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Financial Management and Analysis of Projects : 3. Preparing and Appraising Investment Project : 3.6. Loan Covenants
3.6.3. Capital Structure Covenants3.6.3.1. Introduction to Capital Structure Covenants3.6.3.1.1. ADB uses four capital structure covenants: (i) debt service-coverage ratio, (ii) debt-equity ratio, (iii) absolute debt limitation, and (iv) capital-adequacy ratio. These covenants shape the capital structure by limiting the debt that may be incurred in relation to annual cash flows, the amount of equity capital, or absolute annual amount. 3.6.3.1.2. The capital-adequacy ratio covenant seeks to ensure that the equity of a financial institution will at least be adequate to meet its losses. Some form of debt limitation covenant, usually either the debt service coverage or debt-equity ratio, should be used for projects involving revenue-earning entities. The debt limitation covenant complements an operating covenant to provide assurance that fixed debt service obligations will be met even when the broader financial objectives of the operating covenant are not. 3.6.3.1.3. Where an operating covenant is not appropriate, the debt limitation covenant serves as the main covenant promoting financial viability. Exceptions to the use of both types of covenant would be where an entity is financed predominantly through borrowing, and earnings may reasonably be expected always to be sufficient to meet debt service obligations; for example, where a public utility project, usually in the water supply or sewerage sector, funds virtually all of its capital requirements through borrowings and its financial performance is regulated by a breakeven covenant. 3.6.3.1.4. When dealing with entities that are likely to pay dividends, it may be advisable to use a dividend limitation covenant to complement a debt limitation covenant. 3.6.3.1.5. Capital structure covenants serve to assure the continued solvency and financial viability of revenue-earning enterprises by imposing prudent limits on their long-term borrowing. If an EA does not incur debt after entering into such a covenant, or refrains from further borrowing after a period of compliance with the covenant, even though the performance criteria agreed to in the covenant subsequently may not be complied with (for example if the debt service-coverage ratio falls below 1), the EA is not in default of the covenant until it again commences to incur debt. 3.6.3.1.6. The limits of a covenant should be set so as to enable debt service obligations to be met under adverse as well as normal business conditions, taking into account business and financial risks. 3.6.3.1.7. The distinction between debt and equity is not always clear. For instance, preference shares have many characteristics of debt while convertible notes might be treated as equity. Furthermore, derivatives and other financial instruments add layers of complexity. To this end, for the purposes of formulating covenants, a cautious approach should be taken by including any difficult-to-classify instruments in the definition of debt. 3.6.3.2. Short-Term Debt and Financing Leases in the Capital StructureShort Term Debt3.6.3.2.1. ADB's standard definition of the term "debt", as applied in the design of capital structure covenants, is any indebtedness of the borrower maturing by its terms more than 1 year after the date on which it is originally incurred. This limits the application of the covenant to what is usually referred to on a balance sheet as long-term debt, and it excludes short-term debt usually shown on a balance sheet as part of current liabilities-though current maturities of long-term debt are part of current liabilities, by definition they are part of the long-term "debt" covered by capital structure covenants. This exclusion is appropriate when short-term debt is incurred as a source of working capital, since any limitation on such uses that is considered necessary can be covered by a liquidity covenant (see section 3.6.4). However, if the current portion of long-term debt is included in the definition of debt for purposes of a capital structure covenant, it should still be retained as a current liability for purposes of a liquidity covenant. 3.6.3.2.2. Consideration should sometimes be given to the need to refine the definition of "debt" or to use a supplementary covenant to cover some short-term loans that are: (i) being continuously rolled over, or (ii) used as "bridging funds" pending receipt of the proceeds of sale of equity or long-term debt. In the former case, if the amounts involved are likely to be significant, they should be included within the definition of debt covered by the covenant or be covered by a complementary limitation on short-term debt. In the latter case, the need will depend on the judgment as to the likelihood and timing of the replacement by long-term debt or equity. When in doubt, the overall objective should be used as a guide; viz., if the borrower's recourse to long-term debt needs to be restrained, no alternative facility in the form of short-term debt should be admissible, unless suitably defined, categorized and counted in part, or in total, as long-term debt for purposes of the covenant. Financing Leases3.6.3.2.3. Some institutions use finance leases to acquire the use of assets; the final ownership of the asset being dependant upon the terms of the lease. 