The start to 2020 has seen the most sponsor-friendly leveraged loan terms Debt Explained has ever reviewed. Several lender protections have been eroded even further than (what we thought were) the pro-sponsor extremes of the 2019 market. One such erosion, which we have seen in two leveraged loan deals to date, has been the introduction of an “auto-cure” in the financial covenant default provisions.An “auto-cure” allows sponsors to cure a financial covenant default at any time, provided the lenders have not accelerated
. The provision has already raised concerns for lenders in the unitranche market and, in this article, we evaluate the possible implications for leveraged loan market participants.
The 'Standard' Approach to ‘Cov-Lite’ Breaches
The leveraged loan market is now a “cov-lite” market. This means that the financial covenant package consists solely of a (usually senior secured) leverage test undertaken quarterly (but sometimes semiannually) if the drawn amount of revolving credit facility loans (sitting along-side a term B facility in the senior facilities agreement) exceed a certain percentage of revolving credit facility commitments (test condition).
When the borrowing group is in default, sponsors are allowed to cure the breach within a certain amount of time (the cure period, which is often 20 business days) by injecting cash into the borrowing group so that the leverage test is satisfied (an equity cure). If the breach is not cured by the end of the cure period, the revolving lenders are allowed to accelerate their loans and, if they do, the facility B lenders are then also allowed to call an event of default and accelerate their loans (under the cross-acceleration provisions).
In practice, if not already begun, the expiration of the cure period would kick off discussions between the revolving lenders and the sponsors about a potential work-out. In addition, depending on how stressed the credit is and what possible solutions they may be able to offer, facility B lenders may also be invited to join, or be fighting for a place at the work-out negotiation table. The loan agreement itself does not give facility B lenders a right to a place at the negotiating table and the leverage test is drafted specifically for the benefit of revolving lenders only.
Post-cure period discussions offer a valuable opportunity for the lenders to ascertain more detail about the financial ill-health and prospects of the borrowing group, and provide them with time to come up with solutions, while also giving them the right to accelerate should they so wish. A right to accelerate could affect the dynamics of the discussions in the lenders’ favor.
How Auto-Cures Differ From ‘Deemed’ Cures
A “deemed cure” states that if a financial covenant default occurs, is not cured within the cure period, and the revolving lenders have not accelerated by the next testing date, the breach will be “deemed” cured if, on that date, the outstanding revolving loans are below the threshold in the test condition (meaning that there is no need to determine whether the leverage test has been met or not) or, the borrowing group passes the leverage test.
Deemed cures essentially act as an “anti-dithering” long-stop date; the lenders only have until the quarter end to agree work-out terms or to accelerate, otherwise the lending will continue as if the default had never happened, if the borrowing group is back in compliance on the next quarter date. Of course, if the borrowing group has not been able to take advantage of the deemed cure provision, the default will remain. Deemed cures make the timing clear to both sides and are now very common, appearing in 85% of all leveraged loans we have reviewed since Jan 1, 2019.An auto-cure is arguably a game-changer in that it gives more power to the sponsors than “deemed” cures at a time, post-default and in a distressed scenario, when arguably it should be the lenders who have the better hand to play.
The auto-cures that we have reviewed have not contained any conditionality, such as a cap on the number of times it can be used. While we have yet to see an auto-cure provision utilized, it is clear that their inclusion increases uncertainty.
Curing Without New Equity Injection
Like deemed cures, auto-cures allow cures to take place without requiring any new equity to be injected. Auto-cures can be effected simply by re-calculating the test condition and the Leverage Test based on new internally available financial information, such as monthly management accounts (to be delivered to lenders). There is generally no express requirement as to how the recalculation is to be done or what factors, including the source of funds, to take into consideration.
So it could be that since the breach, a business change has occurred (such as the disposal or acquisition of an asset), or something has been reassessed, or can now be taken into account, such that there is a positive impact on EBITDA for the borrowing group. Both auto and deemed cures allow for these types of “non-equity” cures.
