Navigating Uncertainty: Spring Time for RCFs - Part 1: Borrowers Benefit From Limited Drawdown Conditions; Documentary, Calculation Flexibilities May Allow Borrowers to Duck Triggering Financial Covenant Plus Prevent Breach Once RCF Is Drawn; Senior Secured Net Leverage Test Is Predominant

As the business impact of the Coronavirus pandemic intensifies across Europe, numerous companies have looked to draw their revolving credit facilities (RCFs) either pre-emptively or to meet current liquidity needs. In Part 1 of this twofold piece on springing covenants, we briefly discuss conditions for borrowing under RCFs and examine the consequences which may flow from RCF drawdown in relation to springing leverage financial covenants. Part 2 will address the consequences of any breach of financial covenants and available cure rights.
 
In normal times, RCFs are essentially committed overdraft facilities made available for working capital or general corporate purposes which enable borrowers to fund short-term liquidity or capital requirements. RCFs are rarely expected to be fully drawn and, in this era of cov-lite loans, extensive use of a revolver might be one of the first indications of financial distress.

Revolving loans are typically drawn for a term of one to six months after which they must be repaid, or rolled over into a subsequent interest period. Frequently, conditions to new RCF drawings in the current European leveraged loan market are limited to no existing or resulting actual or potential event of default and the ability to make relevant repeating representations; these lax conditions offer slim pickings in the way of drawstops for lenders reluctant to lend new money to a borrower now perceived as stressed. For rollovers, the conditions are often even less onerous and may require only that there has been no acceleration under the relevant credit agreement, allowing borrowers to keep drawn loans outstanding even when in default and potentially incentivizing them to draw down earlier rather than later.

With drawdown requests seemingly coming thick and fast, sources suggest that lenders have begun to question whether material adverse change events of default or “material adverse effect” language in representations the borrower is required to make on request and drawdown dates could provide a reason to decline to fund. A detailed interrogation of MACs is beyond the scope of this article but lenders should be aware that 50% of 2019/20 European loans reviewed by Reorg Debt Explained are absent a MAC event of default. When present, drafting would need to be carefully considered in each individual case, with the burden on lenders to demonstrate that they are entitled to refuse to lend.
 
Traditionally, leveraged finance loans contained a package of maintenance covenants tested quarterly, which operated as an early warning system for downturns in a borrower’s performance. Since 2017, the great majority of deals in the European leveraged market have been cov-lite, only requiring a financial covenant to be tested for the benefit of the RCF lenders when use of the RCF exceeds a specified threshold (springing leverage covenant).

Typical features of springing leverage covenants are below:
 

• Covenant-based on the ratio of net debt to Cons. EBITDA (“net leverage”), with those based on senior secured net debt outweighing those based on total net debt by 2:1 from 2017 to date;

• Ratio set with headroom of 35%-40% over relevant closing date net leverage (ensuring that even with a material decline in EBITDA the covenant may not be breached) and deleveraging over the life of the loan rarely required;

• Not tested during an initial “covenant holiday” of, traditionally, two complete financial quarters after closing or signing, now commonly extended to three or four;

• After the covenant holiday expires, only required to be tested if RCF utilization exceeds a specified amount (the “spring threshold”) at the end of a financial quarter;

• Spring threshold is either a hard amount or, more commonly, a specified percentage of the total RCF commitments at signing or the relevant quarter end date or, increasingly, the higher of the two;

• If the spring threshold is exceeded at the end of a financial quarter, the borrower must provide a compliance certificate demonstrating its compliance with the financial covenant at that quarter date;

• Compliance certificate not required to be provided until the deadline for the relevant quarterly or annual financial statements, which may be a substantial amount of time after the test date; and

• Breach of the springing leverage covenant does not cause an event of default for term facility lenders unless the RCF lenders accelerate.

As can be seen from the above, a number of hurdles may need to be jumped before springing leverage covenant testing is triggered, and, even when tested, the 35%-40% in-built headroom means that covenants are unlikely to bite until there has been a significant deterioration in performance.

Spring Thresholds in European Law-Governed Deals

   
Sponsors often succeed in excluding certain amounts from the tally of “utilizations” that will count toward the threshold to determine if the springing covenant will be tested. This means that even if the actual amount of the drawn revolver exceeds the spring threshold, by virtue of the documentary exclusions in the numerator, the springing covenant will not be tested.

