Mon 04/11/2022 15:49 PM
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Encompass Health Covenant Analysis:

Relevant Items:
Covenant Tear Sheet, Debt Document Summaries
Encompass Health Debt Documents

Encompass Health provides facility-based and home-based integrated healthcare services. The company plans to spin off its home health and hospice business, or HHH, during the second quarter of 2022. For the 2021 fiscal year, which ended Dec. 31, 2021, the HHH segment contributed about 22% of total net operating revenue and held 25% of the company’s total assets, with a segment adjusted EBITDA of $211.5 million.

The company has already received consent solicitations from the holders of its senior notes that amended the relevant supplemental indentures to expressly permit the spinoff. The company has not disclosed whether it plans to amend its credit agreement. Although the spinoff is likely permitted under the current agreement (as discussed below), the company may wish to decrease the revolver amount because the company’s size would be decreasing by about one-fifth.

The company’s capital structure as of Dec. 31, pro forma for the redemption of the remaining senior notes due 2023, is shown below.

 
Is the Spinoff Permitted by the Debt Documents?

Senior Notes

As mentioned above, consent solicitations have been received for the outstanding senior notes. The notes due 2025 are subject to the Eleventh Supplemental Indenture; the notes due 2028, 2030 and 2031 are subject to the Twelfth Supplemental Indenture. These supplemental indentures will not become effective until certain consent payments are made, and those payments are contingent upon the execution of the spinoff distribution:
“Encompass Health does not intend to make the Consent Payment unless it intends to consummate the Spin-Off, and the Proposed Amendments will not become operative unless Encompass Health makes the Consent Payment. If Encompass Health does not consummate the Spin-Off prior to December 9, 2022, the Proposed Amendments will not become operative and Encompass Health will not make the Consent Payment.”

Thus, if the spinoff does not occur, the amendments in the supplemental indentures will never become effective.

Each supplemental indenture added baskets to the restricted payment and asset sale covenants, as well as the “Permitted Investment” definition, permitting the “Distribution” - defined as “the distribution to equityholders of the Company … of at least 80.1% of the common stock of SpinCo (with cash in lieu of any fractional shares) in one or more transactions” - as long as the net leverage ratio is not more than 3.5x. Cash netting is capped at $75 million under the 2025 notes and $100 million under the other notes.

In addition to the Distribution, the disposition of any equity of SpinCo held by Encompass after the Distribution (the “Permitted Retained Interest Disposition”) is also permitted, as long as the net leverage ratio is not more than 3.5x

The supplemental indentures also added a catch-all provision that states that nothing in the indenture will “prevent the consummation of any of any Distribution or any Permitted Retained Interest Disposition, nor shall any Distribution or any Permitted Retained Interest Disposition give rise to any default” as long as the net leverage ratio is not more than 3.5x

In addition, upon the effectiveness of the supplemental indentures, SpinCo will automatically become an unrestricted subsidiary. This designation is not necessary to complete the spinoff, as the supplemental indentures (once effective) expressly permit the spinoff, and SpinCo will cease to be a subsidiary as soon as the spinoff occurs, unless Encompass plans to have SpinCo engage in a restricted transaction (such as incurring debt) prior to the spinoff.

Although SpinCo will become unrestricted, the designation as unrestricted will not cause SpinCo to be released as a guarantor (if it is a guarantor). While the concept of an unrestricted guarantor is highly unusual, given that the unrestricted designation appears intended to occur on the spinoff date, SpinCo will still be released as a guarantor (if it is a guarantor) pursuant to the guarantor release provision that releases a subsidiary guarantor if it is no longer a subsidiary of the company.
Credit Agreement

The definition of “Distribution” in the supplemental indentures suggests that the company plans to distribute the new HHH shares to the current shareholders rather than sell such shares to public investors, which means that the restricted payments covenant is the main consideration.

