What is Debt Compliance?

Alexa: 

Hey guys, welcome to the Treasury Update Podcast Coffee Break Session. The show where we cover foundational treasury topics and questions in about the same amount of time it takes you to drink your coffee. 

Alexa: 

Hi everyone. Welcome back to the Treasury Update Podcast Coffee Break Sessions. This is your host Alexa. And today I’m joined with Melody Hart, a senior consultant at Strategic Treasure. Welcome Melanie. Thank you for joining me today. 

Melody Hart: 

Hi Alexa. Thank you for having me. 

Alexa: 

So today, Melody and I are going to be talking about debt compliance. So I guess let’s get right to it. What is debt compliance? 

Melody Hart: 

Okay. Anytime you issue debt, typically your investors, the lenders, will want to have some security of some form. I don’t mean that necessarily you secure the loan. Some loans are secured, but they’re going to have criteria where they want to keep track of your financial condition. And those terms can be, they’re negotiated, but they can be pretty severe if you’re poor credit or they can be very loose if you’re not a poor credit. 

Melody Hart: 

So they usually have things that they call covenants. So there’s negative covenants and there’s positive covenants in the agreement. So positive covenants are things that you must do. It’s like achieve a certain threshold in certain financial ratios, ensure facilities and factories are in good working condition. Perform regular maintenance of capital assets, provide yearly audit and financial statements, ensure your practices are in accordance with GAP. It’d be typically things like that that you have to do, and you have to usually report it on a quarterly basis. 

Melody Hart: 

Negative covenants are things that you can’t do. And it’s typically things like you can’t borrow more debt, or if you issue debt, it can’t be more senior than the current debt. You can’t sell certain assets. You’re not allowed to enter into certain types of agreements or leases. Sometimes you’re not able to pay cash dividends over a certain amount. And you can’t enter into M and A. So these are things that could be, they aren’t necessarily all going to be in there, but they could be in there. And the lower the credit, of course, the more of them there will be. 

Alexa: 

Okay. So are these rules, if you will, apply to all companies or are they just public companies or just private companies? 

Melody Hart: 

No, they’d apply to all companies. 

Alexa: 

Okay. You kind of alluded to it, but a lot of these are rules that kind of go around different ratios. So what are compliance ratios? 

Melody Hart: 

Okay. Compliance ratios are negotiated ratios that are indicators to lenders of your financial strength. The threshold will be specified, for example, if it is not a single number that you must hit all the time, it’s more like a threshold, like not greater than three to one, something like that. If you fall outside the specified ratio, you would be in default of that agreement, which has pretty severe consequences in that you might not be able to borrow anymore as one consequence, or they could immediately accelerate repayment of the loan. 

Melody Hart: 

And usually if a loan gets in default, most loans have crossed default provisions, which means that it would then cause default of your other loans. So it’s a serious thing if you go into default. Common ratios, some of them would be like a debt to EBITDA. EBITDA is earnings before interest, tax depreciation and amortization. So debt EBITDA is one common one. Debt to EBITDA minus CapEx. There’s a fixed charge coverage, which is EBITDA divided by total debt service, plus CapEx, plus tax. There could be debt to equity, debt to assets. Interest coverage is a common one, which is EBIT, earnings before interest and tax divided by interest expense. That’s a common one. Those would be common ones. 

Melody Hart: 

It depends on the company, what they would do. Sometimes they have things about net worth. Depends entirely on what’s negotiated and what’s important to that company. 

Alexa: 

Okay. How would these companies handle other compliance items that you kind of mentioned at the beginning, that are not these specific ratios? Since I know the ratios, you can look at your balance sheet and kind of calculate them or. 

Melody Hart: 

It’s important actually to track the other types of compliance because they’re not ratios. I mean, you’re going to have to do the ratios. Your going to have to submit that for your compliance to the banks every quarter. but you don’t have to submit your buckets, what I call buckets to the bank every quarter, but you do need to track them because if anyone asks you better have the number. 

Melody Hart: 

Normally when the bank says no additional debt, as an example, you would take into account your company’s ongoing needs and you’d negotiate exceptions, because obviously you’re going to have to issue some debt sometime. So you would negotiate what I call buckets. You might negotiate meaning, I’m going to need 15 million of foreign debt. So as an exclusion, I can have up to 15 million foreign debt. Or I might know I want to do a securitization, say I want 150 million of securitization debt. So that would be another exception. Or I might need 20 million of capital leases. 

