Contacts
The risk profile of the deals could be measured more precisely taking into account the covenant breach risk, according to a forthcoming article by Emanuele Borgonovo and Stefano Gatti

Covenants are contractual clauses designed so as to provide lenders with early warning signals and safety buffers. Specifically, they trigger the technical default of the borrower even in the absence of insolvency. Because overlooking the consequences of covenant breach might lead decision makers to underestimate the risk involved in a project, Emanuele Borgonovo (Department of Decision Sciences) and Stefano Gatti (Department of Finance and CAREFIN) propose that covenants should be taken into account when analysing an investment's risk profile. This extension in risk analysis would improve the estimation of risk measures and help decision makers to assess projects' financial performance.

In their recent paper entitled Risk Analysis with Contractual Default. Does covenant breach matter?, forthcoming in the in European Journal of Operational Research (doi: 10.1016/j.ejor.2013.04.047), the authors propose a direct quantitative investigation of the impact of covenant breach on risk profiles and, consequently, on risk measures. They design a quantitative model of the consequences of covenant breach, differentiating the perspectives of shareholders and lenders, and taking into account the important distinction between material breach (when the violation is disrupting the orderly continuation of the deal and the borrower is forced to default) and technical breach (when the transaction proceeds with enforced monitoring or renegotiated loan terms).

Moreover, the authors translate the model into a simulation procedure which is applied to a real case study concerning the project financing of a 64-million euro biomass plant located in Italy. For this project, the authors had access to the financial model used by shareholders and lenders in their evaluation of the deal. The availability of the financial model allowed them to examine quantitative results relying on real data instead of simulated ones. The results show that accounting for potential technical breaches has little impact on a project's risk profile. On the contrary, material violations seem to expose shareholders and lenders to important risks (loss of equity cash flows for shareholders, partial or total default risk for lenders) that must be included ex-ante in the decision-making process. Indeed, the simulation analysis shows that the impact on the risk profile of including material covenant breach is substantial. In addition, the results suggest that the values of risk measures can be remarkably different from those obtained in an analysis that fails to capture the consequence of a covenant breach.

This simulation analysis confirms the authors' theoretical predictions that covenant breaches do matter and that risk analysis models must include such contractual clauses in order to provide decision makers with a higher degree of confidence as to projects' financial performance. Moreover, this model improvement can be used by lenders to fine-tune the loan tenor, the spread and the debt/equity ratio.

Research