Tony Featherstone advises directors of smaller companies to keep a watchful eye on the company’s debt position, loan covenants, the strength of its banking relationships and its prospects for refinance.

    The biggest risk for many small companies is not deteriorating trading conditions, staff shortages or myriad other operational problems. Rather, it is the surety of their banking relationships. Nothing kills a company faster than when the bank withdraws funding support because a loan covenant is breached.

    Even large companies struggle with this risk. Fortescue Metals Group’s valuation tumbled in September after media reports suggested it risked breaching its debt covenants because of the lower iron ore price. Fortescue quickly secured an additional US$4.5 billion credit facility, but the episode was a timely warning for directors to pay close attention to debt covenant terms.

    Unlike Fortescue, small private companies cannot secure large slabs of debt at a moment’s notice or raise capital by issuing shares on the Australian Securities Exchange to stay compliant with debt covenants.

    They are at the mercy of their bank and its independent expert’s report and recommendations when the loan covenant, which is usually based around cash-flow metrics, is breached.

    With the economy likely to slow next year, more companies will breach loan covenants. Their executive teams and boards will sweat on whether the bank decides to let the business keep trading, change or sell it, or put it into administration. Some boards will wonder why they did not pay enough attention to loan covenants when debt was raised or monitor compliance closely enough.

    Much depends on whether the banks are more aggressive in calling in problem loans in 2013. They have done a better job in managing loans after the global financial crisis than they did during the waves of loan defaults in 1987, 1991 and 2001, and have been less hostile in calling in default loans.

    But one senses the banks’ patience could run thin in 2013 as they protect their own balance sheets and cut their losses on problem loans that are costly to manage and have been on the books for a long time.

    The message for directors of smaller organisations is clear: understand the company’s debt position, loan covenants, the strength of its banking relationship, and prospects for refinance as part of normal risk-management practice. Do not assume a long-standing, positive relationship with a bank lasts in perpetuity. It can quickly sour when loan covenants are breached and could come as a huge shock.

    Also, ensure there are early-warning processes that identify when the risk of breaching a covenant is increased, and understand how the bank would respond. Being proactive and working with the bank before the breach occurs is the best strategy, although it can be costly and raise unnecessary alarm bells with the bank if trading conditions improve and the risk of a breach recedes.

    This sounds like governance common sense, yet I wonder how many directors of small companies deeply understand their organisation’s loan covenants, or how many boards think about the strength of the banking relationship and monitor and test it.

    I suspect too many small company boards are lulled into a false sense of security by long-standing bank relationships and personal associations.

    I asked Slonim Consulting founder Neil Slonim about the rising threat of breaching loan covenants for small and mid-sized organisations.

    He worked at National Australia Bank for 25 years, was regional director of its Major Client Group, and left the bank in 2008 to consult to mid-sized corporates and larger family groups on their banking relationships. Their loans mostly range from $5 million to $100 million.

    Slonim says: "As we saw recently with Fortescue Metals, even a potential future covenant breach creates challenges for the borrower and the banks. In the current difficult banking environment, the risks associated with a covenant breach should be well understood by directors, CEOs, chief financial officers, accountants and auditors.

    "If your business is one of the many that has never breached a bank covenant, you should still ensure you understand the role they play in the banking relationship, what actions might flow from a breach and what can be done to minimise the likelihood and impact of a breach."

    Slonim says the company’s bargaining power tends to evaporate once a covenant is breached, or is about to be, and that the best time to negotiate with the bank on covenants is when the loan is being established.

    When negotiating, Slonim says companies should aim to:

    • Gain as much headroom in loan covenants as possible. In the current tough borrowing climate, getting the bank to agree on more headroom (on certain performance indicators) could be of far greater value than focusing on gaining debt at the lowest possible price.
    • Negotiate the inclusion of a remedy period before the bank can call a default based on a breach. This gives the company time to fix the problem before a breach becomes a default.
    • Make sure directors clearly understand the meaning and implications of covenant definitions. For instance, if your business is seasonal, it is critical to ensure that the covenants reflect this. One size does not fit all situations.

    Tony Featherstone is a former managing editor of BRW and Shares magazines.

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