Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The M&A Covenant Trap That Cost a Buyer $25 Million
Transcript
- Lucas: Luna, let me tell you about a deal that looked perfect on paper — a private equity firm buying a specialty chemical company for $150 million. Strong EBITDA, clean due diligence, everything lined up. Except for one clause buried in the target's existing credit agreement with its bank. Luna: A single clause killed a $150 million deal? That's a lot of leverage for one sentence. Lucas: Well, it didn't kill it, but it cost the buyer $25 million. The clause was a negative covenant — specifically, a prohibition on incurring 'additional indebtedness' without the lender's consent. The PE firm planned to finance the acquisition with a new loan, but that new loan would be additional debt of the company they were buying. The existing lender said, 'Not without our permission.' And permission came with a $25 million fee. Luna: So the seller's own loan agreement blocked the sale? That sounds like something the seller's lawyers should have flagged before they even went to market. Lucas: You'd think so. But here's the thing — the seller was a founder-run company. They'd had the same credit facility for years, never needed to borrow more, so nobody paid attention to the fine print. The founder's CFO assumed the covenant was standard boilerplate. And it was standard — but standard doesn't mean harmless. Luna: If these conversations have moved your work forward, helped you spot a trap, or saved you from a costly mistake, consider supporting the show. It's what keeps us ad-free and focused on the real deal mechanics. You can do that at buy me a coffee dot com slash fexingo. And now, back to that $25 million covenant. Lucas: Right. So the PE firm's lawyers found the covenant during confirmatory due diligence — after the letter of intent was signed. The seller's bank was in a strong position. They knew the company was being sold, they knew the new owners would need financing, and they could demand a consent fee. The PE firm had two choices: pay $25 million or walk away from a deal they'd already spent months and millions on. Luna: They paid. Because the sunk cost was too high. But who bears that cost? In the end, does it come out of the purchase price? Lucas: Interesting question. In this case, the PE firm tried to renegotiate the price down by $25 million. The seller pushed back hard — 'That's your financing issue, not ours.' Eventually they split it. The seller took a $12.5 million haircut. So both sides lost. But the real lesson is: this was entirely preventable. Luna: How? What should a seller do differently? Lucas: Before you even call an investment banker, review your credit agreements for what's called the 'covenant stack.' Look for negative covenants — promises not to incur debt, not to change the business, not to sell assets. If you have any, start a conversation with your lender early. Ask: 'Will you consent to an acquisition of the company? Under what terms?' Sometimes the answer is a simple waiver with a small fee. Sometimes it's a $25 million surprise. Luna: And for buyers? What's the checklist item? Lucas: Buyers should flag this during preliminary due diligence — before the letter of intent. Ask for the target's material contracts, especially credit agreements, and have your M&A counsel review all negative covenants. Then negotiate a covenant condition in the acquisition agreement: seller must obtain necessary waivers or consents before closing. If the seller can't, you have a walk right. But if you discover it after the LOI, your leverage evaporates. Luna: So the real trap is timing. Discover it early, and it's a negotiating point. Discover it late, and it's a crisis. Lucas: Exactly. And there's a subtler version of this trap that catches even sophisticated buyers. Sometimes the covenant isn't in the target's own credit agreement — it's in a parent company guarantee, or in a supply agreement that has a change of control clause linked to debt levels. You have to map the entire web of restrictions. Luna: That sounds like a lot of work. How many deals actually have this problem? Lucas: I've seen studies suggesting that roughly 10 to 15 percent of middle-market deals hit a covenant issue during due diligence. Most get resolved with a waiver or a renegotiation, but about 1 to 2 percent actually collapse because the lender refuses consent or demands terms that make the deal uneconomic. The $25 million case is on the high end, but I've seen consent fees of $2 million, $5 million, even $8 million. Luna: Who typically holds these covenants? Is it always a bank, or can it be a private credit fund? Lucas: These days, it's often a private credit fund — direct lenders. And they can be tougher negotiators than traditional banks because they're not in the business of relationship