Lenders often want to restrict a borrower’s possibility to incur other debt than the loan amount or what is explicitly known to the lender when entering the loan agreement. Here is an example:
Permitted Financial Indebtedness provision example
The Borrower shall not incur any Financial Indebtedness except for Permitted Financial Indebtedness.
“Permitted Financial Indebtedness” means Financial Indebtedness incurred under:
- this Loan Agreement;
- the Revolving Credit Facility; and
- Subordinated Loans.
What is it?
A Permitted Financial Indebtedness provision determines what types of financial indebtedness a borrower may incur after it has entered into a finance agreement containing a financial indebtedness covenant. The starting point is that debt other than what is incurred under the finance agreement in question is not permitted, and then specific carve-outs are made to ensure that the borrower group may incur certain other types of financial indebtedness.
Why is it used?
The lender wants to restrict the possibility of the borrower group to incur additional indebtedness which may impair the borrower’s ability to serve the loan in question. There are also other tools to achieve this goal, such as financial covenants like leverage ratio requirements. Those ratios will however grow as the EBITDA of the borrower group grows and may not offer sufficient protection for a lender. Furthermore, specific carve-outs provide the lender with visibility on the types of debt the borrower group intends to incur during the term of the loan. It also enables the lender to ensure that risky debt with potentially aggressive lenders is not part of the lender’s financing structure. This may prove useful if the borrower group runs into trouble and has to restructure its debt.
How is it used?
Provisions on Permitted Financial Indebtedness is common in financing, especially high yield and leveraged financing. It is either construed as a definition containing all the types of indebtedness the borrower can incur, or as a carve out with relevant items listed directly in the indebtedness restriction.
Why should a lender pay attention?
By specifying what types of indebtedness a borrower and its group can incur, a lender has a useful tool to manage its credit and financing risk. Although financial covenants to some extent measures the group’s financial performance, it does not restrict the type of indebtedness a borrower can incur. This is important for a lender because it can then avoid certain types of risky debt and debt instruments with potentially aggressive lenders. It will also flush out the financing existing in the group at the time the financing is provided, thereby giving the lender a better understanding of the capital and financing structure of the borrower.
What does it mean for the borrower?
First of all, the borrower needs to ensure that all existing financial indebtedness is listed. If not, the borrower will either have to repay the indebtedness before the issue date/utilisation, ask for a waiver or an amendment (which is not the way you want to start the loan and it could also have a reputational effect) or default on the indebtedness immediately. None of these alternatives are particularly tempting, so borrowers need to carefully consider the existing indebtedness. A general basket is typically also provided, which means borrowers have some leeway.
Furthermore, borrowers also need to consider whether additional financing or other types of financing is likely to be required during the term of the loan. Not an easy exercise for some borrowers, which means borrowers should consider more generic exemptions such as revolving credit facilities, unsecured financing from financial institutions (potentially subject to an incurrence test), subordinated loans and unsecured capital markets financing.
Important to note
Even though it is understandable that a borrower wants flexibility with respect to what types of financial indebtedness it can incur during the term of the financing, flexibility comes at a cost. It may increase the risk of the investment from the lender’s perspective, and by that increase the total costs for the borrower.
