Financial Information Undertakings: Reduced Deliverables Make it Difficult for Lenders to Monitor Covenant Compliance; Delayed Delivery May Enable Financial Health of Borrowers to Be Disguised - Part I

Lenders to companies with leveraged loans are more than ever in need of up-to-date financial information about business performance. With the negative effects of Covid-19 becoming visible only in the coming months, receiving frequent and up-to-date financial information is not only key to assessing a company’s liquidity needs and understanding how loans will trade, but it also ensures lenders have the requisite information to make timely and well-informed decisions which can be critical to a company's survival.

Data analyzed by Reorg Debt Explained over the last three years shows:
 
Arguably, these trends reflect the fact that deals in the European leveraged finance market over the same period are now predominantly “cov-lite”, containing springing leverage financial covenants and an incurrence-based covenant package (based on New York law-style credit agreements and high-yield bonds), and do not include maintenance-based financial covenants which require periodic testing (as were traditionally found in Loan Market Association, or LMA, style deals).

However, the need for regular and timely financial information has not by any means been obviated in “cov-lite” deals and in Part 1 of this article we explain:
 

• Why the legal obligation to provide lenders with such information is still vitally important;

• Explain the negative effect lack of financial transparency can have on both lenders and borrowers (and the market itself); and

• Analyze the data which shows (with the limited exceptions shown below) the steady decline of informational flow.

This article focuses on credit agreements containing springing leverage financial covenants and incurrence-based covenant packages only. The data in this article is based on senior loans analyzed by Debt Explained in the European leveraged finance market from Jan. 1, 2017, to April 28, 2020 (the relevant period) with emphasis primarily on the financial undertaking provisions set out in credit agreements governed by the laws of England and Wales.
 
For Lenders and Investors

For lenders and investors how often and how quickly they are entitled to receive financial information is a vital for a number of reasons:
 

• The financial information clause goes hand in hand with the financial covenant(s) and related definitions as, without the requisite financial information to test any financial covenant(s), such covenant is of little worth. To the extent a deal contains a springing leverage financial covenant, these are typically tested quarterly against the numbers included in the quarterly accounts if the relevant “spring” has been triggered - see Navigating Uncertainty Spring time for RCFs articles Part 1 and Part 2 for a detailed explanation of this type of financial covenant.

• To some extent, financial information enables lenders to monitor the activities of a borrower (often retrospectively) and ascertain whether the non-financial covenants in a credit agreement have been/are being complied with. The following is a non-exhaustive list of some key areas which are based on financial information:
  • If the credit agreement adopts incurrence based covenants (rather than maintenance-based covenants), the relevant ratio(s) for example to incur debt, make permitted investments, pay dividends, or dispose of assets must be satisfied not only before the borrower can carry out the relevant transaction but often also on a pro forma basis taking into account the effect of these transactions. Lenders will need to be aware of major transactions that have taken place during the accounting period so they can verify the calculations and query compliance with the covenant if necessary. This is in marked contrast to traditional LMA maintenance style covenants which are easier to test, as they tend to include limits that apply at all times during the life of the facilities or limits that apply in each financial year, so the regular delivery of financial information allows lenders to test covenant compliance on periodic dates throughout the life of the facilities.
  • Monitoring the EBITDA of a borrower will also be key for lenders when monitoring compliance with EBITDA-based grower baskets in the credit agreement. The same would be true if the grower baskets were based on a different metric (such as total assets).
  • Determining whether the correct amount of interest has been paid under any applicable margin ratchet provisions, usually based on a leverage ratio, will also be a focus for lenders.

• Ascertaining whether the guarantee coverage requirement (if any) has been complied with and whether any additional entities are required to grant guarantees and security as a result of becoming material companies/subsidiaries.

• Quarterly management accounts and annuals and their accompanying compliance certificates enable lenders to identify potential or actual covenant breaches. As such a return to the rarer (and now somewhat historic) practice of requiring delivery of monthly management accounts in addition to quarterly and annuals would give lenders a better and more frequent ability to monitor covenant compliance and, if there is a breach, enable them to engage with the borrower at an earlier stage.
   
• Regular and timely financial information enables lenders to minimize their losses and ultimately enhances creditor recovery by accelerating the loan on a continuing event of default after grace period expiry (presupposing in “cov-lite” structures that the RCF lenders have already accelerated or if RCF lender acceleration is not an automatic event of default for term lenders, that the cross-default clause has been triggered) and enforcing the security at the most appropriate time to achieve the best recovery before value in the group is irrevocably lost.