banking. They're in the business of maximizing return on their loan. So consent fees can be steeper. But even traditional banks can play hardball if they sense leverage. Luna: And what about the seller's perspective? If you're a founder listening to this, what's the one thing you should do this week? Lucas: Pull out your current credit agreement. Find the section that says 'Negative Covenants' or 'Restricted Payments' or 'Indebtedness.' If you see language like 'Borrower shall not, directly or indirectly, incur any additional indebtedness' — that's a red flag. Call your lender and ask: 'If I sell my company, will you consent to the buyer's financing? What would you charge for that consent?' Get it in writing. Put it in your data room. Luna: That's practical. I think a lot of founders don't even know what's in their loan documents. They sign them at closing and never look again. Lucas: Right. And the loan document may have been signed five, seven, ten years ago. The lender's personnel may have changed. The covenant may have been drafted by a lawyer who's since retired. But it's still binding. Ignorance is not a defense. Luna: So let's pivot to the buyer's side again. Besides the negative covenant on debt, what other covenants should a buyer watch for? Lucas: The big ones are: restrictions on dividends or distributions — that could block the buyer's ability to cash-flow the acquisition debt. Restrictions on asset sales — that could prevent the buyer from selling a non-core division post-close. And restrictions on mergers or change of control — which is exactly what happened in this case. Also, watch for 'cross-default' provisions that tie the loan to other agreements. Luna: So a cross-default could mean a default on a supply agreement triggers a default on the loan? Lucas: Exactly. And that can create a cascade. If the acquisition triggers a change of control default in a key customer contract, and that contract has a cross-default to the credit agreement, suddenly the entire loan is due. That's a nightmare scenario. Luna: Is there any way to protect against that contractually? I mean, in the acquisition agreement itself? Lucas: You can include a representation from the seller that no consent is required for the acquisition under any material contract. And you can have a condition to closing that all necessary consents have been obtained. But the seller can only represent what they know. If they haven't reviewed their contracts, they might unknowingly give a false representation. That's where the indemnification comes in — if the representation is breached, the buyer can seek damages. But proving damages after closing is messy. Luna: So the best protection is pre-closing due diligence. Not just reading the credit agreement, but reading every contract that references debt or change of control. Lucas: Yes. And here's a tip: don't just read the definitions section. The definition of 'Indebtedness' in a credit agreement can be incredibly broad. It might include things like letters of credit, surety bonds, even deferred purchase price obligations. If the buyer's acquisition financing includes a seller note, that could be considered indebtedness under the definition. Suddenly you need a waiver for the seller note too. Luna: That's sneaky. So even a simple seller-financed note could trip the covenant. Lucas: Exactly. I've seen a deal where the buyer was going to give the seller a $5 million promissory note as part of the consideration. The target's bank said that note was 'indebtedness' under the credit agreement. The buyer had to pay a $500,000 waiver fee. The seller ended up netting $4.5 million instead of $5 million. Luna: So both sides lose. The seller gets less, the buyer pays more. And it all comes back to one clause. Lucas: That's the nature of M&A traps. They're not always dramatic frauds or hidden liabilities. Sometimes it's just a few words in a contract that nobody bothered to read. Luna: Alright, let's wrap with a takeaway for our listeners. If you're selling, what's the single most important action item? Lucas: Audit your covenant stack before you go to market. If you have debt, get a waiver letter from your lender in principle, with a cap on the consent fee. Put it in your data room. It will increase buyer confidence and potentially increase your purchase price. Luna: And if you're buying? Lucas: Make covenant review a standard item on your due diligence checklist. And negotiate a covenant condition in your acquisition agreement — seller must deliver all required waivers and consents before closing. Don't let the lender become an uninvited partner in your deal. Luna: Good advice. Next time, we'll look at another hidden trap — the 'material adverse change' clause that almost killed a $200 million deal. Until then, keep reading the fine print. Lucas: See you next time.