annually by the loan
officer
Used (3 years or
older): 70% of
listed value
Reviewed at least
Cash Surrender 100% of confirmed insurance
quarterly by the loan
Value of Life company value, minus prior
90%
officer, including update
Insurance
charges
on premium payments
Reviewed at least
Savings
90% (assuming
100% of the face amount
annually by the loan
Investments
same currency)
officer
Reviewed regularly by
the loan officer,
Range from 0%
Shares
Market value
depending on market
to 70%
volatility and the level of
the LTV
Reviewed regularly by
Up to 90% of
The realizable value from sale of
the loan officer,
value, depending
Bonds
government and semi-government
depending on market
on credit rating
securities
volatility and the level of
and liquidity
the LTV
Commercial
Lower of cost or appraisal value 70%
Reviewed when the loan
Real Estate and
is being considered,
Construction
usually by an
Light Trucks
and
Automobiles

New: Market value

independent valuer

Single Family
Lower of cost or valuation value 80%
Residence

For construction
projects, regular visits
by professional advisers
or engineers is required
Reviewed when the loan
is being considered,
usually by an
independent valuer

If the lender does not take collateral, the deal structure must prevent other
stakeholders from taking collateral. Otherwise, the lender will be subordinated.

What You Need to Do


Collateral
Collateral is an important deal structure component. It protects the lender from structure risk,
subordination, and dilution risk in particular. Therefore, you should be aware of some
important issues:

Check that the risk analysis demonstrates that the loan can be serviced or repaid from
future cash flows.

Be clear about which of the borrowers assets and cash flows are included in, or
excluded from, the collateral pool.

Assess the subordination or dilution risk on the assets and cash flows outside the
collateral pool. In particular, determine what collateral other stakeholders have, and
whether the deal structure includes covenants preventing the borrower from giving
collateral or disposing of assets.

Determine the quality of any collateral valuation on which the lender is relying. In particular,
consider several key issues:

What were the lenders instructions and the quality of the valuer?

Is the valuation based on forced or market value?

Will any large costs of realization need to be deducted?

What is the time scale required to realize the valuation? For example, in some
developing legal systems, it can take more than five years to complete all legal
proceedings to realize a mortgage over property.

Check that the collateral has been legally perfected. (Note: If there is more than one legal
jurisdiction, the process will be complex.) In particular, consider some specific legal issues:

All legal documents and local registrations should have been completed in the
required time frame.

Acknowledgements from third parties, where required, have been received.

Insurance arrangements are in place.

Make sure that monitoring procedures are in place to check regularly the insurance, physical
control and condition of the secured assets. This includes personal visits, review of
maintenance records or site visits by professional advisors.
Guarantees
Guarantees are an important deal structure component because they add another legal
counterparty to the deal structure. Therefore, you should carefully consider several issues
regarding guarantees:

Establish the financial strength of the guarantor, and assess the impact of a guarantee
claim on the leverage and debt service capacity of the guarantor.

Confirm with legal experts that the guarantee is enforceable. This is especially
difficult in many legal jurisdictions where the guarantor does not receive a
commercial benefit, or is in a different country than the beneficiary of the guarantee.

Be clear about what conditions are required for the guarantee to be called.

Assess the subordination and dilution risk on the guarantee claim. In particular,
determine whether the guarantor has issued other guarantees or given collateral to
other parties.

Check that monitoring procedures are in place to monitor the final health of the
guarantor. Regularly notify the guarantor that the guarantee is still in force.

Consider all the above in light of your institutions policies. Follow the basic collateral and
guarantee rules and related procedures of your institution. Make sure that collateral and
guarantees are reliable deal structure components that will protect from increasing LGD in
the stress scenario.

How This is Useful


A lender needs protection against two major issues:

Deteriorating PD in the future, due to business and financial risks

Increasing LGD, as a result of structure risk

Collateral is an important deal structure component that protects against the risk of increasing
LGD, especially in situations where the PD is deteriorating or is uncertain because of poor
quality information. Collateral can help in several ways:

It increases the negotiating power of the lender with other stakeholders and with the
borrower in a stress scenario. This is especially helpful if the stakeholders do not react
positively and with cooperation when the business faces problems and cash flow is
under pressure.

