The global implications of coronavirus are fast evolving. Around the world, there are health concerns, disruptions to workers, supply chains and travel, and effects on M&A, equity and debt market confidence. Each of these challenges will have at least some effect on potential, committed and existing leveraged finance transactions. This article discusses general themes that borrowers, lenders and financial sponsors must consider, keeping in mind that resolving these complex issues will depend, as always, on careful analysis of the specific contractual wording in the relevant finance documents.
M&A transactions and committed funding
Many leveraged finance deals are undertaken to fund the purchase price of M&A transactions. From a committed funding perspective, M&A transactions can effectively be split into two types of transactions: (i) certain funds or (ii) non-certain funds.
A certain funds transaction is either required for regulatory reasons (usually due to mandatory takeover laws) or because the selling party wants increased certainty on the buyer’s ability to close the transaction, and thus will not allow a financing condition in its sale and purchase agreement.
In a certain funds transaction, only extremely limited conditions or factors would allow financing parties to withdraw their committed funding from the deal. Thus, coronavirus should not have an impact on already committed funding and the buyer’s ability to draw debt to close should not be impacted. While good for the M&A, where the acquisition financing is on a bridge-to-bond basis, under the cloud of coronavirus, the “take-out” bond may be difficult to market (or simply impractical as investor meetings are postponed or cancelled), and so the take-out transaction will be delayed. This will affect the buyer, as the bridge pricing is likely to step up every three months in the first year of the bridge period.
All of the above may of course have an additional impact of delaying M&A due to either banks’ concerns over their ability to syndicate while the coronavirus situation develops, and thus reluctance to commit financing, and/or buyers’ unwillingness to risk being caught in hung bridge debt.
The alternative is to have a financing “out” in the M&A agreement, which would allow the buyer to pull out if it cannot secure financing. This would allow the debt commitment papers to include a material adverse change (MAC) provision which would terminate debt commitments when a MAC occurs.
MAC and MAE – business, payment and market
There are generally three types of MAC, business MAC, payment MAC and market MAC. It is relatively rare to include MAC clauses in an acquisition financing as a drawstop, but they can be included under certain circumstances, and are more common in other leveraged financing transactions such as a refinancing or dividend recapitalization. However, such MAC clauses do exist, and are closely linked to material adverse effect (MAE) clauses, which are discussed together at this stage.
MAC clauses are also the obvious way that financial institutions could try to protect themselves from market deterioration when signing debt commitments, although their incompatibility with acquisition finance transactions that lack a corresponding financing “out” is likely to continue to limit underwriters’ ability to include this provision in many situations. When relying on a MAC or MAE, the drafting of the relevant provision and what it covers is key.
Business MAC: If there is a business MAC, it typically relates to an adverse effect on some or all of the business, condition, operations, performance, assets or prospects of the borrower. However, while this may seem broad, common law courts have traditionally set a very high materiality threshold on matters of MAC and there would need to be compelling evidence based on existing coronavirus circumstances, that the buyer’s business was in fact materially adversely changed. Particularly given the relatively early days of the outbreak and the developing situation, it may be difficult to say what the impact will actually be and how, or when, it will affect any particular business. However, to the extent the current circumstances subsist for a significant time, particularly as businesses report Q1 2020 financial results (likely from May onward), we expect parties to financings will further consider these points.
Payment MAC: A payment MAC relates to the borrower’s ability to pay its obligations under a finance document. Payment obligations are fairly straightforward to determine and, traditionally, focus on a one-year time frame. Accordingly, to trigger this limb, the relevant creditors would most probably need to establish that the issuer/borrower would be unable to make its payment obligations falling due in the following 12-month period. This can be a difficult threshold for lenders to prove.
Market MAC: A market MAC refers to a MAC in either the debt, equity or capital markets (either international or domestic) (or a derivative of those terms), and/or may relate to stock exchanges and/or currencies. Again, while the specifics will be key, the wider markets have generally reacted negatively to coronavirus-related news and these losses are both more public and in most cases more immediate than the impact on any one particular business. The market MAC may also extend to issues with syndication. This may leave more room for discretion on the banks to call a market MAC condition, given they will have more information than the borrower on syndication conditions.
A market MAC is often also included as a closing condition in a high yield bond purchase agreement. Given the closing period on a high yield bond tends to be only three to ten days, this is a more limited period, and in addition, the change must happen during that period and so the underwriters of the bond cannot change their minds based on a mere continuation of bad news, there would need to be additional market developments, for that to be triggered.
In either case, it is important to consider the state of affairs when one entered or enters into an agreement containing a MAC clause. Parties entering into new transactions as coronavirus spreads must consider this carefully, as whether there has been a material adverse change to any particular circumstances must reference the circumstances at the time of contract. Thus it may be more difficult for more recent contracting parties to call a MAC based on coronavirus, though of course it cannot be predicted how circumstances will ultimately end up and what further adverse effects on business may occur.
