Assessing the impact of coronavirus (COVID-19) on leveraged finance financial covenants

Assessing the impact of coronavirus (COVID-19) on leveraged finance financial covenants

Jeremy Duffy and Richard Lloyd, partners at White & Case, discuss the impact the coronavirus (COVID-19) pandemic on financial undertaking compliance in the leveraged finance market and what actions borrowers and sponsors can take to avoid breaching their financial undertakings during this time.

What impact has the coronavirus crisis had on financial undertaking compliance in the leveraged finance market so far?

It is anticipated that earnings before interest, taxes, depreciation, and amortization (EBITDA) will have reduced significantly from forecasted levels for the majority of borrowers and as a result, certain borrowers with financial undertakings based on leverage have begun to seek covenant holidays, resets or waivers.

This is more of a prevalent issue in the mid-market where many borrowers are subject to, at a minimum, a leverage maintenance undertaking, which is tested quarterly. Outside of such mid-market deals, many leveraged finance credit facilities are cov-lite, which means that there is no regular testing of a financial maintenance undertaking. Nonetheless, many borrowers have become reliant on their RCF in order to maintain liquidity, which creates a greater risk of triggering the threshold of RCF drawings at which a springing leverage financial undertaking would be tested under such cov-lite documentation.

Do you see an increase in defaults coming up? If so, when?

As borrowers are expected to report on their financial undertaking compliance at the end of Q2 of 2020, we anticipate that there will be an increase in those seeking holidays, waivers and amendments to avoid defaults. For credits that have already had difficulty with financial covenant testing, lenders are generally cooperating with borrowers in order to accommodate such requests, often agreeing to testing holidays and to waive existing defaults and avoid future defaults for a period of time, in exchange for borrower concessions.

Notwithstanding the above, we have witnessed an increase in defaults by credits during the coronavirus period, some of which were struggling with their covenant requirements prior to the onset of coronavirus. The entertainment, hospitality and travel industries are examples of sectors that have suffered an increase in defaults and potential defaults. Across the spectrum, this may be anticipated to continue as coronavirus remains a relevant factor.

Temporary changes to local insolvency regimes to deal with coronavirus and general government guidance regarding event of default moratoria and forbearance has also set the tone for avoiding a default and/or acceleration scenario.

What kinds of provisions in current documentation may assist borrowers avoid breaching their financial undertakings?

The EBITDA definition is key and underlying drafting should be considered on a case-by-case basis.

The flexibility of EBITDA add-backs will, in many cases, allow for an add-back of extraordinary item costs expended in connection with the coronavirus crisis. On that basis, lenders will see more coronavirus related add-backs in compliance certificates, as borrowers attempt to ‘normalise’ the relevant period. The extent of these add-backs and how they may be relied upon by borrowers in order to comply with financial undertakings has recently been the subject of increased attention (so-called ‘EBITDAC’)—however, while costs that have actually been suffered will qualify as ‘Exceptional Items’ (although such definitions can be broad), revenue add-backs are not customary. Lenders will have to make judgements on what add-backs are acceptable, potentially being more accepting if adjustments are made to maintain financial undertaking compliance versus increased flexibility for future actions (such as dividends linked to a leverage test).

With end of Q2 of 2020 fast approaching lenders are likely to see more coronavirus related pro forma adjustments for group initiatives or synergies (sometimes including cost and revenue synergies). These will not form a direct add-back for revenue lost due to coronavirus; rather, they will be intended to account for relevant expected revenue increases (rather than potential lost revenue). Borrowers may also utilise any flexibility regarding basket carry forward and/or carry back, along with relevant basket re-allocation mechanisms, in order to assist with financial covenant satisfaction.

In addition, sponsors should consider their equity cure rights, including whether they can overcure and if deemed cure provisions allow a covenant breach to be avoided if the impact is felt only temporarily.

What changes to documentation might borrowers and sponsors be seeking on new transactions to reduce the risk of financial undertaking breach?

As a general carve-out, borrowers may seek to incorporate within their documentation a waiver of any existing defaults plus language to prevent the occurrence of future defaults, if they arise directly or indirectly as a result of coronavirus (which will likely be for the agent to determine).

Provisions linked to cost add-backs in adjusted EBITDA and/or revenue add-backs need to be considered very carefully and these may cover pandemic-type events generally or otherwise be related to coronavirus only and capped to apply up to a specified date.

Borrowers may also consider requesting first financial undertaking test dates starting one to three quarters later than is standard and an extension of the delivery date for annual audited accounts (and the related compliance certificate) for year-end 2020.

If the borrower envisages accessing any state aid packages, then they could request that any liabilities incurred are permitted and appropriately treated (including being disregarded) under leverage based financial undertakings.

Is there anything else lenders or borrowers should be thinking about?

As lockdown restrictions globally are eased, there is a danger in thinking the risks linked to coronavirus will soon pass. The possibility of a second wave of infection and/or lockdown or an altered way of life for the foreseeable future means lenders and borrowers need to be careful when negotiating changes to their documentation to cover coronavirus. There will need to be a balance between borrowers not wanting to have to go back to their lenders in a few months’ time with additional waiver and amendment requests and lenders wanting to avoid granting short term concessions that ultimately become long term amendments and act as a fetter to key protections. We expect that lenders will use amendment and waiver requests in order to soften certain particularly aggressive documentary terms and to enhance their rights, in each case to appropriately take into account the potential ongoing impact of coronavirus on borrowers.

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About the author:

Miranda is a solicitor specialising in leveraged and acquisition finance. She trained at Hogan Lovells International LLP and qualified into the international banking and finance team. During her time at Hogan Lovells she worked on a variety of domestic and cross-border transactions, acting for both borrowers and lenders. She also experienced secondments to Barclays Bank PLC and Kaupthing Bank hf.