Case 073Asset-backed, project and real-asset lendingCore

A shipping company's loan has a value maintenance covenant. Vessel values fall 30% while the charter keeps paying. Is the covenant breached, and how much must be cured?

The situation

Kolmera Shipping owns a product tanker worth Rs 400 crore, on a five-year time charter to an oil company paying Rs 60 crore a year net of running costs. Its bank lent 60% of the vessel's value, Rs 240 crore, at 9%, repaid Rs 20 crore a year with a balloon of Rs 140 crore at the end of year 5.

The loan has a value maintenance covenant: the vessel's market value, from an independent valuation, must be at least 125% of the loan outstanding. Six months into the loan, second-hand tanker values fall 30%. Kolmera has made every payment on time.

Your task

Is the covenant breached, what are Kolmera's ways to cure it and how much does each cost, and why does the bank have this covenant at all?

Quick check

After the fall, is Kolmera in breach?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Yes: the vessel is now worth Rs 280 crore against the Rs 300 crore required, 125% of the Rs 240 crore loan, so the covenant is breached by Rs 20 crore of value. Kolmera can post Rs 20 crore of cash collateral or prepay Rs 16 crore; prepaying is cheaper because it also shrinks the requirement. Every payment is still covered 1.44x by the charter, which is exactly the point.

Step 1Why can a loan breach when every payment is made?

Think of a loan against gold jewellery. The lender asks you to top up the gold or repay part of the loan when the gold price falls, even if you have never missed a payment, because the gold is what it would sell if you stopped paying. A value maintenance covenantA loan term requiring the value of the collateral to stay above a set percentage of the loan, with a cure if it falls below. protects the lender's exit, not its income, so it can breach while cash flow is fine. Kolmera's charter covers the Rs 41.6 crore of year-1 debt service 1.44x. The covenant is about the balloon: in year 5 the bank needs the vessel to be worth enough to refinance or sell.

A value covenant can breach while every payment is made400Vessel value300125% of loanBefore the fall280Vessel value300125% of loanAfter a 30% fallshort 20Two ways to curePost cash collateral280 + 20 = 300 = 125% of 240Rs 20 crorePrepay the loan280 / 1.25 = 224 of loanRs 16 croreCharter still pays 60 a year:debt service cover 1.44x
Before the fall the Rs 400 crore vessel clears the Rs 300 crore requirement; after a 30% fall it is worth Rs 280 crore, Rs 20 crore short, which Kolmera can cure with Rs 20 crore of cash collateral or a Rs 16 crore prepayment.
Step 2Why is prepaying cheaper than posting cash?

Posting cash adds to the value side: Rs 280 crore of vessel plus Rs 20 crore of cash equals Rs 300 crore. Prepaying works on both sides at once: each rupee repaid cuts the loan by a rupee and the requirement by Rs 1.25, so a smaller payment closes the gap. The loan must fall to Rs 280 crore divided by 1.25, Rs 224 crore, a prepayment of Rs 16 crore. The cash collateral is not lost, since it is returned if values recover, but it is trapped; the prepayment is gone for good but also saves 9% interest on it.

The relationship
Cash cure=1.25×240−280=20Prepayment=240−2801.25=16\text{Cash cure} = 1.25 \times 240 - 280 = 20 \qquad \text{Prepayment} = 240 - \frac{280}{1.25} = 16
1.25the covenant: value at least 125% of the loan
240loan outstanding
280vessel value after a 30% fall
What it says in wordsCash adds to value only, while a prepayment lowers the loan and the required value together, so it needs fewer rupees.
Step 3What else would you look at as the lender?

Timing and the valuation. The next scheduled Rs 20 crore instalment cuts the loan to Rs 220 crore and the requirement to Rs 275 crore, below Rs 280 crore, so the breach cures itself at the next payment if values hold. That argues for a short standstill or a waiver with a fee rather than enforcement, provided the charter counterparty is sound. Ask whether the valuation is charter-free or with the charter attached; a vessel on a long charter at a good rate may be worth more to a buyer than the charter-free figure. And look at the balloon: Rs 140 crore is due in year 5 on a vessel five years older, so if values stay down, the refinancing, not today's covenant, is the real risk.

Where candidates lose it

The usual error is saying no breach because Kolmera pays on time. The covenant does not test payments; it tests collateral value against 125% of the loan.

The second is computing the cure as Rs 20 crore whichever route Kolmera takes. Cash adds to value; a prepayment reduces the loan and the requirement together, so only Rs 16 crore is needed.

What the interviewer asks next

  • Values fall a further 10% next quarter. What cure is needed then?
  • How would you set the covenant level at the start of the loan, and why 125% rather than 110%?
  • Would you accept a second vessel as additional security instead of cash?

Company names and figures are illustrative.