3.6.3.2.4. A finance lease effectively places all the risks upon the lessee, and therefore it is reasonable to interpret the existence of such a lease and its associated lease payments as debt and debt service respectively, for purposes of the capital structure of EAs with which ADB works. Therefore, where an EA has entered into, or proposes to enter into finance leasing agreements, the value of the lease and the annual lease payments should be included in the capital structure and the debt-servicing requirements of the agency for purposes of covenants in loan agreements. Restricting the Use of Loan Funds3.6.3.2.5. Capital structure covenants have the inherent limitations that although they are primarily intended to constrain the amounts of borrowing, they neither regulate the use to which any permissible borrowing can be put, nor ensure that existing debt will be serviced, if further borrowing is not incurred). Also, planning and implementation of new projects having substantial debt requirements sometimes delay the completion of ongoing projects, by preempting the use of scarce loan resources. If there is substantial concern that a revenue-earning entity is likely to embark on additional projects of questionable merit, a supporting covenant may be needed to restrict the enterprise to investments, which are economically justified and financially appropriate. Such limitations, however, are generally not needed or advisable, and should be employed only exceptionally and usually limited to the implementation period of the project. 3.6.3.3. Debt Service Coverage Covenant3.6.3.3.1. Models of debt service coverage covenants are provided in Knowledge Management (see sections 7.13.1 and 7.13.2). The two key issues to be decided in formulating the debt service ratio covenant are (i) whether to base it on historical or forecast earnings, and (ii) what particular ratio to require as the minimum acceptable coverage. A good rule to follow is to allow the enterprise reasonable flexibility in making financing arrangements without requiring ADB's frequent approval for new borrowings. This factor must be balanced against the need to maintain prudent limits on the enterprise's debt service obligations. Section 4.4.7.6 describes the application of this covenant. 3.6.3.3.2. As a general rule, the covenant should be on the historical earnings basis if it is expected that the test could be met on this basis for the reasonably foreseeable future, or that the need to seek ADB approval for an exception would occur no more frequently that about once every several years. 3.6.3.3.3. The forecast basis should be used when it is likely that during a year there would be many occasions for incurring debt obligations, which would otherwise require prior ADB approval. This is particularly relevant for an enterprise that has a large investment program containing many projects, with long implementation periods and a need to arrange many borrowings to finance the program. It may also be advisable to use the forecast basis in highly inflationary conditions to ensure that tariffs and rates are moved in concert with interest rates. 3.6.3.3.4. A ratio typically recommended for this covenant is 1.5, but it can vary from as low as 1.2 to as high as 2.0 or more depending on industry averages, or how stable or cyclical the earnings of the EA are judged to be. Where business risks are similar, the appropriate ratio would be lower when using historical earnings than with forecast earnings. However, it is essential that the financial analyst be prepared to justify the ratio recommended, particularly the excess requirement over 1.0. Any "mark-up" over 1.0 must be quantified in terms of the amount it is estimated to provide, and the proposed application of the funds (working capital, reserves, investment purposes, dividends, etc). It is not sufficient to either select a "comfortable" or noncontroversial figure, or to continue using a ratio already in a legal agreement for previous operations of the borrower. Section 4.4.7.6 describes the application of Version A (Historical orientation) and Version B (Forecast orientation) of the Debt Service Covenants. 3.6.3.3.5. Capital structure covenants have a limited use, in that they are not intended to perform as revenue-generating covenants. They serve only to restrict the borrowing capacity of EAs. The debt service coverage ratio covenant may be adapted to include a forecasting provision that would require an EA to institute mandatory adjustments to tariffs, or rates (if within its discretion, or to make the necessary applications for increases, if not). ADB staff should seek the advice of OGC before discussing with a borrower/EA the possible application of such a modified capital structure covenant. 3.6.3.4. Debt: Equity Ratio Covenant3.6.3.4.1. The debt:equity ratio covenant is simple to understand and administer, and is consistent with the need to maintain a sound capital structure without unduly restricting the entity's ability to make its own routine financing decisions. It is pertinent to note that for this form of covenant, debt need not be defined in the same way as for the debt service coverage covenant. For the latter, the definition applies to the entire amount of the long-term debt, and the applicable debt service obligations, as of the date of signing the contract for the debt. Section 4.4.7.7 describes the application of this covenant and a model is provided in Knowledge Management (section 7.13.3). 