For Borrowers

For the borrower, supplying financial information on a regular basis can also be advantageous because:
 

• Greater financial transparency and proactive information sharing leads to a collaborative approach between lenders and borrowers;

• Enhanced visibility means that lenders are better appraised of potential events of defaults and more willing to “get round the table with the borrower,” to explore what can be done to prevent a potential financial covenant event of default becoming an actual event of default on the next test date;

• Lenders better understand the long-term financial viability of the group’s business and as such may be more responsive to/proactive in their support for Covid-19 related waiver requests as detailed in part 2 of this report;

• Informed lenders generally are more willing to agree to amendments to credit agreements, covenant postponements and/or waive financial covenant events of default. Continuing events of default could have serious consequences for borrowers, such as a drawstop and turning off the ability to incur further debt where such incurrence is subject to an event of default stopper, even prior to acceleration. This can be particularly catastrophic as continued liquidity and tapping available credit in the market could be the key to survival in an economic down turn;

• The chance of an event of default continuing unremedied and/or unwaived is lessened if the lenders have adequate information to monitor activity and the risk of loan acceleration, security enforcement and potential insolvency of the group is therefore reduced; and

• Lenders and investors feel more confident with borrowers who give them detailed financial information on a regular basis.

In today’s climate lenders will look more favorably upon borrowers who proactively keep lenders/investors appraised of their current cash resources, share financial viability and solvency projections and illustrate financial model stress testing which takes into account the impact of pandemic and which illustrates what mitigation and contingency plans are being put in place.

Negative Impact of Less Financial Information Delivered Less Frequently in Cov-Lite Credit Agreements
 

• No “real time” lender monitoring of calculations carried out by the borrower during the relevant period enabling them to take permissive action under the credit agreement;

• As delivery times for financial statements have increased, breaches of covenants are not discoverable until a much later period of time after the action has been taken - this can be many months after the incurrence covenant is tested by the borrower;

• The combination of incurrence style financial covenants in cov- lite facilities and reduced type and frequency of financial information has a “double whammy” effect in distressed market conditions. In marked contrast to maintenance style covenant packages where financial covenants are tested and have to be complied with on an ongoing basis, incurrence based testing does not provide the lenders with the same early warning system that a borrower’s financial condition is rapidly deteriorating thereby facilitating a renegotiation of credit agreement terms before the borrower’s viability is seriously affected;

• Borrowers/sponsors, who are permitted by the terms of their credit agreements to use latest internal financial statements when calculating baskets and compliance with ratio based incurrence covenants (rather than doing the calculations on the basis of the numbers set out in the financial statements most recently delivered to the lenders; although the calculations done on internal calculations may subsequently be recomputed at the time of delivery of the relevant financials), can take such permissive action at an earlier point in time and before the economic deterioration is known by the lenders. If there is a subsequent downturn in financial performance the permissive action may have already resulted in negative consequences for lenders/investors for e.g. value leakage through restricted payments. This borrower flexibility is exacerbated as only very few loan agreements now contain a requirement to deliver monthly financial statements to the lenders /investors.

• As explained in a prior report an RCF springing leverage covenant is only tested if the amount drawn under the revolving credit facility (taking into account any exclusions or ability to net off cash) exceeds a certain percentage (usually between 35% and 40%) of the total revolving commitments at the quarter end date. If the spring threshold is reached the borrower has to comply with its leverage based ratio financial covenant. However, as the borrower only has to evidence its compliance with this financial covenant to the lenders when it delivers its compliance certificate with its annuals or quarterly financials (in respect of the latter generally within 45-60 days after its quarter end date) the lenders and investors will remain completely in the dark about any failure to comply with the financial covenant until this time and cannot take any action until this time (absent the borrower complying with another reporting trigger (see below) which had required it to notify the lenders /investors ahead of this date);

• The time lag between potential defaults or actual event of defaults occurring and the lenders identifying them from the financial modeling undertaken following delivery of financial statements and/or being made aware of them in an accompanying compliance certificate delivered by the borrower is a real issue in a Covid-stressed economic market environment: a group's financial condition can deteriorate fast and beyond help by the time the lenders get visibility of the issue-i.e. the “horse has well and truly bolted” and with it the window to try and fix the relevant covenant breach;