Non-cash RCF utilizations such as letters of credit and drawings under ancillary facilities established using revolving capacity are frequently excluded from counting towards the spring threshold and, increasingly, cash RCF loans drawn for specified purposes are also disregarded. This artificially reduces the drawn amount and makes it less likely that their spring threshold will be reached.

For groups wishing to draw in cash, the most relevant carve-outs will be those that are wide enough to exclude cash drawings for non-specific purposes, for example:
 

• The common exclusion of cash drawn under ancillary facilities established using a portion of RCF capacity;

• Unusual, RCF drawings for acquisitions or investments, which frequently encompass a wide range of potential transactions (80% of 2017 to date deals with this carve-out capped the amount which could be deducted); and

• Extremely rare, RCF drawings to fund capex (50% of 2017 to date deals with this deduction allowed it on an uncapped basis), which could also have the benefit of freeing up cash previously allocated but unspent for that purpose.

Where the need for cash is less pressing, borrowers may look at utilizing RCF capacity for letters of credit or bank guarantees to support their business instead.


Exclusions From Spring Threshold Calculation in European Law-Governed Deals January 2017-March 2020  
The overwhelming majority of springing leverage covenants are calculated on a net basis meaning that cash and cash equivalents held by the borrower group are deducted from aggregate debt. Focusing on the debt side of the leverage ratio, any increase in gross debt resulting from drawing a revolver will be offset by the drawn and unspent cash held by the borrower, so even drawing an RCF in full in cash may not necessarily cause an immediate deterioration in a borrower’s net leverage ratio. Of course, if normal ongoing sources of liquidity are unavailable or insufficient to support the business and RCF cash is spent, net debt will increase over time.

Clearly, the net debt position is only one side of the leverage ratio and any increase in net debt could be offset by an upturn in EBITDA, whether due to an upturn in operating performance or, perhaps more likely in the current challenging business environment, the flexible adjustments permitted in the vast majority of EBITDA definitions or pro forma covenant calculation calculations. We also need to take into account the fact that leverage ratios are almost always based on trailing four-quarter EBITDA, so any financial covenant test at the end of the first financial quarter in 2020 is likely to include only one quarter affected by coronavirus. Looking to the next financial quarter and beyond, however, many borrowers will likely face decreased revenue from normal operations and, coupled with an increase in net debt, this could begin to eat into their generous covenant headroom.
 
In addition to the common carve-outs mentioned above, two considerably more aggressive provisions have cleared the market, which could substantially delay, or at worst prevent, springing covenant testing even if an RCF is fully drawn:
 

• As previously identified in our Data Highlights series, since 2017 a number of borrowers have successfully negotiated the ability to deduct cash and cash equivalents held by the group from RCF outstandings when calculating whether the spring threshold is met. This means that cash drawn under the RCF, and unspent at financial quarter end, will reduce the corresponding RCF outstandings to zero for spring threshold purposes even if earmarked for use shortly afterwards. This ability to “net” out RCF cash drawings when determining the spring threshold, coupled with the netting of such cash in calculating the ratio test is a double-whammy that seriously erodes the effectiveness of the springing financial covenant.

• We have also seen a small number of credit facilities over the same period where RCF drawings (in total or up to a capped amount) are not included as “debt” for calculating the leverage ratios. In such cases, aggregate debt would not increase when the RCF is drawn, even if all the cash was spent.

Financial covenants are not the only credit facility provisions which may be directly affected by increased RCF borrowings and borrowers should also consider the following:
 

• Increased debt will affect flexibility under incurrence-based covenants where capacity is determined by reference to a leverage-based ratio. “Netting” of RCF cash as mentioned above could also have an impact on whether or not such incurrence tests can be met.

• Impact of increased interest costs on fixed charges and consequences for utilizing FCCR-based baskets.

• Potentially increased margin under leverage-based ratchets.

• Leverage-based grids affecting prepayment obligations.

Finally, any borrower who is considering pre-emptively drawing its RCF because of concerns over its lending syndicate’s liquidity, then placing that cash on deposit, should bear in mind that relatively recent history shows that any bank with liquidity issues is unlikely to be able to meet a withdrawal notice.

If you have any specific queries on the financial covenants, or any other provision, in any document or deal in your portfolio please email questions@reorg.com