What is a Keepwell Agreement?
A keepwell agreement is a legal agreement between a parent company and a subsidiary to ensure solvency and financial stability for the duration of the agreement.
How Does a Keepwell Agreement Work?
For example, let's assume that Company XYZ is a subsidiary of Company ABC. Company XYZ has had a tough year making widgets but wants to expand into the Chinese markets and needs cash to build a factory. It wants to borrow the money from a bank but is a significant lending risk and can't get a loan for less than 15% interest. At that rate, the loan payments would significantly threaten Company XYZ's viability.
To compensate for this, Company ABC and Company XYZ sign a 10-year keepwell agreement. In the agreement, Company ABC agrees to keep Company XYZ solvent and financially stable for the next 10 years. This is a relief to the bank, which now knows that if Company XYZ stumbles in the China endeavor, Company ABC will step in and make sure the loan payments are made.
Why Does a Keepwell Agreement Matter?
Keepwell agreements benefit bondholders because they essentially guarantee that a parent company will bail out a subsidiary if the subsidiary gets into financial trouble. This makes the subsidiary more creditworthy and thus able to issue debt or borrow money more easily.