The credit agreement permits unlimited restricted payments as long as the secured net leverage ratio is not greater than 2x, the net leverage ratio is not greater than 4.5x, there is no event of default, and the company is in pro forma compliance with the financial covenants. All of these conditions were met as of Dec. 31 and should be met post-spinoff, as Encompass’ “anticipated leverage” after the distribution is 3.25x-3.5x. Given the HHH segment’s 2021 adjusted EBITDA of $211.5 million, the company, in order to achieve these leverage ratios, may be planning to further reduce leverage in connection with the spinoff.

The asset sale and investment covenants will also not create problems, as the investment covenant contains a similar leverage-based basket that permits unlimited investments as of Dec. 31 and should be met post-spinoff, and the asset sale covenant excludes all permitted restricted payments.

It is unclear whether SpinCo will become an unrestricted subsidiary under the credit agreement, but given that the designation under the notes appears intended to occur largely simultaneously with the spinoff, such distinction may have little practical effect. Note that post-spinoff, even if Encompass holds on to 19.9% of SpinCo’s equity, SpinCo would no longer be a “subsidiary” and would not be subject to the credit agreement covenants.
Covenant Conclusions

 

  • Financial covenants - The credit agreement contains two financial covenants which are always tested and which benefit both the revolving and term loan lenders: an interest coverage ratio and a net leverage ratio (with cash netting permitted up to $300 million).The April 2020 Covid relief amendment loosened the required thresholds for both ratios from June 30, 2020, through Dec. 31, 2021. The 3x interest coverage ratio was lowered to 2x for the quarters ending June 30, 2020, until Dec. 31, 2021, and the leverage ratio, which was set at 4.5x through Dec. 31, 2021, and 4.25x from March 31, 2022, and thereafter, was raised as high as 6.5x. For the quarter ended Dec. 31, 2021, the required ratio was 5x; from March 31, 2022, and thereafter, the required ratio is 4.25x.

    As of Dec. 31, the company was in compliance with both covenants, with a net leverage ratio of 3.2x and an interest coverage ratio of 6.2x.

  • Debt and lien capacity - The credit agreement permits incremental or incremental equivalent debt (which must take the form of pari secured notes) in an amount equal to the greater of $1 billion and 100% of EBITDA, plus additional amounts so long as the company is in compliance with a secured leverage ratio of 3.5x. This is the only general-use secured debt basket; although there is a general liens covenant, there are no general debt baskets that it can be paired with.The credit agreement also permits $200 million of unsecured debt, plus amounts as long as the company remains in compliance with the financial covenants. Using the Dec. 31 5x leverage ratio covenant, this basket permits another $1.87 billion of unsecured debt; using the March 31 4.25x ratio, this basket would permit $1.01 billion.

    The notes permit $3.1 billion of debt by combining a 2x interest coverage ratio debt basket with a 3.75x secured net leverage ratio liens basket and a general liens basket for the greater of $100 million and 3% of tangible assets. Unsecured debt is permitted until the interest coverage ratio hits 2x; this basket is only available to the loan parties.

  • Structurally senior debt - Nonguarantors cannot use the ratio debt basket in the notes, and there is no specific nonguarantor debt basket, so they are limited to using the general debt basket, which permits $302 million of debt (7.5% of tangible assets) as of Dec. 31.The credit agreement, on the other hand, contains a $150 million nonguarantor debt basket and permits nonguarantors to incur debt using the unsecured debt basket, which (as discussed above) permits over $2 billion of additional unsecured debt as of Dec. 31.

  • Restricted payments, investments - As discussed above, the credit agreement currently permits unlimited restricted payments and investments. The senior notes, however, do not, as their leverage-based basket threshold is a net leverage ratio of 3x, which is not met. Using general restricted payment and investment baskets, the notes permit at least $201 million of restricted payments and an additional $402 million of investments.A builder basket in the notes based on consolidated net income from July 1, 2006, with a $50 million starter amount, may provide additional capacity, although in the 2028, 2030 and 2031 notes, but not the 2025 notes, such basket would be reduced by $200 million if the spinoff occurs and makes the Twelfth Supplemental Indenture effective.

  • Senior note purchases - The credit agreement only restricts the company’s ability to repay, redeem or repurchase subordinated debt, so the company is not limited from prepaying or repurchasing senior debt, including the outstanding notes.


–Alisha Turak
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