Risk analysis with contractual default. Does covenant breach matter?

• Covenant violations are an underhand and often overlooked risk.
• We introduce a methodology for modeling the consequences of covenant breach.
• Results show statistically significant difference in risk profiles.
• Risk measures need to be readjusted to account for default risk.

Mergers and acquisitions (M&A), private equity and leveraged buyouts, securitization and project finance are characterized by the presence of contractual clauses (covenants). These covenants trigger the technical default of the borrower even in the absence of insolvency. Therefore, borrowers may default on loans even when they have sufficient available cash to repay outstanding debt. This condition is not captured by the net present value (NPV) distribution obtained through a standard Monte Carlo simulation. In this paper, we present a methodology for including the consequences of covenant breach in a Monte Carlo simulation, extending traditional risk analysis in investment planning. We introduce a conceptual framework for modeling technical and material breaches from the standpoint of both lenders and shareholders. We apply this framework to a real case study concerning the project financing of a 64-million euro biomass power plant. The simulation is carried out on the actual model developed by the financial advisor of the project and made available to the authors. Results show that both technical and material breaches have a statistically significant impact on the net present value distribution, and this impact is more relevant when leverage and cost of debt increase.