Melody Hart: 

And I might want to say, okay, refinancing of existing debt, which is a common one. You want to be able to refinance, which you already have out there without it counting against you. And you would typically also put in a catchall. It says any other type of debt, 50 million or something. So they’ll like buckets where you can place debt that you put into the bucket and it will be excluded from that and say, okay, it’s in my bucket. So I did not violate a covenant. I did not violate this negative covenant. 

Melody Hart: 

The numbers and the categories, depending on the company’s needs. You would negotiate these for each and every category of the negative covenants. And remember that each agreement has a different starting date as well. So let’s say I did a piece of debt in 2012, I did one in 2016, I’m doing one this year. Well your starting date for the debt, for instance, for refinancing existing debt, the starting date is what debt was in your 2012 agreement you can keep refinancing, but what you issued in 2014 will count as refinancing existing debt in 2012, but not in 2014. So as the agreement ages, the buckets get fuller. So you have to be very cautious on that. 

Melody Hart: 

So it’s important to track those. A default on one piece of debt usually results in, as I said, default in all your debt. So during recessions, when lenders may want to exit your debt, they will look back and determine if they think that you have broken any covenant, even accidentally. And that means not just your ratios, but these buckets. So it’s a leading practice to track those buckets. 

Alexa: 

Just to kind of keep on your buckets analogy, you don’t want any of your buckets to overflow. You kind of want to make sure everything’s balanced just in case something happens in the market or in case somebody comes knocking and asking for this information. How are companies handling these different compliances or these different buckets? 

Melody Hart: 

Yeah, it’s handled differently depending on the company. Some companies are more diligent than others. A large number of companies just do the ratios and other positive covenants and don’t really pay as much attention to the negative covenants of the buckets. If they’re buckets, they might look at it when they’re first going to issue something, but they don’t necessarily track it as closely as they should. That’s not best practice. 

Melody Hart: 

High investment grade companies don’t have to worry as much as they’ll have very few and very loose covenants. For non investment grade companies or low investment grade companies it is really important to track these cabinets. So for example, when I worked at a large automotive company at one point, we were not investment grade, in fact, we were very low credit quality. So we had private placements and asset backed revolvers in term loans and debt agreements all over the world. And my job was capital markets and creditor relations. 

Melody Hart: 

We developed an in-house program whereby people all over the world would have to send in requests to do transactions in the categories of the negative covenants. And we would comb through all relevant debt agreements across the world and locally at headquarters, and would determine whether the transaction was permissible. And if so, what buckets it affected. And if it wasn’t permissive, we’d see if it could be restructured a different way in order to fit into a bucket. And if not, we would have to say, no. We tracked all the buckets and ratios of all the agreements all across the globe in order to ensure we were compliant and would not default. And we would try to enable the business, finding how they could do it but still we had to track this. And each quarter we presented a complete compliance reporting to the risk committee. 

Melody Hart: 

That was obviously, most companies don’t have a program where they can do that, but that was how we handled it there. But a lot of companies may not track it as closely, but when times are bad, there are many instances where investors, the ones who are lenders, will try to seek to get out of an agreement by pointing out where they think you might have defaulted. 

Alexa: 

Or where your buckets are overflowing. 

Melody Hart: 

Right. 

Alexa: 

So I guess to recap on everything, debt compliance is going to be the terms or the negative and positive covenants on a debt agreement. And those are typically reported on a quarterly basis, which would be your compliance ratios or the negotiated ratios. And those ratios are typically a threshold, I think that’s what you said. 

Alexa: 

And then I think the main point that I’ve gotten from this is that it’s very important for your company or your industry to figure out the best way to balance your buckets. Because if you start spilling over, that’s when you can get into trouble with any of these debt instruments. 

Alexa: 

All right. Well, thank you for joining me today, Melody. I appreciate you speaking on the podcast and to all of our listeners, make sure you tune in every first and third Thursday of the month for a new coffee break session. And as always, we love hearing from you. So please send us an email with comments, questions, concerns, topics, anything like that to podcast@strategictreasure.com. Thanks again Melody. 

OUTRO: 

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