Southern Africa Syndicated Loans Documentation Training 31 ...

Southern Africa Syndicated Loans
Documentation Training
31 July 2014, Johannesburg

Financial Covenants

Edmund Boyo, Partner – Clifford Chance

Introduction

• The LMA financial covenants:

– LMA leveraged facility agreement template was
launched without financial covenants

– financial covenant section introduced in 2007 and
Financial Covenant Provisions User’s Guide issued in
2007 and most recently updated in 2012

– the key features
• financial definitions
• financial undertakings (maintenance covenants)
• calculation, headroom and testing methodology

Overview of this session
1) Introduction to basic principles, definitions and testing

2) Financial covenants in a wider transaction context

3) Variation in financial covenants across sectors and
industries

4) Current market trends and recent developments

Key concepts and definitions

• EBITDA:
– Earnings
– Before
– Interest
– Taxation
– Depreciation
– Amortisation

• Key definition for the purpose of leverage/interest
cover/cashflow cover financial covenants

• Calculated on a rolling “last twelve months” basis

Key concepts and definitions

• Borrowings:
– Includes:
• all loans/bonds/debit balances of borrower group;
• finance leases; and
• counter-indemnities in respect of guarantees
– Excludes:
• intra-group debt and [deeply subordinated debt]

• Used as the basis of “Debt”/”Net Debt” in leverage
covenant (and other covenants such as gearing)

• “Flashpoint” test calculated as at relevant testing date

Key concepts and definitions

• Cashflow:
– aim is to adjust EBITDA to include cash items and
exclude non-cash items

– calculated by adjusting EBITDA for the following items
(amongst others):
• changes in working capital position;
• exceptional/non-recurring items (positive or negative);
• pension costs; and
• capital expenditure costs

– different from cash flow statements included in a
company’s financial statements

Key concepts and definitions

• Finance Charges:
– aggregate of all interest, commission, fees and other
charges in respect of Borrowings which are paid or
payable in cash in the relevant LTM period

– used for the purpose of Interest Cover covenant

• Net Debt Service:
– aggregate of Finance Charges in the relevant LTM
period together with repayments of Borrowings made in
such LTM period

– used for the purpose of Cashflow Cover covenant

The financial covenants (1/4)

• Leverage (ratio of Net Debt to EBITDA)
– Net Debt:
• borrowings (net of cash/cash equivalents)
• hedging
• equity and quasi-equity

– EBITDA (Adjusted EBITDA):
• acquired/discontinued operations
• exceptional items
• unrealised gains/losses (hedge accounting)
• acquisition costs
• EBITDA attributable to non-Group members

The financial covenants (2/4)

• Interest Cover (ratio of EBITDA to Finance Charges)
– EBITDA (as per Leverage calculation)
– Finance Charges:
• pension and similar liabilities?
• which interest? (e.g. cash pay/PIK)
• which debt? (senior/subordinated)
• hedging adjustments
• “net” of interest receivable

• Usually requirement for Leverage ratio to decrease and
Interest Cover ratio to increase over time until agreed
“flatline” ratios have been reached and business is “de-
risked”

The financial covenants (3/4)

• Cashflow Cover (ratio of Cashflow to Net Debt Service)
– Cashflow:
• non Group companies
• JV investments/dividends
• capex/acquisition ‘neutralisers’
• acquisition costs
– Net Debt Service:
• Finance Charges
• scheduled repayments (what debt?)
• treatment of voluntary/mandatory prepayments

• Test of ability to meet debt service obligations. Covenant
ratio is normally set at 1.00:1.00

The financial covenants (4/4)

• Capital Expenditure

– Capital Expenditure usually defined to exclude amounts
spent on permitted acquisitions and reinvested
insurance proceeds

– per annum limits (set by reference to base case model),
subject to:
• exclusions based on type of funding source
• carry forward?
• carry back?
• increasing limit based on acquisitions?

Accounting methodology and “frozen GAAP”

• Requirement:
– for the same accounting practices and policies to be
consistently applied;
– to notify Lenders of any change and corresponding
adjustments to allow “like with like” comparison; and
– to amend facility agreements where there has been a
material alteration to commercial terms.

• There may be negotiated positions as to dealing with
anticipated changes to IFRS during term of agreement:
– Lease accounting?
– Joint venture accounting

Headroom in the numbers

• Headroom over agreed base case model:
– what is the % headroom and how is it calculated?
– % under anticipated ratio level in the model?
– % decrease against EBITDA in the model for the testing
period?
– % under anticipated EBITDA in the model for each
period after closing – cash effect of cumulative under-
performance?

• Adjust covenants levels if market flex is exercised?

• Flexibility in the definitions may also provide headroom

Testing (1/2)

• When first tested (covenant “holiday” after closing)?
• Information used for initial “stub period” after closing:

– (pre-closing information, pro forma adjustment,
annualisation or not tested on LTM basis?)

