30
May
09

The Nine Stages of the Covenant Trap

In Ben Shapiro’s presentation to the Chicago HBS Club, he outlined a phenomenon taking hold more and more these days: The Covenant Trap. Troubled companies often fall into a cycle that is difficult to counteract. The cycle follows nine distinct steps:

  1. trappedInventory increases because sales weaken and management fails to react appropriately. These increases tie up cash – often in obsolete or slow-moving stock.
  2. Prices decline as the organization tries to stem the sales slide and clear inventory by lowering prices and stretching requirements for new customers.
  3. Payments slow due to the softening market and the reach for customers that may not meet traditional payment requirements.
  4. No pays increase as the cycle begins to tighten and operational difficulties increase.
  5. EBITDA decreases as the fundamentals in the business continue to weaken and management takes more short-term actions to try to stem the tide.
  6. Financing needs increase with weakening EBITDA and the failure of the actions to take hold.
  7. Debt/EBITDA ratio goes up and begins to impact covenants.
  8. Bank raises rates as covenants come into play and the credit risk increases.
  9. Interest expense increases and the trap is completely sprung, as the higher rates deepen the cycle and make it more difficult to escape the trap.

Recognizing the early signs of the Covenant Trap makes it possible to avoid the deepest parts of the hazard. Proper action in the first phases of the trap can often mean the difference between success and failure – especially in these times!

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