Common Covenant Breaches in LBOs and How to Avoid Them

When managing leveraged buyouts (LBOs), covenant breaches can lead to serious financial and operational consequences. Here's what you need to know:

• Common Covenant Breaches: Violations often involve exceeding debt-to-EBITDA thresholds, missing interest payments, or engaging in activities not allowed by lender agreements (e.g., unapproved asset sales or dividends).
• Why They Happen: Revenue shortfalls, cost overruns, cash flow issues, or weak internal controls are typical triggers.
• Consequences: Breaches can result in stricter lender oversight, higher interest rates, reduced borrowing limits, or even default risks.
• How to Avoid Them: Set realistic covenant terms, maintain open communication with lenders, and monitor compliance regularly.

Key Tip: Proactively address risks and keep lenders informed to avoid costly defaults or strained relationships.

Loan Covenants | Definition, Types, Uses & Breaches

Common Covenant Violations

Knowing the typical covenant breaches in leveraged buyouts (LBOs) helps stakeholders spot risks and take steps to avoid them. Below are the most frequent types of violations in these scenarios.

Debt-to-EBITDA Challenges

Debt-to-EBITDA violations happen when earnings fall short or unexpected costs shrink margins. These issues often arise from:

• Revenue shortfalls: When actual sales don't meet projections
• Cost overruns: Unplanned expenses that reduce EBITDA margins
• Market disruptions: External events impacting industry performance and company profits

For instance, a manufacturing company in an LBO might violate its debt-to-EBITDA covenant if raw material prices surge or key customer orders are canceled.

Interest Payment Struggles

Several factors can lead to problems with interest payments:

• Seasonal cash flow swings that weren't factored into the original covenant terms
• Working capital issues that tie up funds needed for interest payments
• Delays in revenue collection, disrupting cash flow

Covenant Type	Common Trigger Point	Impact
Interest Coverage Ratio	Below 2.0x	Signals inadequate operating income for interest
Fixed Charge Coverage	Below 1.2x	Suggests difficulty in covering fixed obligations

Besides financial challenges, breaches involving unauthorized transactions can further strain covenant compliance.

Unauthorized Transactions

Non-financial breaches often occur when a company engages in activities prohibited by lender agreements, such as unapproved dividend payouts or asset sales. Common examples include:

• Distributing dividends without lender approval
• Selling assets above agreed thresholds without consultation
• Signing major contracts or leases that exceed allowable limits

These violations typically result from weak internal controls or misreading covenant terms. Lenders often view such actions as poor governance, which can lead to tighter oversight or stricter lending conditions.

To manage covenants effectively, companies should maintain open communication with lenders and implement strong internal review processes for major transactions. This helps avoid accidental breaches that could trigger default clauses or lead to harsher loan terms.

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Results of Breaking Covenants

When companies violate LBO covenants, the fallout can impact both their financial health and operational freedom.

Increased Lender Oversight

A breach typically leads to lenders stepping up their involvement. They may require more frequent financial updates, conduct in-depth operational reviews, impose stricter spending limits, or demand additional collateral to secure the loan.

Adjustments to Loan Terms

Lenders often respond to covenant breaches by raising interest rates and reducing borrowing limits. These changes remain in effect until the company's financial performance improves, adding extra pressure to meet compliance.

Heightened Default Risk

If the company cannot meet the adjusted terms, the likelihood of default rises. In severe cases, lenders might demand immediate repayment, enforce asset recovery, or trigger additional defaults. These actions can strain relationships with stakeholders. Maintaining open communication with lenders and addressing potential covenant issues early is key to minimizing these risks.

Preventing Covenant Breaches

Avoiding covenant breaches requires a mix of solid financial agreements and proactive communication with lenders. Two critical steps - establishing realistic terms and staying in regular contact with lenders - help create a reliable compliance strategy.

Setting Realistic Terms

The foundation of covenant compliance is laid during negotiations. Structure covenant thresholds around past performance, build in flexibility for seasonal changes, include step-down provisions, and negotiate cure periods. These adjustments help ensure the terms remain manageable, even when market conditions fluctuate. Along with these measures, maintaining open communication with lenders is just as important.

Staying in Touch with Lenders

Hold regular check-ins, share updates on performance and market trends, and notify lenders as soon as any risks emerge. Keeping a record of these communications helps maintain clarity and trust.

To make this process easier, consider using Clearly Acquired's deal management platform. It offers tools to track covenant compliance and simplify communication with lenders.

Conclusion

Key Takeaways

Managing covenant compliance in leveraged buyouts (LBOs) requires consistent effort. Routine monitoring and quick action can help prevent small issues from turning into major problems. Serious breaches, such as increased interest rates or default risks, can often be avoided with open communication with lenders and strong financial management. Structuring debt to match a company's operational realities and growth goals is a critical step in ensuring smoother compliance.

Clearly Acquired's Role

Clearly Acquired offers tools designed to simplify LBO financing and covenant management. With a database of over 3.2 million verified business listings and advice from 125 seasoned professionals ^[1], the platform helps buyers and lenders establish practical covenant terms right from the start. Its AI-driven tools allow for real-time compliance tracking, and deal management features streamline borrower-lender communication.

The platform helps reduce common covenant violations by offering:

• Advanced tools for monitoring compliance
• Expert guidance for creating manageable debt structures
• Features that improve communication and maintain lender relationships

These resources work together to support effective debt management and reduce the risk of covenant issues, making LBO transactions more successful.