Chapter 46Covenants and Cash Flow Sweeps in Project Finance Models

When negotiating loan agreements, one of the issues that may be analyzed with a financial model are the credit enhancements, including the level of covenants and cash flow sweeps. Along with the debt service reserve account (DSRA), these provisions could be called credit enhancements because they improve the safety of loans from the lender perspective. Loan covenants can range from mandating that the equipment is in good working order and providing financial statements to lenders, to strict limitations on payment of dividends. Covenants that limit dividends change the cash flow distribution pattern over time between lenders and equity shareholders and/or subordinated debt investors. For modeling purposes, it is the latter type of negative financial covenant that limits dividends that are generally evaluated. These covenants can influence returns to equity investors because they affect the timing of cash flows that are paid out as dividends. The effect of equity cash flow timing resulting from covenants is analogous to the way that refinancing influences the equity internal rate of return (IRR) because of the acceleration of dividends. Covenants should be analyzed in the context of a fundamental aspect of project finance loans that some dividends must be allowed before all of the debt is paid off. If equity investors had to wait decades for any cash return at all they probably would not make investments.

Covenants ...

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