The above discussion mainly relates to shorter term financing commitment documents that may currently be in place or may be put in place for a new transaction. In terms of existing financings already in place, the MAE is related to the MAC. The Loan Market Association (LMA) leveraged loan agreement contains an Event of Default where “Any event or circumstance occurs which the Majority Lenders reasonably believe has or is reasonably likely to have a Material Adverse Effect (MAE)”, while the LMA Investment Grade version raises this as optional drafting (though with no specific proposal). MAE is similar to MAC, except that a MAE clause typically would only cover the business MAC and payment MAC as discussed above. This means the issuer/borrower is less at the mercy of wider market sentiment, with a sharper focus on their business. To the extent that financial institutions are worried about market sentiment, Events of Default will therefore generally provide no assistance.
The MAE event of default is often resisted by issuers/borrowers in the US and Europe in any event, but the definition is included to qualify undertakings and representations under the loan agreement. That will mean that specified events (such as breach of laws, authorizations, taxation) must both be breached under the loan agreement and potentially cause an MAE. In most instances, the evidential burden on lenders to try and prove such an MAE, being focused on just the business and payment condition, will be challenging. It is more likely that where an MAE is occurring and the business is actually impacted, the issue will be so fundamental that another more obvious event of default will occur, such as non-payment or insolvency. Ultimately the analysis of these provisions must be undertaken under the applicable legal system for the relevant legal contracts. It may be that common law and civil law jurisdictions would not reach the exact same result.
Maintaining performance – issues with maintenance covenants
While a large proportion of US and European leveraged finance is now cov-lite with no traditional maintenance covenant, a variety of transactions still include maintenance covenants, including older loans, loans in Asia-Pacific, those for lower quality credits, mid-market loans (particularly those held by banks) or private debt deals, as well as more bespoke instruments such as Nordic-bonds. In addition, as discussed below, there is often a springing maintenance covenant in a revolving credit facility which may be included in a financing package.
A maintenance covenant requires an issuer/borrower to maintain a specific financial ratio or metric. Take for example a net leverage covenant, which tests net debt to EBITDA (earnings before interest, tax, depreciation and amortization, which is then typically further adjusted for negotiated items). Negative impacts on a net leverage covenant would either be caused by (i) reduced earnings (impacting EBITDA) or (ii) the use of cash to mitigate such impact, to assist staff or otherwise address a business-need related to coronavirus, which would (i) reduce net income due to higher costs and (ii) increase net debt due to there being less cash to net.
The triggering of a maintenance covenant due to any of the above would be problematic for an issuer/borrower, however there are important mitigating points to consider:
- the definition of EBITDA needs to be reviewed to consider if any add-backs are permitted that may impact the calculation. There may be an add-back for non-recurring (or extraordinary or unusual) losses, charges or expenses. While the exact terminology will differ, it may be arguable (on a case-by-case basis) that costs related to coronavirus which are extraordinary in nature can be added back to adjust EBITDA. However, these all relate to amounts spent rather than lost revenues. In fewer deals, there is also an add-back for reductions that are covered by insurance and are actually reimbursed or that are likely to be reimbursed. This will require both a careful analysis of the exact add-back permitted, but also of any applicable insurance policy to ensure a good grounding for the determination that the applicable add-back conditions have been met. Discussions on these points may also involve auditors and reference to auditing standards and how these will classify the applicable line items. These add-backs may be one of the more topical points in the near term, given the year-long impact of even one quarter of disruption due to coronavirus.
- if the maintenance covenant is a “springing covenant”, then it may only be tested when an applicable drawing threshold is met. This means that if the company can manage its cashflows, it may be able to draw the cash after the covenant testing date and then not be tested for a full quarter. While this is somewhat risky in the event the coronavirus situation worsens, it does provide what could be important additional liquidity at a time when the company may have a more immediate requirement.
- in relation to equity cures (a sponsor’s ability to inject equity into a group to avoid/cure a breach of maintenance covenant), the ability to overcure will also be closely examined given the ongoing uncertainty of the impact of coronavirus, with sponsors’ potentially wanting to provide a cushion for the upcoming year rather than having to repeatedly provide emergency funding. Whether that is permissible will vary on a case-by-case basis.
- lender sentiment will be interesting to assess and will depend on a number of matters. Generally, a maintenance covenant is meant to act as an early warning sign for lenders, rather than necessarily leading to a route to enforcement. The early warning sign in the coronavirus context is perhaps more obvious than in other deals where the underperformance is due to less clear reasons. Lenders will have to assess how to react to any covenant breaches which are connected to potentially shorter term impacts of coronavirus, in particular at a time when they may prefer management to spend time working on mitigants to the business effects of coronavirus rather than additional time with lenders. In addition, the lenders’ position in the capital structure (either as super senior on collateral, or closer to the assets), may mean they are able to exercise patience through the more difficult period for the company, compared to junior creditors without a maintenance covenant who may ultimately bear the brunt of impairments to the capital structure.