It prevents important assets from being sold and the cash being diverted away from
repaying the lender. This should not occur without the lenders permission, even if
intended to meet a deficit in the cash flow.

It realizes an eventual repayment source, depending on the value and liquidity of the
asset in a stress scenario and the maturity of the legal system. Assets whose value is
closely linked to the success of the business (e.g., intangible assets and inventory) are
likely to have little value in a stress scenario. Other assets whose value is determined
by market forces independent of the business (e.g., shares or property commodities)
are more likely to hold their value if the business is in a downturn. However, that may
not be the case when the economy or industry sector as a whole is in a downturn.

Guarantees spread the risk for the lender. This is because the PD of both the borrower and
guarantor need to deteriorate before repayment is at risk. When the guarantee is also secured,
it gives the lender additional protection against increasing LGD from the guarantor.

Questions You Should Ask


Asking proper questions is a key element in mitigating credit risk. The questions listed below
should be taken into account when considering collateral and guarantees for loans:

Has a good risk analysis been completed? Is it clear that the collateral is an
enhancement to the credit and not the reason for the credit?

What are the businesss critical assets, cash flows and contracts?
o

Which are included in our collateral pool?

Which are collateral for other stakeholders?

What protection does the deal structure have to prevent unsecured assets from
being given as collateral to third parties in the future?

Can the collateral be specifically identified and designated?

Can clear title to the proposed collateral be obtained?

Has proper documentation been completed to give the lender a formal collateral
interest in the assets?

Have acknowledgements been received from relevant parties, such as debtors and
insurance companies?

How will you monitor the collateral over the life of the loan to ensure it is locatable,
continues to be insured, meets agreed LTV ratios and is in good condition?

Are there any prior charges or claims on the collateral that would prevent you from
taking a first position?

What were the instructions to the valuer? Is the valuation addressed to the lender? Is it
based on a forced sale value or market value?

Will significant costs be deducted from the realized proceeds?

Does the guarantor have the legal power to give a guarantee?

What would be the impact of a guarantee claim on the debt service capacity and
leverage of the guarantor?

Is the guarantee easily legally enforceable? Under what conditions can the guarantee
be called?

If the guarantee is unsecured, has the guarantor given collateral to other parties that
would subordinate an unsecured guarantee claim?

Knowledge Check
Question 1
The collaterals enhancement to the loan depends mainly on its value, as well as on the
cushion between its value and which factor?

Advance ratio

Appraised value

Loan amount

Loan loss reserve

Collateral is generally taken to lower the probability of a loan loss. A great deal of the
enhancement provided by collateral on a loan is dependent upon the value of the collateral
and the difference between that value and the amount of the loan. The greater the cushion, the
greater the likelihood that the assets liquidated will cover unpaid principal and interest on the
loan
Question 2
Collateral on a loan can enhance the credit so that a marginal loan becomes a good loan.

True

False

Collateral does not make a marginal loan a good loan, and should not be considered a primary
source of repayment.
Question 3
Which type of collateral is normally considered acceptable for a loan to a business?

Accounts receivable (trade debtors)

Restricted shares

Interests in performance contracts

Loans to shareholders

Some acceptable collateral types include accounts receivable (trade debtors), inventory
(stock), machinery and equipment, commercial real estate, single-family residence, shares
and bonds, and savings instruments.
Question 4
A guarantee is an agreement by a third party to repay a loan if the borrower fails to do so.

True

False

A guarantee is an agreement with a third party to repay a loan if the borrower fails to do so.
Question 5
A characteristic of a limited guarantee is that a specific amount is stated in the legal
agreement supporting the guarantee

True

False

A limited guarantee specifies in the guarantee agreement the amount guaranteed. An


unlimited guarantee does not.
Question 6
What is the difference between an unsecured guarantee and a secured guarantee?

Secured guarantee is limited, whereas an unsecured guarantee is not

Secured guarantee is unlimited, whereas an unsecured guarantee is not.

Secured guarantee has collateral, whereas an unsecured guarantee does not

Secured guarantee has no collateral, whereas an unsecured guarantee does

Guarantees reduce LGD by including another legal counterparty in the deal structure. They
give the lender an unsecured claim to the guarantors assets. This can be improved by taking
collateral from the guarantor to convert an unsecured guarantee to a secured guarantee.
Question 7
Generally speaking, how should you proceed if a loan cannot be repaid from cash generated
from normal operations?

