New Coverage: A 4.25x Secured Leverage Maintenance Covenant Under Advanced Drainage Systems’ Credit Agreement Currently Limits Company’s Ability to Fully Utilize Permitted Secured Debt Capacity

Relevant Items:
Covenants Tear Sheet, Debt Document Summaries
Advanced Drainage Systems Debt Documents

Advanced Drainage Systems (“ADS”) designs, manufactures and markets water management solutions in the stormwater and on-site septic wastewater industries. For its fiscal 2022 second quarter ended Sept. 30, 2021, ADS reported an increase in net sales of almost 30%, but gross profits decreased 3%, “due to an increase in the use of third-party logistics services due to labor shortages impacting the manufacturing and transportation operations.”

ADS is the borrower under a single secured credit agreement that provides for a $350 million revolving facility and a term loan. It is also the issuer of a single series of unsecured senior notes.

The company’s capital structure as of Sept. 30 is shown below:

 

 

• Springing financial covenant - The credit agreement contains a springing financial covenant that only benefits the revolving lenders. If the amount of outstanding revolving loans as of the last day of any fiscal quarter (including all noncash collateralized letters of credit) exceeds $122.5 million, the secured net leverage ratio may not exceed 4.25x.
  
  The springing 4.25x secured net leverage ratio covenant is currently tested and the company is in compliance, with a secured net leverage ratio of 1.1x as of Sept. 30.


• Debt and liens - The credit agreement permits about $2 billion of additional secured debt, using a combination of the incremental loans/incremental equivalent debt basket and general liens basket. The loan parties can incur unsecured debt until the interest coverage ratio hits 2x, and foreign subsidiaries can incur at least $125 million of debt secured by their assets.
  
  The senior notes are less restrictive than the credit agreement, permitting loan parties to incur almost $3.3 billion of additional secured debt under a credit facilities basket, secured debt basket and general liens basket. Unsecured debt is permitted until the fixed charge coverage ratio hits 2x, and this basket can be used by both loan parties and nonguarantors. Because the liens covenant in the senior notes only restricts the loan parties, however, the ratio basket essentially permits secured nonguarantor debt until the fixed charge coverage ratio hits 2x.
  
  Nevertheless, because the 4.25x secured leverage financial maintenance covenant is currently in effect, and because the secured leverage ratio includes all debt secured by any assets rather than just debt secured by collateral assets, the company and its restricted subsidiaries are currently barred from incurring more than about $1.8 billion of secured debt.
  
  If the company were to reduce outstanding revolving borrowings to below 35% of revolving commitments, the limitations currently imposed by the financial maintenance covenant would terminate.


• Restricted payments, investments - In the credit agreement and the senior notes, unlimited restricted payments are permitted if the net leverage ratio is less than 3.25x and there is no event of default; unlimited investments are permitted if the net leverage ratio is less than 3.5x and there is no event of default.
  
  With a net leverage ratio of 1.7x as of Sept. 30, ADS can currently make unlimited restricted payments and investments.
  
  Because the financial maintenance covenant is tested net of all unrestricted cash, to the extent the company uses its balance sheet cash to pay dividends or to the extent it transfers unrestricted cash to unrestricted subsidiaries, the resulting increase in secured leverage will reduce the company’s flexibility to incur additional secured debt.


• Senior note purchases - The prepayment covenant in the credit agreement restricts all optional or voluntary prepayments of unsecured debt, subordinated debt or junior lien debt, in each case in a principal amount over $25 million. This means the company cannot purchase its unsecured senior notes in the open market unless it can comply with a basket.
  
  Unlimited prepayments are permitted if the secured net leverage ratio is less than 2.25x and there is no event of default. Given the company’s current secured net leverage ratio of 1.1x, ADS can purchase its notes in the open market.


• Lien subordination amendments - Amendments to the credit agreement that result in the lenders’ liens being subordinated likely only require consent from a majority of lenders.
  
  Because the company can purchase the term loans directly from the lenders in the open market, it is likely able to pursue a superpriority uptier exchange similar to those previously consummated by Serta Simmons, Boardriders and TriMark.

--Alisha Turak