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T.H.A.T. Thought No. 29 – EBITDA-MRI

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Over the last two years, there has been an increasing pressure from bank lenders to move from interest cover to a cash flow covenant – labelled EBITDA-MRI.

It is often demanded as a condition of new debt, while attempts are being made to introduce it in legacy debt under the guise of adapting to FRS102.

To suggest a concerted campaign among the banks on the issue could be an overstatement – but the speed and energy with which they have promoted the covenant suggests something that clearly goes well beyond co-incidence.

This may seem a strange issue to look at in a week when the Government has released its latest White Paper on housing. Yet the issue of inappropriate covenants and the problem of development are closely interlinked.

Since 2008 housing associations have struggled to manage legacy bank covenants that are no longer “fit for purpose” following the changes that have taken place in government support and the business model. Ratios and concepts that made sense when rising rents and 40% grants were available no longer work.

In this process, development has generally lost out; even when the programme is credit-enhancing and well within the capacity of the business.

Nor does the problem end here. With most legacy bank debt heavily under water, attempts at renegotiation are generally met by demands for a material and expensive repricing or restructuring, while repayment often involves realising substantial mark to market losses on embedded derivatives.

This has created a paradox where both parties are caught in a situation that benefits neither:

- Housing associations underperform as they are forced to adopt a development programme that fits in with legacy covenants rather than have covenants designed to fit within a value creative development programme.

- Meanwhile the banks sit with loss making loans, which fail to produce adequate ancillary income as clients are constrained from additional borrowing by inappropriate covenants.

The one bright spot in this situation has been the capital markets where investors have generally avoided corporate financial covenants, leaving management free to manage the business in a sensible manner while relying on security specific requirements to protect their debt.

An unfortunate dynamic and the rise of EBITDA-MRI

Inevitably this situation has led to a general souring of the relationship between the housing associations and their banks.

Housing associations quite reasonably look for ways to sidestep covenants that impede the development of their business, while banks increasingly focus on ways to tightening up the covenants to frustrate this process.

This takes us to EBITDA-MRI. Promoted as a new way of monitoring the underlying cash flow generated from operations, it is actually a reaction to increasing capitalisation of maintenance costs following the introduction of component accounting.

At its simplest, it takes the operating profit, deducts all property expenditure (whether capitalised or not) and then adds back depreciation.

Yet this completely fails to understand the nature of the business the banks are lending to:

Housing associations are responsible for providing long term good quality rental accommodation to those judged in housing need. This inevitably involves investing in those properties; so the maintenance bill involves three types of expenditure:

- Routine maintenance: to address the normal wear and tear of the estate.
- Component replacement: new kitchens, bathrooms etc. under decent homes standard.
- Planned or capital maintenance: to extend the life of the asset.

The last two categories clearly involve expenditure that takes the form of investment as it increases the value of the asset. “Decent Homes Standard” may not directly increase rents, but trying to let a property with 20 year old kitchens and a leaking roof will undoubtedly lead to a rise in voids and a very dissatisfied customer base.

Accountants do recognise this and allow for varying levels of capitalisation of the expenditure.

Sadly, not so the banks under EBITDA-MRI.

Faced with a squeeze in revenue, they appear to be encouraging housing associations to defer expenditure rather than maintain the estate.

It is difficult to see the sense in this. Not only is this directly contrary to the social mission of the associations, it also appears to be against the interest of the lenders; for under-maintaining the property will inevitably undermine the quality of earnings and the value of the security in the business.

The problem of event risk

Unfortunately the problem goes further than this. It touches on event risk or the issue of unintended consequences. For example:

   a. Properties can be subject to a series of unexpected events – subsidence, ground contamination, structural
       defects to name a few.

       All require a rapid response, many involve major expenditure and only some will lead to a successful claim
       against the builder or insurer.

       If it involves a sizable estate, £5-£10m could easily be required. Most would normally be capitalised but if
       booked in a single year under an EBITDA-MRI covenant, this could place a medium sized housing
       association under pressure.

    b. Alternatively, the housing association could face the choice between demolition and replacement or
        refurbishment.

Irrespective of the economic outcome, the former would involve investment in a new property – and so be exempt from EBITDA-MRI – while the latter would involve a major deduction from the ratio.

A matter of negotiation

Of course borrowers can always negotiate amendments with their lenders when unexpected events occur – and in the case of short-dated RCFs, refinance the facility if they do not succeed.

But incorporating this type of covenant into long dated loans clearly changes this situation. As noted above, since 2008 housing associations have been struggling with covenants on long-dated legacy loans which they believe they can neither afford to meet, nor to repay.

As we have already observed, the “covenant-lite” approach of capital market investors provides significant relief from this problem by minimising the need for subsequent amendment to the covenants and avoiding the risk that the attitude, focus or commitment of lenders may change over time – as has happened after 2008 with a number of banks.

It is, therefore, worrying to find capital market investors are asking for the same covenants as are offered to the banks. For good reason, they do not generally receive this in other sectors so it is difficult to see how they justify asking for it from housing associations.

It is even more concerning to have banks refusing to act as arrangers on private placements unless the borrowers offer EBITDA-MRI, suggesting they are more concerned with defending the status quo as a lender than obtaining the most appropriate terms for the borrower.

Conclusion

JCRA believes that EBITDA-MRI is a bad covenant that has been spawned from bad tempered negotiations on legacy loans. It ignores accounting convention and fails to distinguish between routine maintenance and capital investment. Furthermore it encourages outcomes that are of no benefit to the long-term business, the association, the tenant or the lender.

In an ideal world this should be the subject of a review by the Regulator and the Nat Fed. Given the renegotiations on covenants that will arise out of FRS102, it might be an appropriate time to arrange for high level discussions between bank lenders and the sector on the future shape of covenants – a subject both sides have sidestepped for too long.

But, in particular, there needs to be an absolute determination to avoid EBITDA-MRI becoming part of the capital markets covenant package. And to banks that push for investors to adopt it – just remember your fiduciary duty to the client as an arranger; to provide best advice and offer best execution!

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