Are existing financial covenants in leveraged loan agreements suitable in a post-pandemic world?
Over the past few months the coronavirus pandemic has brought financial covenants in leveraged loan agreements into sharp focus and it will continue to do so even as the impact of the coronavirus abates. In this article we look at:
- financial covenant trends before the coronavirus pandemic arrived in the UK and
- the short and medium term future of financial covenants in the leveraged finance mid-market after the pandemic
- Pre-Coronavirus financial covenant package
The financial covenant package in leveraged loan agreements was well settled prior to the arrival of coronavirus. Lenders would receive the benefit of an adjusted leverage test (i.e. adjusted EBITDA to debt on either a gross or net basis) and at the smaller end of the market (and in most bank led deals), a cash cover/CFADS test.
Over recent years, the weight of liquidity and the number of lenders looking to deploy capital, had led to private equity sponsors and their investee companies benefiting from terms in loan agreements that softened the impact of those financial covenants. In particular the market saw:
- an ever increasing list of exceptional items to add back to EBITDA. It was this in particular that led to some (but not all) limited partners of debt funds to request aggregate caps on exceptional items in loan agreements (between 5-20% depending on the lender);
- a widening of the circumstances when unrealised cost synergies could be included in adjusted EBITDA. In recent years that concept had moved beyond synergies arising on an acquisition to include synergies that may arise on JVs, group reorganisations and restructurings and other wider group initiatives designed to create cost savings. Furthermore, the threshold before third party diligence is required was typically being set at 20% rather than the 10% that had been the market position previously;
- a trend toward financial covenants benefiting from more headroom to base case. On highly levered deals it was not unusual to see that set at 40-50% in some circumstances (despite 30% having being accepted in recent memory); and
- finally, in the upper end of the market the financial covenant package has also been established on an incurrence (cov-lite) rather than a maintenance basis. Rather than there being on-going quarterly tests the financial covenants are only tested for example, if the company wishes to make an acquisition or incur other debt.
In light of the above, many felt that mid-market sponsors were getting a good deal on financial covenants. So much so that market participants were starting to call the top of the market and were anticipating a re-adjustment. No one however could have anticipated the re-adjustment being brought about by the coronavirus pandemic.
- Financial covenants during CV-19
Across the market we have seen a variety of responses to financial covenants during the coronavirus pandemic. Perhaps unsurprisingly, the approach taken by lenders has largely depended on the sector in which the investee company operates.
Many investee companies in the leisure, retail, dining and travel sectors have not been generating anything other than minimal earnings since March and so the usual financial covenant suite of a leverage test and cash cover test simply isn’t appropriate.
As a result of that, in the worst affected sectors we have seen financial covenants suspended for between two and four tests (in effect 6-12 months) and replaced with a minimum liquidity / minimum cash test for that period. To support those financial covenant waivers a range of technical events of default (such as cessation of business, material adverse affect and certain insolvency events of default that may be triggered when the company speaks with its landlords) have also been temporarily waived for the duration of that covenant suspension period.
It is therefore worth focusing on minimum liquidity as it is likely to be here for some time – at least until investee companies can establish a consistent LTM EBITDA. Minimum liquidity is typically where lenders require the aggregate amount of cash, cash equivalent investments, availability under an RCF (or overdraft) and (occasionally) other permitted financial indebtedness to exceed a set amount. The minimum liquidity covenant is typically tested by reference to a weekly or fortnightly 13-week cash flow forecast. The minimum liquidity tests that we have put in place over the past few months operate on both a look forward/forecas basis and an actual basis. Indeed it is for that reason that we see minimum liquidity tests being capable of cure (both by way of equity injection and deemed cure). We have also seen some lenders accepting that a forecast breach must happen twice before it triggers an event of default or that the forecast simply triggers a renegotiation or discussion around liquidity support from the sponsor.
That being said, not every sector has been so negatively impacted. In those sectors where investee companies have been less affected by the coronavirus pandemic and have been generating earnings we have seen more attention given by management teams and shareholders to the range of EBITDA add backs. As one finance director said to us "I've never needed these add backs before but I want to bring them into my covenant calculations now so that I can use them if I need them". Many lenders are seeing that approach across their portfolios with their borrowers checking that the costs of factory closures, furlough top up payments, home working equipment, PPE equipment, health and safety audits are all exceptional and capable of being added back. Where a company is close to meeting (or indeed missing) its financial covenants, we would expect most finance directors to be looking at adding these (and other) exceptional costs back to their June and September EBITDA numbers.
- The future of financial covenants
As the economy slowly emerges from lockdown, will lenders be forced to think differently about financial covenants in leveraged loan agreements? In our view there are a number of issues facing market participants considering covenant packages for businesses that emerge from lockdown. Those issues would appear to be:
- whether management teams and shareholders can accurately produce forecasts for base case models
- whether covenant packages are flexible enough to take into account a second wave of the coronavirus and an associated "W" shaped recovery
- when covenant packages are turned back on will leverage tests be suitable given the LTM is likely to include some degree of covid impacted earnings?
Starting with those companies that have been unable to generate much if any earnings during lock down, it is clear that the typical package of leverage test and cash cover test on a last twelve months (LTM) basis is going to be unsuitable. The main reason being that management teams and shareholders will want to avoid both including a period where there were no or weak earnings and further exposing their business to a second financial covenant breach should there be a second wave of the coronavirus pandemic in the autumn. For that type of business we would expect to see minimum liquidity tests remain until a sensible trailing EBITDA can be established.
For businesses less affected by coronavirus or that expect to be better able to weather any second wave, we suspect that lenders will be keen to see the return of a leverage financial covenant sooner rather than later, although it is very likely that the initial leverage ratios will be lower than the pre-covid anticipated levels. How quickly those ratios will climb back to a normal or the precovid anticipated levels will doubtless depend on a variety of factors, but fundamentally a lot will depend on the strength of the forecasts and how much reliance all stakeholders (management, sponsor and lenders) can place on them. Right now for a lot of businesses any forecast is going to be subject to a host of material assumptions. We suspect that finance directors in particular will want to be cautious but if the forecasts show a very slow return to normality that will doubtless increase lender demands for sponsors to provide cash injections as a price of lender support.
Longer term we would expect the leverage test to remain, primarily due to valuations being based on EBITDA and institutional inertia making it very unlikely that regulators, lenders and investors in lenders will accept any change to it. However it may be the case that whilst earnings are depressed minimum EBITDA tests come to the fore until the pandemic in the UK is well and truly in the rear view mirror. The testing of other KPIs is another option (such as recurring revenues).
What is clear is that lenders may have to convince credit committees to accept a non-standard approach to financial covenants until the UK economy is firmly back on its feet.