With the volume of credit and venture capital at record levels in Brazil, domestic and foreign lenders and investors need to pay attention to their contracts and understand which affirmative and negative covenants are essential for post-closing surveillance.
We highlight below 5 covenants that, based on track record, are important to be negotiated in financial and equity transactions with Brazilian borrowers and invested companies:
1. Covenant to Furnish Periodic Financial Statements and Report Material Adverse Events: This affirmative covenant is essential in post-closing as it keeps the lender / investor updated on the borrower / investee’s quarterly and annual financial information, and obliges it to report, whenever (or if it is expected to occur) facts that impact cash flow and business, including a substantial reduction in revenue / margin, loss of relevant lawsuit, loss or default of an important customer, debt acceleration, among others.
With this information, the creditor / investor will be able to plan and take immediate action, if necessary.
2. Covenant to Recompose Collateral If Asset Value Deteriorates: It is common for credit and equity transactions to be backed by collateral, including movable assets, real estate, shares and receivables. It is important that the contracts contain a provision that, in the event that the collateral loses market value, the borrower / investor is obliged to recompose it in “X” days of the event that reduced its value.
Creditors and investors need to be aware of the variation in the market value of the collateral package, given that some are more volatile than others and there are many cases in which the value of the collateral has been drastically reduced without the creditor / investor noticing.
3. Obligation to Maintain Key Financial Covenants: Defining financial covenants to be complied with by the borrower / investee during the transaction’s term is also a key clause. The ratios vary according to the sector and type of business, and include Net Debt/EBITDA, EBITDA/Total Indebtedness, among others.
Defining in contract and monitoring the evolution of financial covenants after closing helps creditors / investors to anticipate potential stress events for the company.
4. Covenant Not To Enter Into Merger, Acquisition, Sale of Strategic Assets: This negative covenant linked to corporate events is one of the most important in contracts. Merger, acquisition, investment raising, incorporation and purchase or sale of strategic assets are currently common and can impact credit, operation and reputational risks, among others, for the lender / investor.
Therefore, it is necessary to provide in the contract that, in occurrence of events that may generate a “material adverse effect” on the borrower / investee, the creditor / investor must have the right to prior consent, or, at least, that it has the right to previously evaluate the transaction and, if not approved, have its funding prepaid.
5. Covenant Not To Increase Indebtedness: Another sensitive negative covenant is that which does not allow the company to increase its indebtedness at levels far above what it was on the closing date and in a disorderly manner, which could affect its ability to repay or comply with its obligation or meet your other commitments in the course of your business.
The inclusion of indebtedness limits for working capital and capex is a common practice in the market.
The above covenants may give lenders and investors greater control and transparency over the borrower’s / investee’s activities after the transaction closes.