The Potential Impact of the COVID-19 Coronavirus on EBITDA and Financial Covenant Calculations in Loan Agreements

April 06, 2020

Whilst the full scope of the potential impact of COVID-19 for financial covenant calculations and other purposes within loan agreements can only properly be assessed on a deal-by-deal basis, it is still possible to identify some of the issues that will need to be considered as part of that analysis.

How these issues are dealt with in the market will, in large part, be driven by accounting interpretation. Financial covenant calculations are generally required to be calculated in accordance with Accounting Principles and reported on annually by a business's Auditors, so where differing views as to interpretation of COVID-19-related issues arise, these overarching requirements should help to ensure some market-based discipline can be maintained.

However, as recognised by the FCA, FRC and PRA in a recent joint statement, market practice in relation to the timing and content of financial information and corresponding audit work will change as a result of COVID-19-driven issues. Exactly how this will manifest is still to be worked through, but it seems likely that there could be pressure across the market for bespoke accounting treatments to be recognised.

The calculation of EBITDA will go to the heart of financial covenant compliance calculations, but it is also likely to impact Margin ratchet testing, Permitted Acquisition and Permitted Payment criteria as well as incremental debt establishment and, in many loan agreements, Permitted basket calculations.



a) The starting point for calculating EBITDA is determining the operating profit of a business (i.e., revenue minus costs). For many businesses, COVID-19 has already resulted in reduced revenues through a fall in customer demand, business closures, increased costs through supply chain disruption, hygiene/cleaning costs and remote working/relocation costs etc. – all of which will impact underlying operating profit. However, the application of addbacks, exclusions and deductions may mean that the impact is lessened to some extent when translating operating profit into EBITDA when calculating covenant compliance or, at least, the extent of any non-compliance.

b) There may also be other changes to revenue and/or costs which arise from the response to COVID-19 that may impact operating profit and/or EBITDA (whether directly or through the application of Exceptional Items), for example, payments received under the government’s job retention furlough scheme, receipts under business interruption insurance, rental payment and creditor payment deferrals, supplier discounts and reduced overheads.

2. Exceptional Items


a) The standard LMA position is for Exceptional Items to be excluded (on an uncapped basis) when calculating EBITDA.

b) Varying formulations of this definition are seen across the market – some include only an exhaustive list of pre-agreed Exceptional Items and some are more generic in nature and encompass a non-exhaustive list of Exceptional Items.

c) Depending on the formulation of this definition, Sponsors/Borrowers may be able to argue that certain costs incurred in response to COVID-19 (employee relocation, IT equipment funding, unfulfillable contract termination) should be treated as Exceptional Items and not taken into account when calculating EBITDA.

d) The LMA definition of Exceptional Items refers to ‘items’ that are included/excluded when calculating EBITDA rather than identifying/distinguishing between costs and revenues. Some Sponsors/Borrowers may seek to argue that revenue shortfalls and other losses resulting from COVID-19 should also be treated as an Exceptional Item and ignored for the purposes of EBITDA.

e) Care should also be taken to ensure that there is no double counting of items that have already been included/excluded from operating profit and/or the other limbs of the EBITDA definition through the Exceptional Items definition.

3. Adjusted EBITDA


a) Leverage covenants are typically calculated by reference to an adjusted version of EBITDA, which is intended to reflect the impact on EBITDA of acquisitions and disposals made during the relevant testing period.

b) Recent years have seen the expansion of the Adjusted EBITDA concept to also include synergies/savings associated with Group Initiatives or similar concepts, which are often broadly defined to capture new Group activities that are intended to be value creative or revenue enhancing and/or restructuring/reorganisation initiatives that are intended to reduce or save costs. Given their wide and often vague formulation, it can be difficult to dispute what should (or should not) be included within the scope of these types of definition.

4. Shock Adjustments


In recent years, EBITDA "shock" adjustment concepts have been included in some loan agreements to offer one-off relief to Borrowers in the testing of compliance with financial covenants (often formulated as an ability to replace EBITDA in the affected period with the EBITDA generated in the equivalent period in the preceding year). Historically, these types of adjustments were included as a response to potential terrorism-related concerns for certain types of businesses, but consideration should be given to whether the drafting of such provisions could be interpreted to also cover the impact of COVID-19.

5. Borrowings


a) Actual or anticipated costs of responding to COVID-19-related issues are likely to result in Borrowers increasing their usage of revolving credit and working capital facilities. The corresponding increase in debt will, typically, flow through to the financial covenant calculations.

b) Where government loan schemes are available to businesses, the inclusion of that debt within Borrowings and any required resetting of covenant levels will need to be considered (albeit initial indications suggest that such loans are unlikely to be accessible to private equity-owned businesses).

6. Testing/Accounting Principles


a) It is worth remembering that financial covenants are tested on a "last twelve months" basis, so even if the impact of COVID-19 transpires to be short-term on businesses, the impact on financial covenant testing is likely to continue for a much longer period. This will be important to note in any discussions around financial covenant resets.

b) Financial covenants are determined in accordance with the Accounting Principles, i.e., GAAP and/or IFRS. The manner in which accounting methodologies may change as a result of COVID-19-related issues is not yet known, but any such change may impact the manner in which certain of those costs are dealt with when determining covenant compliance.

As can be seen, this is an area where there is the potential for significant debate as to the impact of COVID-19 on financial covenant calculations between Sponsors/Borrowers and Lenders as the impact of COVID-19 unfolds and, as always, the devil will be in the detail.

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