Obtain unlimited personal guarantees from the owners.

Obtain unlimited corporate guarantees from the parent company

Obtain collateral security in an amount equal to the loan size

Do not proceed with the loan.

Generally, a loan that cannot be repaid from cash generated from normal operations should
not be made, regardless of the quality or amount of collateral.
Question 8
What collateral type represents normal sales made and recorded, but not yet collected in
cash?

Accounts receivable

Inventory

Savings instruments

Intangible assets

Accounts receivables are normal sales made and recorded, but not yet collected in cash.
These accounts are expected to be liquid and not subject to dispute or performance risk. In
taking these fairly liquid assets as collateral, lenders frequently subtract all non-eligible
receivables. Non-eligible receivables are commonly defined as receivables over 30-60 days
old, related party receivables and receivables in dispute or with set off.
Question 9
What collateral type can generally have a higher LTV?

Accounts receivable

Inventory

Savings instruments

Intangible assets

For details, refer to the table in the Collateral section, specifically the row: Light Trucks and
Automobiles.
Question 10
What collateral type generally requires at least quarterly review?

Accounts receivable

Mobile equipment

New light trucks

Machinery

For details, refer to the table in the Collateral section, specifically the row: Accounts
Receivables (Trade Debtors).
2016 Moody's Analytics

Deal Structuring: 5.3


Covenants
Introduction
Setting and monitoring covenants can be a critical part of determining the effectiveness of a
deal structure. Covenants can help provide early warning signals of deteriorating probability
of default. They can also offer some protection from increasing loss given default and
exposure at default.
This lesson helps you assess the effectiveness of covenants in a deal structure. Two major
topics are discussed:

Various types of covenants and their purpose

Seven steps to consider when setting covenants

What You Need to Know


Covenants are conditions set in facility agreements that must either be achieved (affirmative
covenants) or not broken (negative covenants).
Failure to comply with the covenants leads to an event of default, which gives the lender the
legal right to cancel or accelerate the credit facility (subject to local legal environment). The
event of default can occur immediately, or it can take place after a set period of time given to
the borrower to resolve the situation, during the remedy period, if the situation is not
resolved.
There are five broad categories of covenants:

Event Covenants
Event covenants trigger default on the occurrence or non-occurrence of a critical
event, usually of high importance to the business operations. Examples include loss of
a license or failure to complete a contract on time.

Restrictive Covenants
Restrictive covenants prevent actions from being taken that would increase risk for
the lender. Examples include no payment of dividends or no further debt and
limitations on capital expenditure clauses.

Non-financial Covenants
Non-financial covenants are designed to control the risk without setting financial
parameters. Examples include a negative pledge triggering default if collateral is
given, or a cross default, which occurs if the borrower defaults with a third party.

Financial Covenants
Financial covenants trigger default when financial ratios based on the balance sheet,
income statements or cash flow are not met.

Information Undertakings
Information undertakings traditionally require the client to provide financial
information on a regular and timely basis during the tenor of the credit exposure or at
the specific request of the lender. Information requirements can be made effective and
dynamic by linking the required information to the clients business and the lenders
monitoring plan. Default is triggered if the information is not given upon request or
within the agreed time frame.

In general, the stronger the borrower, the fewer and less stringent the loan covenants will be
in the deal structure.
A strong, low-risk borrower may agree to a covenant lite deal structure requiring regular
financial information (semi-annual or annual) and an understanding not to give collateral to
third parties. That means that the lender needs to rely mainly on dynamic internal monitoring,
rather than the deal structure, to identify a change in risk profile

A high-risk borrower, on the other hand, may need to provide a variety of strong covenants
and very regular information (monthly or quarterly) on the business operations and financial
budgets and reports.
A high-quality covenant structure does not guarantee repayment. A lender's analysis of the
expected outlook should show that the debt can be serviced or repaid on time. Covenants, if
effective, provide additional protection in two areas:

If the expected outlook is not being achieved, covenants provide an early warning
sign (EWS).

When probability of default deteriorates, covenants prevent structure risk from


causing loss given default (LGD) to increase.