Effect of Auto-Cures on Existing Cure Provisions
Overall, the effect of an auto-cure on the existing cure provisions found in a syndicated loan agreement is two-fold:1 - Lenders have less certainty about the sponsors’ position
. During the cure period, the sponsors will either implement an equity cure by providing more cash, thereby indicating their commitment and general positivity for a recovery, or they won’t. An auto-cure however allows a cure by any means and at any time
, so sponsors are not forced to provide a “cash” indication of their position. (That being said, the requirement for sponsors to provide their cash for the equity cure, has been chipped away in very aggressive deals, as cash of the borrowing group can be used to effect a prepayment cure. This means that an equity cure can be effected without a sponsor cash injection.)2 - Lenders have no visibility on timing
. If the borrowing group comes back into compliance with the financial covenant, the breach is deemed cured at that time; and there is no need to wait until the next test date. Auto-cures can be seen as accelerated deemed cures. As such, there is no need for a deemed cure to be in the same loan agreement as an auto-cure, although the two deals we have seen in the market to date with auto-cures also contain “deemed” cure provisions.
Key Concern - Sponsors' New Weapon
One of the key concerns in the market about an auto-cure is that, used to its maximum advantage, it could give sponsors the chance to flush out details of the revolving lenders’ strategic position; Will they accelerate their debt or agree a work-out and, if the latter, what will the terms look like?
It also allows sponsors to shut down negotiations whenever they choose, prevent acceleration, and buys them time until a subsequent breach of the financial covenant, or potential payment default etc.
Practical Considerations Relating to Auto-Cures
How an auto-cure would play out in practice will of course depend on many factors. For example, a family-owned group may be more willing to inject further cash into a failing business to cure breaches (and they may therefore seek to initially utilize an equity cure) than an institutional sponsor which has seen the credit restructured on a number of occasions and may be less willing to risk more of its cash (resulting in the auto-cure being utilized, if possible, to cure the breach and buy time).1 - Are auto-cures a threat to revolving lenders in practice?
The market is now not only “cov-lite” but what could be called “helium-lite” in that most of the market do not consider a “cov-lite” financial covenant package to be much use as a red flag for signaling the group’s financial distress. As just two examples of how “cov-lite” protection has been diluted down (i) headroom built into the leverage test is now high enough that it makes it unlikely the covenant will ever be breached, and (ii) generous EBITDA addbacks and other adjustments help to keep the group’s leverage well below the leverage test.
So to some extent, an auto-cure may not be of concern, given there is unlikely to be a breach to cure in the first place. But however unlikely a breach may be, auto-cures still give sponsors an extra right to cure which could be problematic for revolving lenders should a transaction ever reach a post-cure period stage.
Revolving lenders are most often traditional deposit taking banks, so are likely to want a work-out rather than seeking acceleration or any kind of enforcement. The auto-cure could still be a headache for revolving lenders, who wish to prevent any further value destruction to the group by quickly implementing their work-out, should the sponsors pull the rug from under their feet and use it. And this threat may also change their strategy and the negotiating dynamics for them.2 - Should facility B lenders push back on a covenant from which they do not directly benefit?
There may be some value in facility B lenders resisting the introduction of auto-cures more widely into the market. Not just in relation to the current “cov lite” market where, if the revolving lenders are never in a position to accelerate for breach of the leverage test, neither will the term lenders be but in relation to what may come next in the economic cycle.
Should an economic downturn occur, it is possible (arguably probable) that the market will revert to having a protective maintenance financial covenant package, with a leverage test, tested quarterly without exception, that directly benefits and protects facility B lenders. However if an auto-cure has become an entrenched sponsor right in the syndicated leveraged loan market by such time, it would be another flexibility for lenders to negotiate to remove. To avoid this, facility B lenders should resist having auto-cures in their “cov-lite” loan agreements from the off. On the other hand, if the financial covenant itself is to be tightened then this will go hand-in-hand with a tightening of the cure provisions, including a possible deletion of the auto-cure.
Lender Push Back Yielding Results
The start of the 2020 market has not been completely bleak for facility B lenders. We have seen successful lender push-back during syndication in a few of the deals reviewed so far, even though in some cases the changes have been minimal. Interestingly, the two “auto-cure” deals saw a synergies cap introduced, and in one of the deals (i) the "inside maturity" basket for incremental facilities was removed, (ii) the margin ratchet had the number of step-downs reduced and the size of the step-down increased, (iii) various changes were made to the transfer provisions, and (iv) the "net short lender" provision was removed.
Successful resistance to the wider introduction of the auto-cure is not implausible. Revolving and facility B lenders just need to decide if this battle is worth it when there are many other battles to fight with each term sheet that comes their way.