In the Asia market, where the near term effects of coronavirus have been most acute and, so far, the most long-lasting and widespread, certain market dynamics have meant that the themes discussed top the agenda for parties to financings. Given the high prevalence of maintenance covenants in Asian loans, the add-backs to EBITDA (mentioned above) and mechanics for equity cures are being closely examined. In addition, in the Asian markets, virtually all leveraged loans are amortizing, so borrowers face a crunch to meet scheduled amortizations, meaning payment defaults are being brought into acute focus. These are obviously of a more immediate concern to lenders and are a more significant near-term issue than in many other markets.
Remember LTM: It is important to note that the covenant impact will also occur on an ongoing basis. Maintenance covenants are based on a rolling last twelve months (LTM) of EBITDA. This means that the impact seen in Q1 2020 will still affect companies deep into the year, as their look-back period takes into account their operations during the initial growth phase of coronavirus. This also impacts incurrence covenants, as discussed below.
Coronavirus is not an excuse: It is worth noting that finance documents seldom (if ever) contain a force majeure provision, i.e. one that excuses performance of the contract on the basis of a defined set of circumstances. This is relevant in the context of maintenance covenants, as the issuer/borrower will be unable to merely rely on such a provision and wait for coronavirus to pass. If a maintenance covenant is breached, the issuer/borrower will ultimately still have to resolve this with the lenders in due course. While beyond the scope of this commentary, in certain legal systems, there are additional considerations such as doctrine of frustration, but this tends to be an even higher threshold than a force majeure clause would have been held to (if included).
Taking action – issues with incurrence covenants
Many leveraged loan deals in the market are in fact now “incurrence” covenant based, which is the high yield bond covenant position, tested only when certain fundamental corporate actions are taken such as incurring debt, distributing cash to shareholders and/or selling assets.
These cannot be triggered unless such actions are taken: incurrence covenants effectively cannot be breached unless (i) you do not pay interest or (ii) you do not provide relevant financial information (see below).
However, going forward there are impacts on these incurrence covenants worth noting:
- while there are no financial maintenance ratios, there may be incurrence based ratios, such as a net leverage or fixed charge coverage ratio debt incurrence covenant, and the ability to use each of these may be impacted as with a maintenance covenant. While the result is less severe than a default, the inability to use such ratios may impact the business (preventing, for example, the incurrence of additional debt or the payment of dividends or cash distributions to shareholders)
- the ratios, as well as certain additional tests such as “grower” baskets for various covenant restrictions, may be based on EBITDA. Thus, the discussion above related to EBITDA may be important. Alternatively, there may be a non-fundamental default outstanding that the issuer/borrower is able to remedy in the near term, but they must be mindful that certain corporate actions or covenant baskets may be unavailable while a default is outstanding.
- as also discussed above, the rolling 12-month basis of EBITDA means that notwithstanding a near term coronavirus resolution, the virus’ effects will be felt for the 12-month period under EBITDA. This may particularly affect any businesses that rely on a busy first quarter (due for instance to seasonality), as they may have lost out on a boost they typically get from that quarter in their LTM test, which will impact them for the next year.
Reports, audits and information
Frequent reporting is an important investor information right under finance documentation. This typically requires audited annual and unaudited quarterly information to be delivered under a high yield bond, as well as monthly information under certain loan agreements, in each case, within a certain specified time period. Businesses interrupted by coronavirus may face certain reporting issues, such as an inability to obtain accounting information due to facilities closures. As discussed above regarding force majeure, there is typically no provision for additional time for filing such information due to external issues (which contrasts with, for instance, the position taken by the US SEC, which has announced certain conditional relief for delayed earnings report filings for companies impacted by coronavirus). This means that an issuer/borrower may find itself in default if it cannot provide the relevant information, for instance because it cannot get an audit due to the lack of some supporting information. One solution may be to finalize a qualified audit for the period. However, under the LMA loan agreement, an audit qualification is an event of default, and for future capital markets transactions, a qualified audit can be undesirable.
Beyond leveraged finance
While this commentary focuses on leveraged finance, many of these points will apply to finance documents at all levels of the market. In particular, the points related to audits and information reporting will impact even high grade issuers, and borrowers at all levels will need to check that suite of financings to identify any potential issues and address them appropriately. For instance, this may include re-visiting business plans which may have been based on expectations of subsidiary performance, which may be impacted in their local financings by some of the points above.
The White & Case Banking and Capital Markets teams across Asia, EMEA and the Americas continue to monitor developments related to coronavirus and the manner in which it implicates both global and local markets.
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