Covenants give the lender more time to discuss corrective action with the client, and prevent
other stakeholders from improving their debt priority position. There is no guarantee,
however, that at the time of covenant breach cash flow will be available to repay the debt.
Lenders need to consider a seven-step approach when designing and assessing the
effectiveness of covenants:
Step 1. Identify the critical risk factors.
A good deal structure is based on high-quality risk analysis. To select which covenants are
most appropriate, the lender needs to identify and prioritize two types of factors:

Key factors that indicate a deteriorating probability of default (PD), such as an


increase in business and financial risk, or a decrease in business or financial natural
mitigants

Critical structure factors that lead to an increase in LGD

This provides a benchmark for the lender to assess to what extent the covenants selected will
provide an EWS, and protect against structure risk.
Step 2. Determine who the covenants will apply to.
Covenants may apply to the legal counterparty (borrower or guarantor) or the credit base
(groups or shareholders) or both. This needs to be clearly specified. There is a difference in
the protection, depending on whom the covenant is set. For example, if a cross default
covenant is set on the borrower, and another member of the group goes into default, the
lender cannot take action because a covenant breach has not occurred. However, if the cross
default clause is taken on a group basis, the lender has the power to call default because a
covenant has been breached.
Step 3. Assess the definitions of the covenants.
In a stress scenario, the borrower may delay breaching the covenants as long as possible. One
potential escape route is a vague or imprecise definition of the covenant. For example, if a
maximum debt clause defines debt as only bank borrowing, the borrower can raise debt from
other parties such as leasing companies or bonds. This makes the maximum debt clause
ineffective.

Developed loan markets have a standard market definition of covenants that has been agreed
to by market participants such as the Loan Market Association (LMA) and the Loan
Syndications and Trading Association (LSTA). This provides a benchmark and represents the
compromise negotiated between representatives of lenders and borrowers. From the lenders
perspective, however, these definitions could be tighter, especially in a high-risk situation like
a problem loan. Unless the lender has strong negotiating power, the shortcomings in the
market definitions need to be compensated by internal monitoring.
Step 4. Link the covenants to projections.
Financial covenants should provide a corridor of financial parameters within which the
business should perform. The lender relies on projections. Therefore, the covenants should be
set at a level that allows for an agreed variance from managements projections. For example,
a variance of 10% to 20% could be set, depending on the level of optimism in the projections
and the level of risk.
If projections are not a critical part of the lending decision, the financial covenants should be
based on historical financial performance.
Step 5. Determine when the covenants will be triggered (or bite).
One role of covenants is to provide an EWS. This includes an assessment of the financial
condition of the business when the covenant is breached. Will the business still be able to
generate some cash flow for partial repayment? Or are the covenants set so loosely that they
have no bite until the business is in a very serious position. If that is the case, the lender
needs to rely on internal monitoring to meet the shortfall in protection from the deal structure.
The effectiveness of covenants can vary. Financial covenants are commonly listed in order
from most effective to least effective:

Restrictive or event-based covenants (most effective)


They state specific actions or events that must or must not occur.

Cash flow covenants


They highlight when the debt service capacity is not meeting the expected outlook.

Income statement covenants


They eventually reflect a change in the cost and revenues from changes in the
business operations. However, they do not accurately reflect changes in the cash flow.

Balance sheet covenants (least effective)


They only measure one point in time, and all financial data can be more easily
manipulated by creative accounting.

For example, a lender wanting to control the level of debt has a potential range of options in
terms of effectiveness:

Restrictive or event:
No more or maximum level of debt clause covenants

Cash flow:
Debt service capacity covenants

Income statement:
Interest coverage or Debt or EBITDA covenants

Balance Sheet:
Leverage covenants, based on debt or total liabilities figures from the balance sheet

The weaker the option agreed to, the more reliance is placed on internal monitoring to
provide an EWS. Otherwise, the client and the lender have limited options to take corrective
action.
Step 6. Identify actions to take when a covenant is breached.
The lender should assess all available options when the covenants are triggered and
repayment is no longer likely to follow the original plan. Options available to the lender and
client may include:

An independent alternative source of repayment, such as a guarantee or equity


injection

Restructuring or improving the flexibility of the business operations to generate more


cash flow from reduced costs, capital expenditures and working capital requirements

