COVID-19: implications for debt agreements
While many companies have been considering the impacts of coronavirus on their commercial agreements (see our briefing Coronavius: implications for commercial contracts and M&A agreements), to the extent they have borrowed in the leveraged loan market, they should also consider some additional practical questions in relation to their debt arrangements, anticipating that financial markets will continue to be volatile due to the widening impact of the coronavirus (COVID-19) and the oil pricing war between Saudi Arabia and Russia.
Here are some practical questions to ask in relation to your debt arrangements:
- Does my company have sufficient liquidity? Should the company use available lines of credit to ensure it has sufficient liquidity? Consider reasonable steps to ensure you have access to cash if your business foresees a drop in revenue from less demand and/or customers not settling invoices in a timely fashion.
- What will this do to the company’s financial covenants? Are there actions the company should take before the ratios are measured again? Consider whether financial ratios caused by a drop in consolidated net income and/or EBITDA will cause a default or prevent other key transactions.
- When does the company’s debt mature? Do contingency plans need to be made in the event the markets will not support a refinancing for an extended period? Consider whether a maturity date is approaching and, if so, whether to begin discussions with lenders to amend and extend existing debt arrangements.
- Are there opportunities for my company to improve its financial position in the current environment? How does my company take advantage of them?
Can the company borrow under its revolver? What other options are there to maintain liquidity?
It depends on the borrowing conditions in the contract, but generally borrowing under a revolver requires the following:
- Accuracy of representations. Representations generally must be accurate when a borrowing is requested and on the date of the borrowing. Many agreements will contain a representation that there has been no Material Adverse Effect on the borrower. While many definitions of Material Adverse Effect will include any event that causes a material adverse effect on the financial condition and/or operations of the borrower’s business, we have not yet heard of banks refusing to fund revolver draws on this basis and such a refusal is very uncommon.
- No Default or Event of Default. A confirmation that there is no continuing default and the borrowing will not cause a default. This should be evaluated in light of any financial maintenance covenants (as discussed further below).
In addition to drawing under a revolver, consider any flexibility in your loan agreement to implement new cash management practices, raise new debt or sell assets to raise cash.
What might happen in light of the company’s financial ratios? Can I deliver my annual audited financials? What are the consequences?
Consequences will depend on the nature of a borrower’s business and the terms of its specific debt agreements, but generally:
- Effects on ratios. Many borrowers will see either a reduction in consolidated net income (CNI) from a slowdown in sales and/or an increase in costs as supply chains are rerouted and accommodations are made to help employees. CNI typically forms the basis of a borrower’s calculation of EBITDA, which is then used in financial ratios. EBITDA definitions typically have a number of adjustments. A common adjustment is a right to add-back to EBITDA any losses and costs incurred for events that are extraordinary, unusual or non-recurring. That may provide some relief to some borrowers. Most borrowers, however, will see ratios deteriorate in the more general economic slowdown arising from COVID-19 and the volatile markets.
- Consequences of reduced EBITDA on financial covenants. The majority of loan facilities will include either a regularly tested financial maintenance covenant or (if ‘cov-lite’) a ‘springing’ financial maintenance covenant that is tested regularly after a borrower’s revolving facility is drawn above a certain threshold. Each borrower should evaluate whether borrowing under its revolver will cause a springing covenant to be tested and, if so, whether it can comply with the ratios. A default arising from non-compliance with a ‘springing’ covenant can almost always be waived with the consent of a simple majority of the revolving lenders only.
- Consequences of reduced EBITDA on transactions. If its EBITDA deteriorates, a borrower may also be restricted from consummating key transactions which may need to meet certain financial ratios, including incurring debt, granting liens, selling assets or making restricted payments (among others). Each borrower should evaluate what actions it may wish to take before deteriorating EBITDA prevents it.
- Timing of testing ratios. When financial ratios are tested depends on the terms of each loan agreement. Most loan agreements test financial ratios quarterly by reference to the most recently delivered audited or unaudited financial statements. With a backwards-looking test, there may be an incentive for borrowers to draw on debt or undertake key transactions before delivering financial statements that show declining EBITDA.
- Audited financial statements. Most loan agreements require borrowers to deliver annual audited financial statements for fiscal year 2019 no later than a date somewhere between end of February and end of April. Borrowers who are in the middle of their audit season should discuss with their accountants whether their audit reports can be completed by the date required under their loan agreements. If not, borrowers will need to discuss an extension with their lenders.
When does the company’s debt mature? Does a contingency plan need to be made in the event the markets will not support a refinancing for an extended period?
While debt investors assess the new economic reality resulting from COVID-19, new debt issuances in the syndicated loan market may only be an option only for investment grade borrowers. Others should consider:
- Debt maturity. Luckily for the market as a whole, only 5% of leveraged loans in the market have a debt maturity in 2020 and 2021, and most do not mature until 2024 or 2025.
- 2020 maturities. Borrowers that have debt maturing in 2020 and 2021 will either need cash on hand to repay the debt or will need to seek an extension of the maturity date from existing lenders. Amendments to extend maturity dates typically require the consent of all lenders, subject to the rights of the borrower to replace non-consenting lenders in certain circumstances.
Are there opportunities for my company to improve its financial position in the current environment? How does my company take advantage of them?
- Debt buybacks. For many companies, their loans are trading below par on the secondary debt market right now due to general concerns about corporate debt in the market. A borrower that is comfortable with its liquidity position may be able to retire debt at a discount. Most loan agreements will permit a borrower or its affiliates to buy its debt, sometimes subject to an aggregate cap or a requirement that an offer to purchase be conducted by Dutch auction among all current lenders. If a borrower or another obligor purchases its own debt, then it is typical that the debt agreement requires the debt to be immediately retired. If an affiliate that is not part of the credit group purchases the debt, there is typically an aggregate cap on the amount that can be bought and held.
- Interest rate swap agreements. Central banks have cut lender borrowing rates to near zero, and reference rates such as LIBOR are at historically low levels as a result. As of the date of this briefing, swap desks at most major banks continue to offer interest rate swaps at commercial rates. Borrowers can lock in low interest rates for some or all of their interest rate exposure on long-term debt by entering into interest rate swaps during this period of historically low rates.