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On 26 March 2020, the Prudential Regulation Authority (the PRA) sent a 'Dear CEO' letter to banks and other authorised firms which, whilst acknowledging the importance of loan covenants in helping lenders manage their risk, urged firms to be pragmatic when it comes to breaches of covenants arising from the effects of Covid-19. 

But just how easy is it to be sensible when testing financial and other key loan covenants when they are almost impossible to meaningfully test due to a pandemic? Here we take a look at some of the problems that lenders and borrowers may need to consider.

Financial covenants

Broadly, financial covenants in a loan agreement test the value of a lender's security or the performance of the business servicing the loan. Covenants designed to test the value of a lender's security will be measured against an assessment of value on a given day, while performance covenants may look backward or forward over a period of time in order to try and assess whether a borrower's business is showing signs of stress.

As a result of the steps taken to combat the pandemic, many businesses have seen a severe and abrupt drop in income which will affect the ability of businesses to meet performance covenants.  There are also issues that arise in respect of value covenants.  As a result many businesses have had, or may find themselves shortly having, to request waivers from their lenders of some or, possibly, all of the financial covenants in their loan agreements.  Lenders need to work out how they are going to respond to those requests to reset loan covenants at a time when the end to the difficulties is not yet in sight, and they need to do so in a way that enables them to continue supporting customers without undermining the risk management afforded to them by those same covenants.

Debt service cover tests

Debt service cover tests typically look both backward and forward for a period of up to 12 months to assess whether a borrower is receiving sufficient income to be able to pay the amounts it owes to its lender(s) and in the current circumstances that may not be the case.  If the underlying loan is an interest only loan, then the covenant will be measuring whether the business has, and will be, generating enough income to cover interest and finance costs due, but if the loan is an amortising repayment loan, then the test will be adjusted to measure whether the business can repay principal as well as interest and other costs owed to the lender(s).

Cashflow cover tests

As with debt service cover tests, cashflow cover covenants assess the ability of the underlying business to generate sufficient income to service a borrower's loan obligations.  However, cashflow is determined by reference to a borrower's EBITDA (earnings before interest, tax, deductions and amortisation) and the Loan Market Association's recommended position is that 'Exceptional Items' are not deducted from earnings in the calculation of EBITDA. As businesses see a drop in income and increase in costs, lenders may be asked by borrowers to recognise costs incurred in response to Covid-19 (such as employee relocation, IT equipment funding, unfulfillable contract termination) as 'Exceptional Items'.    

The lockdown restrictions imposed in the UK and in many other places around the world have left many borrowers in a position where they either have no income at all or significantly less income than they would have expected for an as yet undetermined period. How then do you adjust a financial covenant now which may be being tested in 12 months time against a 3 or 6 month trading period in which no income was received? Will an interest payment or capital repayment holiday now cause problems in the future because debt service cover covenants are being tested at a time when the underlying business is just beginning to recover? How much Covid-19 latitude can you afford a borrower when being asked to recognise 'Exceptional Items' as part of the calculation of EBITDA and how, as a lender, can you separate defaults caused by deeper structural problems within a business from those that have occurred as a result of the pandemic? 

It is important to remember that no two loan agreements will contain identical financial covenants.  This means that borrowers are going to have to dust off their loan agreements and check the small print in order to work out how best to address current or future breaches of financial covenants and to see whether or not they have the right to take action to cure the actual or potential event of default. Lenders will then need to consider any resulting waiver requests and any supporting information provided to decide on an appropriate course of action. Unless a borrower was already in financial difficulty before the pandemic took hold, we expect most lenders to be prepared to agree a combination of short term measures to alleviate any immediate problems coupled with new requirements on borrowers to provide additional information and updated business plans as the lockdown restrictions ease and the situation begins to normalise.  

Loan to value tests

Loan to value (LTV) tests measure the amount that a business has borrowed as a percentage of the market value of the properties over which the lender has security.  Usually a LTV covenant test will be set so that, when tested, the amount borrowed will be between, for example, 55% and 70% of the market value of the properties as set out in the most recent valuation provided to or, obtained by, the lender.  Depending on the length and type of the loan, lenders will require updated valuations at anything from 12 month to 3 yearly intervals but they reserve the right to request a new valuation at any time when a default has or they believe may have occurred.

The lockdown restrictions mean it is more difficult for valuers to access properties in order to provide reliable valuations, so what happens if you want to test the value of your security?

Although the property market is open for business again we are yet to see whether prices will rise or fall as a consequence of the lockdown.  As a result lenders may still elect to postpone regular portfolio valuations and continuing to test against pre-pandemic valuations. As an alternative, they could obtain desktop valuations against which they can test but those valuations may be qualified because additional information is required and no matter what type of valuation is obtained it will almost certainly include a 'material uncertainty clause'..


Covid-19 has affected every business differently. There are some businesses that are already in or will very shortly be in default as a result of a financial covenant breach; for others those breaches may arise as the crisis continues and lockdown restrictions change and ultimately ease.  The difficulty for all lenders and borrowers is how to address or pre-empt those breaches in such a fluid situation.  It is clear that the PRA wants lenders to look carefully at the underlying business to establish whether or not the problems would have arisen anyway and to act accordingly, in which case most businesses should be looking to agree short term waivers of such breaches with a view to resetting the covenants when they have the information and certainty to be able to do so.  In the meantime, it is going to be critical to maintain an open and honest dialogue with lenders and to provide them with relevant information as and when appropriate.  Never have relationships with lenders and agents been so important.