Above all, given that the situation is uncertain, the lender needs to be in a strong negotiating
position with third parties and with the client, if agreement for remedial action is not likely. A
strong negotiating position is possible only under certain conditions:

The covenants can be easily legally enforced

The lender can call default, if needed

The lender is not subordinated to other stakeholders

Therefore, the effectiveness of covenants in the deal structure is questionable where the local
legal environment does not allow covenant breaches to be easily enforced, or if the deal
structure provides little protection against structure risk.
Step 7. Examine the quality of compliance.
The covenant structure sets out the negotiated expected outlook with the client. It is critical
for the lender to know as soon as possible when the client is not compliant with the deal
structure. This means that the negotiated outlook has changed. If the covenants are loose, or
the compliance requirements from the client are weak, the covenant package is ineffective.
There are critical issues to consider in terms of compliance:

Is compliance confirmation being received at the lenders request, monthly, quarterly


or annually?

How detailed are the compliance statements required by the deal structure? Do they
provide enough detail to allow the lender to substantiate the compliance statements
made by the client?

Is it possible for the lender to insist on an independent review of compliance in a


stress scenario?

How stringent are the lenders internal controls to ensure that compliance statements
are received on time and in the required format?

Can internal monitoring systems compensate effectively for compliance and deal
structure weaknesses?

Is the cost to the lender of the compliance and monitoring justified, when compared to
the pricing of the loan?

This seven-step approach should be applied in line with the internal policy of the lender. Most
financial institutions have policies on the type of covenants to be included in deal structures
for different types of loans. They also set guidelines on definition issues.
The approach not only helps assess the effectiveness of individual covenants, but also the
combined package of covenants. Some covenants in the deal structure may be strong enough
to compensate for weaker covenants.
The lenders assessment of the effectiveness of the whole covenant package is determined by
how well the stronger covenants compensate, or fail to compensate, for the inadequacies of
the weaker covenants.

What You Need to Do


When setting covenants, consider in detail the seven-step approach in the context of the
clients negotiating power. The clients negotiating power is determined by a number of
factors:

Financial strength

Covenants in existing or past credit agreements

Local market practice

Intensity of competition between debt providers

Applying the seven-step approach requires you completion of several detailed actions. Each
action is described below according to each step.
Step 1. Identify the critical risk factors.
Use the Credit Risk Grid discussed in previous lessons, to prioritize the existing business,
financial and structure factors. Create a range of covenants to protect and control the potential
negative impact of these factors on future PD and LGD. The various covenants available
include event, restrictive, non-financial, financial and information undertakings.
Step 2. Determine who the covenants will apply to.

Draw a group legal structure organizational chart. Decide which other legal counterparties
and credit bases, in addition to the borrower, should be covered by the covenants. Other legal
counterparties will most likely include guarantors. Other credit bases will most likely include
other group companies and shareholders. Then decide on the mix of unconsolidated or
standalone covenants and consolidated or group covenants.
Step 3. Assess the definitions of the covenants.
For financial covenants, examine the most recent financial statements. Look for critical
accounting policies and potential issues of creative accounting, such as misuse of asset
revaluation and capitalization of costs.
Check that the covenant definitions do not allow the client to use creative accounting as an
escape route to avoid covenant breach. Look for ambiguous definitions that can be used to
gain an advantage.
Non-financial covenants can also use weak definitions as an escape route. Look for weak
definitions such as the two examples listed below:

High thresholds
For example, cross default only triggers when a debt of a very large size goes into
default.

Exceptions
For example, a negative pledge covenant may restrict a borrower in the airline
industry from providing collateral from all assets except aircraft, which in reality
accounts for 70% of total assets.

Step 4. Link the covenants to projections.


