How the banks will weigh up Andrew Forrest’s plea for relief

Andrew ‘Twiggy’ Forrest’s got the begging bowl out.

The company he founded and still owns one third of, Fortescue Metals Group, is asking its lenders to give it a year-long reprieve on its debt covenant obligations.

This would give Fortescue the freedom to breach some of its financing conditions in a bid to boost profitability in the long term.

When the news was broken yesterday by The Australian Financial Review, the stock took a beating. It fell 14% in closing trade, slashing the value of Forrest’s 32% holding by $500 million. He’s now worth $3 billion – a quarter of what he was in 2008, and well below the $6.2 billion in stocks he held in September 2011 when he knocked Rupert Murdoch off the BRW’s executive rich throne.

Fortescue has benefited in recent years from vast and aggressive expansion, fuelled in part by $US8.3 billion in debt (analysts expect its debt to peak at $US 10 billion). This has left the company exposed in recent months, with the price of iron ore dropping 27% since the start of July.

In response, the miner announced nine days ago that it would cut 1000 jobs from its general staff, contractors and consultants, defer $US1.6 billion in development spending and slash $US300 million from operating costs.

At the time, CBA analyst Andrew Hines said the company should be raising capital, “perhaps by a deeply discounted rights issue”.

The company stood firm, reiterating its opposition to a capital raising.

Fortescue has $2 billion in cash, but presumably its current arrangements with the banks prevent the company from spending this money as it sees fit. Perhaps this is why Fortescue is seeking a loosening of its debt covenants for a time.

But will the banks, as requested, allow it to breach its debt covenants for a whole year?

It depends on the severity of Fortescue’s predicament, says Neil Slonim, the managing director of banking consultancy Slonim Consulting and a former corporate banking executive at NAB who often helps companies in danger of breaching their debt covenants.

“They’ll ask themselves, ‘Is this a short, one-off event that is relatively easily corrected, or is it signifying significant financial trends which are of great concern’,” Slonim says.

“That’s what debt covenants really do. They provide warning signs to banks as to potential looming financial difficulties, which then give the banks time, often with external specialists, to determine appropriate actions to protect their position.”

Forewarning isn’t likely to do much good, Slonim cautions. “The banks aren’t inclined to say, ‘Oh well, you’ve given us advanced notice so everything is going to be okay’.”

“The bank wants the borrower to abide by the loan covenants. If there’s a breach one quarter, the bank wants to know there won’t be a breach the next quarter. If that’s likely, the bank might provide a waiver, maybe with conditions like a capital-raising attached.”

Any bank in this situation carefully scrutinises a company’s financial accounts to gauge whether or not a breach is likely to be significant. “They may get assistance from one of the big accounting firms to check the numbers, to check the assumptions and do some modelling, so they can get a good sense of what the position might be.”

A breach of a debt covenant can in most cases trigger a default. However, sometimes, a bank may choose not to exercise this option, and can instead issue a letter acknowledging the breach but reserving any action.

“If the news from the company is bad, and it displays poor judgement, or if there are significant financial discrepancies, the actions taken by banks can be much more severe. There could be the appointment of receivers, or voluntary administrators.”

Part of the difficulty for Fortescue is that it has multiple banks as lenders, including all four of Australia’s major banks, and Bank of America Merrill Lynch. The company needs to get all of its banks to agree to waive its covenants, which is no mean feat. Negotiations with multiple banks frequently come undone, Slonim says.

“It can become very difficult, particularly where you have both foreign and local banks. They may all form their own views as to the level of credit risk.”

Troublingly for Fortescue, the costs of such disagreements are usually severe.

“Often what happens when banks fail to agree is that it falls to the worst-case scenario – formal appointments and receiverships.”

Myriam Robin is a journalist with LeadingCompany. You can follow her on Twitter at @myriamrobin This article first appeared on Leading Company.