• Poor financing reporting deters secondary market investors who have not lived and breathed the credit from its start;

• Poor financial reporting can delay secondary trades while potential investors seek further financial historical reports and revised forecasts before investing;
   
• Borrowers who have poor financial reporting are more susceptible to market rumors;
   
• When demand for syndicated debt in the secondary market outstrips supply, original lenders are less concerned about the strength of their financial covenants and reporting requirements in their credit agreements. This, however, no longer applies in a distressed market where syndication and secondary trades become severely impacted particularly for credits where the true extent of any financial deterioration is difficult to assess due to weak financial reporting.
   
• A borrower who has historically provided little financial transparency can find themselves penalized on pricing and credit availability when it is looking to raise new finance or if already on a downward financial trajectory may find that they have fewer restructuring options available to them to fend off insolvency.
   

The type of financial information required to be delivered and the frequency with which it has to be delivered varies from deal to deal but typically European leveraged credit agreements require the borrower to deliver:

Annual Financial Statements
 

• Audited consolidated annual financial statements for the group under the credit agreement are typically required.

• On the other hand, less than 40% of credit agreements in the relevant period additionally required (whether prescribed or at the agent’s request) unconsolidated audited financial statements for the obligors or material companies/subsidiaries.

• Annual financial statements will typically include a cash flow statement, balance sheet and income statement or profit and loss account both on audited and pro forma bases and explanatory footnotes for any material acquisitions, dispositions or recapitalizations. In addition they will normally include a commentary on the financial condition, results of operations, liquidity and capital resources, material commitments, contingencies and critical accounting policies of the group and a description of the management/shareholders, all material affiliate transactions, material debt instruments and adjusted EBITDA for that year.

• Delivery times for annual financial statements have remained pretty constant with the typical delivery time being 120 days after the financial year ends, although a small percentage of borrowers have 150 days. Additional time (usually 30 - 60 days) is often given for the first financial year after closing/drawdown and/or if an acquisition is made in the fourth quarter of the financial year.
   

Quarterly Financial Statements
 

• Unaudited quarterly management accounts (consolidated and/or individual) are typically required to be delivered - although such requirement was missing in a small handful of deals reviewed in the relevant period.

• Such management accounts may be accompanied by details of the amount of consolidated net/senior/total /secured debt and other amounts referred to in the credit agreement to determine EBITDA, leverage and other ratios used and baskets, a commentary on financial performance and if there is a requirement to deliver a budget a comparison between budgeted performance and historical performance for the corresponding period for the previous financial year.

• Typically the delivery time ranges between 45-60 days after the quarter end. Additional time (usually 15-30 days) is often given for a number of quarters after closing/drawdown (ranging from one quarter up to a year) and/or if an acquisition is made in the relevant quarter. Often, the requirement does not commence until the second quarter after closing/drawdown and there has been an increasing trend for quarterly financial statements to be delivered for the first three quarters only: 44% of the deals in second half of the 2019 financial year and 36% in the 2020 stub period contained no fourth-quarter delivery requirement, which means that lenders are being asked to wait for and test covenant compliance against the annual financial statements which of course have even longer delivery times after the relevant period end than quarterlies.
   

Compliance Certificates
 

• Compliance certificates are required to be delivered at the same time as (or, in a handful of deals, shortly after) the quarterly or annual statements to the lenders. The content of a compliance certificate is negotiated.

• The main purpose of a compliance certificate is to
  • Confirm that a borrower is in compliance with its financial covenants, which are tested by reference to each set of accompanying financial statements. These statements should show any material adjustments made to exclude the results of each person which is consolidated in such financial statements but is not a member of the credit group (including unrestricted subsidiaries where the credit agreement has a restricted group concept).
  • The compliance certificate, also usually requires the borrower (i) to confirm that no potential event of default and/or actual event of default exists or to the extent that an actual event of default exists identify the same and explain what steps are being taken to remedy it and (ii) provide other information for lenders to ascertain that other non- financial covenants are being complied with.
  • A compliance certificate may identify excess cash flow if there is an excess cash flow sweep, identify material companies/subsidiaries, show compliance with the guarantor coverage test (if any), detail the margin computations if there is a margin ratchet, and list the borrower’s unrestricted subsidiaries where there is a restricted group subsidiary concept.