Check that the stress case projections breach the financial covenants. If not, either the stress
case is not stringent enough or the covenants are set at too loose a level. If the covenants are
loose, the lender needs to monitor the covenant internally at a tighter level to provide an
earlier warning signal. For example, assume that a Debt or EBITDA covenant is set too loose
at 4.00 as a result of the clients strong negotiating power. However, the lender feels the
correct level should be 3.00. The lender then chooses to set the covenant at 3.00 as the
internal trigger. This means that when the internal trigger is broken, it will indicate an EWS
even though the covenant has not yet been breached.
If there are no projections, check by what percentage the historical performance needs to
change before covenants are breached.
Step 5. Determine when the covenants will be triggered (or bite).
Run an estimate of the situation when the covenant is breached and make a risk assessment.
For example, if an event covenant would be breached by a loss of license, assess what the
impact would be on the clients cash flow.
For financial covenants, calculate key parameters such as the likely increase in debt,
reduction in equity, profit and cash flow if the covenants were breached.

Once you have forecast the approximate situation, assess whether the business will be in a
strong enough position to take remedial action. If not, you may need to set earlier warning
signals from internal monitoring.
Step 6. Identify actions to take when a covenants is breached.
Assess the relative importance of the covenant structure in relation to the other deal structure
components. Establish to what extent the deal structure includes flexibility and control:

Is there an independent alternative repayment source, such as a guarantee, injection of


equity or highly liquid enforceable collateral? If not, you rely on the clients
cooperation, and on the flexibility of the business to conserve cash flow on capital
expenditure and reduce costs.

Do you have control over critical assets, cash flows and contracts? Control provides
strong negotiating power over an uncooperative client, and avoids being subordinated
to other stakeholders. Without control over key assets and cash flows, you have little
influence with an uncooperative client, or with other stakeholders who likely have a
superior debt priority position in claiming funds from the business.

Step 7. Examine the quality of compliance.


Assess to what extent the frequency and detail of the compliance reports provide an EWS and
allow a detailed calculation of the financial covenants.
Make sure that internal monitoring will immediately identify compliance procedures that are
not followed, or signal a covenant breach.
On completion of these seven steps, check that the covenant package is in line with internal
lending policies. Then assess if the combined effectiveness of the whole covenant package
can provide an EWS for deteriorating PD and protection against increasing LGD.
If the covenant package is less than ideal, clearly show how this is compensated by the other
deal structure components, such as collateral and information undertakings, or by dynamic
internal monitoring.

How This is Useful


The selection, definition and level of covenants are important for several reasons:

Covenants are a critical part of deal structure design and negotiations. The client
wants to retain control over the business and may regard strong covenants as placing
unacceptable limitations on that control.

Covenants are an essential part of monitoring against the most likely outlook.

Covenants are a major tool for the lender in managing unexpected changes in the risk
profile.

Adopting the seven-step approach provides flexibility and control:

Create options and suggest alternatives that may be more acceptable to the client,
while still retaining some protection.

Assess the effectiveness of the covenant package, and how it combines with other
deal structure components and internal monitoring to provide an EWS of increased
risk, and protection from subordination and dilution.

Undertake professional credit risk management by being better protected to manage


future uncertainty relating to the client and the transaction.

Questions You Should Ask


The questions listed below are based on the sevenStep approach and arranged accordingly. They assume that you have already undertaken an
in-depth analysis of the risk factors and the negotiating power of the client. In particular, you
should be aware of two main issues:

Have the borrower risk profile or market conditions changed significantly (positively
or negatively)? If yes, should you or the client seek different terms from the existing
covenant package?

Does your competitive position allow you to seek a tighter covenant package? Or
does it force you to rely on other deal structure components or internal monitoring to
provide the protection needed?

Step 1. Identify the critical risk factors.

What type of covenants will give the best protection against the most important
business, financial and structure factors? Is the ideal covenant type event, restrictive,
non-financial, financial or information undertakings?

What is the most realistic range of covenants to aim for in line with your current
negotiating power, internal policies and market conditions?

Step 2. Determine who the covenants will apply to.

Are the covenants most applicable to the borrower, guarantor, group, shareholders or
other legal counterparties and credit bases?

What is the difference in protection provided by unconsolidated or standalone


covenants and consolidated or group covenants?

Step 3. Assess the definitions of the covenants.

Are there standard local market definitions? It is possible to tighten the definition? Is
reliance placed on internal monitoring to compensate for the limitations of covenants?

Are standard lender definitions available in the institution that can be used uniformly?

What are the critical accounting policies in the clients financial statements? Does the
definition of financial terms in the financial covenants prevent these polices from
being manipulated to avoid a covenant breach?

