Wed 01/27/2021 09:40 AM
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During the month of January, GameStop, Express, Bed Bath & Beyond and Party City have staged massive rallies. In just one month, GameStop’s stock is up more than 340%, and in the past three months it’s up more than 540%. Similarly, Express is up more than 250% in the past month and more than 375% in the past three months. While Bed Bath & Beyond’s and Party City’s gains have been more modest, in the past month they are up more than 80% and 14%, respectively. In the past three months, Party City’s stock has risen more than 250%. Continue reading for our Americas Covenants team's analysis of the massive rallies in equity markets and Request a Trial for access to the linked debt documents, tear sheets, and summaries as well as our coverage of thousands of other stressed/distressed debt situations.

Although none of these companies have any imminent, pressing needs to repay their outstanding debt, the rise of their stock prices could present an opportunity to issue new equity and use the proceeds to reduce outstanding debt. The companies could also use the proceeds to pay dividends and make investments, including, in some cases, transfers of assets to unrestricted subsidiaries.

In this article, we discuss how proceeds from equity issuances run through credit agreements and high-yield bond indentures and the additional flexibility companies could gain from issuing equity.
Equity Proceeds Under Debt Documents

All debt documents include negative covenant baskets that provide companies with the ability to incur debt and liens, pay dividends, make investments and prepay debt. Although many of these baskets provide capacity as a fixed amount that can be used while the debt remains outstanding, some baskets provide capacity that is based on something else and will grow over time.

Most debt documents include builder baskets that provide capacity based on retained excess cash flow or 50% of consolidated net income. To the extent a company generates positive free cash flow or net income, capacity available under these builder baskets increases.

Similarly, many debt documents provide capacity based on cash contributions and proceeds from equity issuances received after closing. Notably, most of these baskets that provide capacity based in part on proceeds of equity issuances do not actually require that those proceeds be used under those baskets.

For instance, debt documents that permit a company to pay dividends based on “Excluded Contributions,” which are typically defined to include proceeds from equity offerings that are designated as Excluded Contributions, merely limit the amount of restricted payments made under that basket, but they do not limit the form of those restricted payments to the specific proceeds received from the applicable equity issuance.

If a company issues $100 million of equity, the Excluded Contributions basket would permit restricted payments equal to $100 million, but those restricted payments could be $100 million worth of equity of a subsidiary, or they could be the $100 million of proceeds from the equity offering.

As such, although equity offerings could provide a company with increased balance sheet cash, which is a benefit for lenders, they could also allow the company to transfer valuable assets away from creditors.

We provide a general overview of these baskets below.
Excluded Contributions, Builder Baskets

As mentioned above, many debt documents include Excluded Contribution baskets that permit restricted payments, investments and prepayments of debt based on cash contributions and proceeds from equity proceeds received after closing and designated as such and not otherwise applied.

The builder baskets based on retained excess cash flow or 50% of net income mentioned above also include components that are similarly based on cash contributions and proceeds from equity issuances received after closing to the extent not designated as an Excluded Contribution.

Although access to a builder basket may be conditioned on meeting a specified leverage, or, more likely, an interest coverage test, Excluded Contribution baskets rarely have any conditions that must be met in order to access them.
Post-Equity-Offering Dividend Baskets

Most negative covenant packages include post-equity-offering dividend baskets that allow companies to pay annual dividends based on a percentage of proceeds received (typically either 6% or 7%), market capitalization (typically 7% and based on the average market capitalization over the previous 30 trading days) or both.

Whereas dividend baskets based on proceeds received are not particularly problematic, given that the company has actually received those proceeds and, theoretically, could use them to pay those dividends without using other balance sheet cash or other assets, dividends based on market capitalization provide companies with capacity that may not accurately reflect their financial health.

On the basis of Tuesday’s closing price of $150 per share, 7% of GameStop’s market capitalization is equal to $700 million. On April 3, 2020, when the company’s share price was about $2.60 per share, 7% of market capitalization was equal to about $13 million.
Contribution Debt

Many debt documents also allow companies to alternatively use cash contributions and proceeds from equity issuances to incur debt; some debt documents permit companies to incur debt equal to 200% of the amounts of such proceeds.

Although not typical, some debt documents even include corresponding lien baskets that allow all such contribution debt to be secured.

To the extent companies incur debt based on equity proceeds, they cannot also pay dividends based on Excluded Contributions, and capacity under builder baskets cannot increase by the amount of such proceeds.
Leverage-Based Baskets, Baskets Based on Total Assets

Even where debt documents do not include Excluded Contribution baskets, builder baskets, post-equity-offering baskets or contribution debt baskets, proceeds from equity issuances that are added to balance sheet cash will improve companies’ net leverage ratios and provide more flexibility to access leverage-based debt, lien, restricted payment, investment and prepayment baskets.

An increase in balance sheet cash would also increase a company’s total assets, which include balance sheet cash, and provide increased capacity in negative covenant baskets that provide capacity based on the greater of a fixed amount and a percentage of total assets.

The table below illustrates which of these mechanisms are available to the companies discussed above under their debt documents:
Massive rallies in equity markets

--Maribeth Lemen
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