As alluded to elsewhere in this report, there has been a reduction in the amount of financial information lenders receive under credit agreements in the current market. Here, we look at the other types of financial information that lenders may receive, but it will vary from deal to deal, and we consider how the requirements for such information to be delivered have been eroded.

Monthly Financial Statements

Requirement for Monthlies

As is shown in the graph below the requirement to deliver monthly accounts has steadily declined over the relevant period from 60% of the deals requiring monthlies in the first half of 2017 to only 19 % in the second half of 2019, according to Debt Explained data.The stub period of 2020 appears also to reflect this trend although it is of course based on a period of less than six months (and a six-month period significantly impacted by Covid-19) so may not be truly representative.
 

Extended Delivery Times for Monthlies

The graph below shows that the time period for delivery has been increasing over the relevant period from 30 days after the month end to 45 days after the month end. On average 55% of the deals in 2017 and the first half of 2018 had a 30-day delivery period but 62% in 2019 had a 45-day delivery period, and in 2020 it went up to 60 days (but this 2020 stub period may not be truly representative for the reasons stated above).
 

Semiannual Financial Statements

Semiannual Financial Statement Requirement

The graph below shows that most European leveraged credit agreements do not require companies to deliver semi-annual accounts and the small percentage that do is declining. It is worth noting that unlisted public companies and private companies do not have a statutory requirement to prepare semiannual accounts but listed and AIM are required to do so.
 
Extended Semi-Annual Delivery times

Putting aside the 2020 stub period which may not be truly representative, the graph below shows that where semiannual accounts monthly accounts are required to be provided under credit agreements the time period for delivery has also increased from 60-90 days in the first half of the financial year 2017 to between 75-120 days in the financial year 2019.
 

Lender Presentations

Annual Lender Presentation Requirement

As can be seen from the graph below, on average over the relevant period the majority of deals have a requirement for borrowers to deliver lender presentations about the on-going business and financial performance of the credit group.
 

Frequency of Lender Presentations

The graph below shows that borrowers and sponsors have whittled down the requirement to give additional presentations upon the occurrence of potential events of default so they are only required more frequently than once a year upon the occurrence of an actual event of default or even more aggressively upon the occurrence of a non-payment, financial covenant or insolvency event of default.

In addition the requirement to request additional presentations more frequently than once a year on the occurrence of a potential event of default which was present in certain credit agreements in 2017 and the first half of the financial year 2018 no longer features in credit agreements entered into in the second half of the financial year 2018 nor for the remainder of the relevant period.
 

Lender Calls

Requirement for Lender Calls

Encouragingly there has been a slight increase in the requirement for lender calls but on average 75% of deals over the relevant period still do not require lender calls.
 

Frequency of Lender Calls

The typical frequency of lender calls is once per annum. The graph shows the decline in the requirement for quarterly calls and capping calls. Whether or not there will be a shift to lender calls only being required upon the request of the agent as evidenced by the data for the 2020 stub period remains to be seen. This stub data may, however, be an anomaly arising from a decline in new deal volumes for this stub period because of the impact of Covid-19.
 

Budget

Budget Requirement

As shown in the graph below, the requirement for providing a budget has decreased. The number of deals where cash flow forecasts and/or a budget consistent with the annual financial statements, setting out cash flow and income projections and the relevant assumptions has declined over the relevant period.
 

Extended Budget Delivery Times

Budget delivery times are variable as shown in the graph below but over the relevant period. The requirement to deliver the budget within 30 days has declined as the requirement to deliver it within 60 days after the financial year end has increased.
   
It will be interesting to see whether Covid-19 will put the brakes on the continued adoption of “cov-lite” European leveraged credit agreements as the previous credit crunch did, albeit only for a limited period of time prior to the bull markets and liquidity returning.

What certainly is true is that the adoption of incurrence covenant packages, the trend for weak financial reporting and the extended time periods to deliver financial information compounds lenders’ ability to assess the financial health of a borrower, particularly in the stressed market conditions we are facing now. While this gives borrowers a window of opportunity to carry out transactions until deteriorating financial performance becomes apparent to lenders this is not always in a borrower's best interests as any lifeline the lenders could otherwise have thrown borrowers if they had been aware of the deterioration earlier may be too late to save a company.