Are there any significant exceptions, qualifications or thresholds in the non-financial


covenant definitions?

Step 4. Link the covenants to projections.

How much can the management projections be allowed to underperform before PD


deteriorates?

Are the financial covenants set at that level?

If not, will the financial covenants be monitored internally at a tighter level than in the
documentation, to provide an earlier warning signal?

Are the covenants breached under the stress case scenario?

If there are no projections, do the financial covenant levels give an EWS of variance
from historic performance, or should they be monitored at a tighter level?

Step 5. Determine when the covenants will be triggered (or bite).


When the covenants are breached:

How much will the performance of the business have declined?

Will it still be sustainable?

How much is debt likely to have increased?

Will there be enough cash flow to at least pay for interest, to prevent debt from
increasing further?

Will the capital and leverage of the business sufficiently allow time for remedial
work?

Step 6. Identify actions to take when a covenant is breached.

Does the deal structure provide alternative independent sources of repayment such as
guarantees or equity injections?

What would be the scope of the business to conserve cash by delaying capital
expenditures, or by reducing costs and working capital requirements?

What control would you have of the key assets and cash flows, compared to other
current and future stakeholders?

How easy would it be to legally enforce default, should the client not be cooperative,
or if unreasonable behavior is threatened by a third party?

Step 7. Examine the quality of compliance.

Are the compliance reports from the client frequent enough for the level of risk?

Will the compliance certificates show detailed covenant calculations?

Do you have the right to call for additional information on a regular basis?

Is it clear internally who is responsible for monitoring the compliance, and how alerts
for non-compliance will be generated?

Summary

What is the overall strength of protection from the whole covenant package?

Has it been integrated into the deal structure and internal monitoring to provide the
best possible EWS, and protection from structure in the current market conditions?

Knowledge Check
Question 1
Limitations on capital expenditure clauses are an example of which type of covenant?

Event

Restrictive

Non-financial

Financial

Restrictive covenants prevent actions that would increase risk for the lender. Examples of
restrictive covenants include clauses such as no more debt and limitations on capital
expenditures.
Question 2
A negative pledge would be classified as what type of covenant?

Event

Restrictive

Non-financial

Financial

Non-financial covenants are designed to control risk without setting financial parameters.
Examples include a negative pledge triggering default, if collateral is given, and cross default,
if the borrower defaults with a third party.
Question 3
If a company fails to complete a contract on time, what type of covenant would most likely
be in default?

Event

Restrictive

Non-financial

Financial

Event covenants trigger default on the occurrence or non-occurrence of a critical event,


usually of high importance to the business operations. Examples include loss of a license or
failure to complete a contract on time.
Question 4

If a company fails to complete a contract on time, what type of covenant would most likely
be in default?

Event/Restrictive

Cash Flow

Income Statement

Balance Sheet

In terms of effectiveness, the order of financial covenants, from most effective to least
effective, is generally restrictive or event based covenants, cash flow covenants, income
statement covenants and balance sheet
Question 5
Adopting the seven-step approach to design and assess the effectiveness of covenants benefits
the lender. Which is not a benefit of this approach?

Creates options and suggests alternatives that may be more acceptable to the client,
and still offer the lender some protection

Assesses the effectiveness of the covenant package, and how this combines with other
deal structure components and internal monitoring, to provide an EWS of inreased
risk and protection from subordination and dilution

Undertake professional credit risk management by being better protected to manage


future uncertainty relating to the client and the transaction

Guarantees that the lender will not be subject to credit losses, if the borrower defaults
on principal or interest repayment

Adopting the seven-step approach provides the lender with various choices for flexibility and
control:

Create options and suggest alternatives that may be more acceptable to the client, and
still offer the lender some protection.

Assess the effectiveness of the covenant package, and how this combines with other
deal structure components and internal monitoring, to provide an EWS of increased
risk and protection from subordination and dilution.

Undertake professional credit risk management by being better protected to manage


future uncertainty relating to the client and the transaction.

Question 6
The existence of covenants on a loan can enhance the credit so that a marginal loan becomes
good.

True

False

Covenants do not make a marginal loan good and should not be considered as a secondary
source of repayment. They do not guarantee that at the time of covenant breach, cash or cash
flow will be available to repay the debt.
2016 Moody's Analytics

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