3.6.3.4.2. For the debt-equity ratio, the definition of debt may be framed in terms of debt outstanding. This provides the entity some flexibility in phasing additions to its equity capital to match the timing of expected drawdowns of debt. 3.6.3.4.3. Defining debt in terms of the amount outstanding is appropriate for the debt: equity ratio covenant only when it is deemed feasible for an enterprise to apply the test each time it intends to draw down debt and, when necessary, call on its shareholders for additional equity capital before the increase in debt outstanding. This is most likely to be the case for financial intermediaries, which can generally limit their commitments to lend funds to the availability of resources in hand. Application of the drawdown concept is likely to be inappropriate in other sectors where use of borrowed funds cannot readily be interrupted if there is a failure to meet a debt limitation test for a particular drawdown of a loan. For similar reasons, application of the drawdown concept is generally not appropriate or feasible under the debt service coverage test. 3.6.3.4.4. The debt: equity ratio covenant is occasionally used for established entities when the borrower has overriding objections to the use of a debt service coverage covenant. Since the major shortcoming of the debt: equity ratio covenant is that it disregards the terms and conditions of the debt and their impact on the debt service burden, it may be advisable when using this form of covenant to add a limitation on medium-term debt; e.g., limiting the amount of debt incurred with a term of issuance of less than 10 years to some 10% or 15% of total capitalization. 3.6.3.5. Debt Limitation Covenant3.6.3.5.1. An absolute debt limitation covenant limits the amount of debt that may be incurred annually to a stated amount (expressed in absolute terms or as a proportion of the total capitalization) and requires ADB concurrence before exceeding this limit. This covenant is used infrequently and only where debt service coverage or debt-equity covenants cannot be applied. Consequently, no example is provided, as each covenant should be uniquely drawn. Section 4.4.7.8 describes the application of this covenant. 3.6.3.5.2. The typical case when this covenant is used involves a public authority whose capital structure consists entirely or predominantly of debt, because of statutory requirements that all externally provided investment funds be advanced in the form of borrowing from government. 3.6.3.5.3. The limit for new debt is fixed at a relatively small amount which, together with the internally generated funds which are likely to be available, allows the borrower to carry out minor plant replacements or improvements, but which requires the borrower to consult with ADB whenever it plans a major expansion. 3.6.3.5.4. Although this form of covenant is simple to administer, it has substantial disadvantages. It is related to a stated amount of debt without consideration of its terms and without taking into account changes in an enterprise's financial requirements or debt-servicing capacity; and it severely restricts an enterprise's freedom of action. 3.6.3.5.5. A preferable approach would be to agree that a substantial part of any loan by the government to the public sector enterprise would be subordinated and treated as quasi-equity capital, thus permitting the use of either the debt service coverage or debt equity ratio covenants. The project team should ensure that it is legally possible to create a subordinated debt. There may be restrictions or regulations of the government, which affect its ability to have its debt treated as quasi-equity. 3.6.3.6. Capital Adequacy Ratio Covenant3.6.3.6.1. This covenant is normally applied to FIs. It is used to compare the adequacy of an institution's available equity to meet losses that may be incurred by losses of financial assets. For this purpose, equity is defined in a similar manner as in the debt-equity ratio covenant, but with the addition of any provisions for bad and doubtful debts (loss provisions). However, the definition of assets will need to be defined on an institutional basis. Section 4.4.7.9 describes the application of this covenant and a model is provided in Knowledge Management (section 7.13.4). 3.6.3.6.2. Local market and lending conditions will materially affect the quality of assets and staff must reach agreement with the borrower on the risk factors applicable to each class of assets. 3.6.3.6.3. This classification of risk by reference to groups of assets-at-risk may need to be varied over the life of a loan, and therefore it will be necessary to introduce regular reviews to determine any required revisions from time to time. In addition, judgment will be needed to determine a safe margin above the potential loss level of assets-at-risk prescribed in the covenant. Normally this is unlikely to be less than 1.00, when equity will at least absorb all potential losses, as calculated in accordance with methods specified in minutes to loan negotiations.
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