Dash for Cash to Boost Liquidity Tests Docs; Embedded Flexibility Can Prevent Triggering Springing Covenants; Top 10 Covenant Areas for Consideration in Pandemic

March has, by all accounts, been a seismic month in the history of the world. The coronavirus has wreaked change in personal and professional lives in an unprecedented manner. The outbreak of the virus moving out of Asia into a raft of other countries in early March put credit markets under enormous pressure. The oil price crisis then overlaid the shock to demand and supply caused by coronavirus.

Covid-19 has taken its toll in multiple spheres, and the world of leveraged finance covenants is not unscathed. There has been a renewed focus on provisions in documents, ranging from delivering financial reports, enhancing liquidity, consequences of materially adverse events, and the testing of covenants.
 
The most significant theme was a desperate rush for cash. This was evidenced in the credit markets, as well as in businesses operating in leveraged finance markets. Companies rushed to either pre-emptively or, in a situation of real necessity, draw down on their revolving credit facilities. To monitor this important trend, Reorg created an RCF tracker for our clients which, among other metrics, states current drawn amounts and applicable financial covenant tests.

This scramble for liquidity to plug the gap created by cash flow slowdowns, shone light on financial covenants, or indeed the lack of them. In the previous financial crisis of 2008, the genesis of most restructurings was a potential or actual breach of maintenance financial covenant. This fundamental protection has all but evaporated in the current cov-lite world. Its replacement, a springing financial covenant, has over the years been denuded of its strength and purpose.

In extreme situations, borrowers can increase its cash balance by utilizing their revolver and all other credit lines such that in reality they exceed their documented financial covenant test - and yet not have a breach under its documents. We wrote about how borrowers can exploit their documents to this end in our Navigating Uncertainty series. On the other hand, there has been discussion among lenders on their ability to refuse a draw, potentially by relying on a material adverse clause (MAC), as we discussed in the Navigating Uncertainty series and our Covenant Conversations podcast.
 
Revolvers, sitting alongside high-yield bonds in Europe are frequently “super senior”. The super senior debt basket in bond documents that such revolvers are drawn under came in the spotlight this month. The key question being headroom. Our research into super senior debt baskets in the heavily affected gaming and retail industries revealed that there is often additional headroom for super senior debt, on top of the RCF, when a bond is put into place. And now companies are making use of that extra slice of super senior capacity - KKR-owned Selecta, which had a €150 million revolver, availed of a further super senior €50 million single currency term loan from KKR Credit under its €200 million super senior debt basket under its 2024 notes in late March. Pizza Express also incurred further super senior debt in March.

Raising liquidity through issuance of debt (be this pari, super senior, structurally senior, effectively senior, or any other kind) was a key focus area in March, as the primary markets for traditional debt issuance was by and large shut for junk issuers. Investors are concerned about getting primed by super senior or flanked by new and unexpected pari passu debt. We scrutinized subordination risks for individual issuers through their debt and liens baskets. In addition, we dug deeper to evaluate the impact of coronavirus on addbacks to EBITDA and CNI, as such addbacks could limit the impact of lost earnings on their covenant EBITDA, which feeds into basket amounts.

We will be hosting a webinar for investors on dilution and subordination risks in mid-April. An invitation will go out to all subscribers soon.
 
Ability to make RCF draws, incur priming debt and prevent financial covenant breaches are not the only areas the investors and borrowers should be concerned about in these testing times. We have compiled a list of the top 10 areas of covenant risk in leveraged finance documents amid the coronavirus outbreak. These include postponement of financial statements, such as Hema, restrictions on transfers that exacerbate illiquidity risks, adequacy of credit support, defaults, waivers and restructuring options.

While the non-delivery of financial statements can be perceived as a more benign sign of stress, more acute stress was felt by weak companies in severely hit sectors such as travel for instance in the case of U.K.-based foreign exchange company Travelex. The group has likely breached its financial covenant under its revolver and is seeking a waiver with little hope to receive financial support from its shareholder Finablr, which is already in restructuring talks. We examined the restructuring options for Travelex, including options to ease the liquidity squeeze in a report HERE.

Rating agencies are predicting an uptick in speculative grade-rated corporate defaults. Most borrowers are likely to fail due to a lack of access to liquidity to keep in business. BrightHouse collapsed into an administration blaming coronavirus. The rent-to-open operator, already struggling, tipped over due to store closures in the U.K. The Restaurant Group, which owns restaurants Wagamama and Frankie & Benny’s, filed a notice to appoint administrators for Mexican chain restaurant Chiquito’s.
 
Central banks responded with extraordinary and sweeping action to ease the tightening of liquidity conditions in March. In consonance, governments across the world made significant fiscal policy changes, providing government aid to affected businesses, such as the €1.8 billion liquidity bolstering loan TUI received from the state-owned KfW bank. Across Europe, governments have begun to address their insolvency law regimes to assist struggling companies and their directors,and regulatory authorities have requested bank lenders differentiate between 'normal' covenant breaches and those that are a consequence of Covid-19.

Yet, as the contagion’s toll deepens, governments are broadening their policy toolkits and considering more direct company and industry-specific actions, ranging from provision of debt and equity - to increasing discussion of previously taboo policy actions, including nationalization. A more expansive form of government action could conflict with the rights of creditors. We analyzed this interplay across several sectors and jurisdictions and highlighted areas of consideration for lenders in such a scenario.
 
Toward the end of March, credit markets started recovering. Yum Brands financed itself in the U.S. high-yield market with a new $600 million bond paying 7.75% and yesterday Carnival, a cruise operator, launched a $4 billion (upsized from $3 billion) senior secured bond issue to stay afloat. Even though it is rated investment grade, it has a full suite of covenants, which would be regarded as tight even in the (pre-coronavirus) high-yield world. Although it is too early to say if this could signal a shift in the world of covenants with tightening of terms coming back after years of covenant erosion.