– availability of accounts for initial period after closing?
• What accounts are delivered and used to test covenants

(including at financial year end)
• Impact of F/X movements over testing period
• Days for delivery of accounts (30/45 monthlies, 45/60

quarterlies and 120/150 annuals)
• Testing may be delayed due to an equity cure

Testing 2/2

Example of testing/default timeline

Profit Breach
Underperformance

Close Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9

Covenant Honeymoon [Mulligan] Equity Covenants Equity Cures
First Cures tested roll off?
Test again
Date

Financial covenants in a wider transaction context

• Selected issues with financial covenant impact:

– disposals
– acquisitions
– the treatment of surplus cash/Excess Cashflow

• Related areas – cash sweep, margin ratchet, dividend
and prepayment trigger levels

Disposals

• Extent of covenanted restrictions on disposals (ordinary
course of business or trade permissions)

• Prepayment provisions with de minimis (per disposal and
per annum) exclusions. Proceeds can typically be
retained if reinvested in the business within [12/18]
months

• Disposal proceeds are generally added to Cashflow (and
deducted from Excess Cashflow) but any related
prepayment may not be included in Net Debt Service

• Pro forma adjustment of financial covenants (in respect of
disposals)?

Acquisitions

• Extent of covenanted restriction on acquisitions may
depend on the source of funding for acquisitions

• Cost of acquisitions reduces Cashflow (unless acquisition
is funded by surplus cash, new equity or [borrowings])

• Consequently, the cash sweep is calculated after the cost
of acquisitions

• Acquisitions increase Net Debt, so acquiring companies
with negative EBITDA is generally restricted

• Acquisitions may be permitted subject to complying with
“look-forward” or “look-back” financial covenant tests

• Financial covenants may be tested pro forma for
acquisitions, including effect of projected synergies over
next [12/18] months?

The treatment of “surplus cash”

• “basket” of “surplus cash” (i.e. cash not arising from
trading activities within a given period) built up from:
– initial cash overfunding (if any)
– retained disposal and insurance proceeds
– cash retained after a cash sweep from a previous period

• What surplus cash can potentially be used for:
– acquisitions/capex (over and beyond limits)
– as a credit to Cashflow when used, subject to
restrictions (overfunding available in first year only or
cash retained after a cash sweep only in the next year)
– paying dividends in the case of cash retained after a
cash sweep
– (subject to reinvestment obligations if disposal or
insurance proceeds) paying other obligations

Prepayment of Excess Cashflow (the “cash sweep”)

• Excess Cashflow is based on Cashflow after Net Debt
Service

• Cash sweep will typically:
– exclude a previous period’s surplus cash

– exclude new equity/subordinated debt

– exclude an amount required to pay for any carry forward
capex or contractually committed capex

– by virtue of the definition of Cashflow be calculated less
amounts spent on acquisitions, permitted JVs, etc.

– be after deduction of a de minimis or “buffer” amount

– require a % proportion (calculated using a leverage grid)
of Excess Cashflow for the previous LTM period to be
applied in prepayment

What is Net Debt in the leverage covenant?

• Net Debt means all borrowings net of cash (and so does
not encourage deleveraging), but cash:

– would include “surplus cash” until such cash is used

– would include new equity/subordinated debt even if not
used for prepayment of senior debt (unless expressly
excluded)

– would include “cash equivalents”

– may not exclude trapped cash

Variation in financial covenants across sectors/industries

• Real estate financings:
– Interest Cover (LMA real estate finance template)
• ratio of net rental income to Finance Charges (may
be tested on a projected or historic basis)
– Loan to Value (LMA real estate finance template)

• Pre-export financings/project financings:
– minimum Tangible Net Worth (LMA PXF template)
• share capital less goodwill, deferred tax, bad debts
– Loan Life Cover (LMA PXF template)
• ratio of [Sales Value] to debt service obligations over
remaining term of the facilities

Variation in financial covenants across sectors/industries

• Financings for retailers:
– “Rent adjusted” leverage and/or interest cover: (using
Consolidated EBITDAR and adding rental expenditure
to Net Debt and/or Finance Charges)

• “Asset-heavy” corporates:
– minimum Tangible Net Worth: share capital less
goodwill, deferred tax, bad debts
– gearing ratio: ratio of debt to net worth

Consequences of syndication

• “Crossover credit” borrowers may benefit from established
relationships with their lenders in certain regions in terms of
negotiating financial covenants and dealing with any
breaches

• LBO borrowers may encounter different approaches to any
subsequent covenant breaches from various types of
lenders in widely syndicated deals (relationship banks,
brokers, “static” CLOs, distressed debt investors):

– Looking for consent fees?
– Willing to consider forbearance?
– Pursuing “loan to own” strategies?

Current market trends and outlook
• Equity cure rights

• “Cov-loose” transactions

• Incurrence or maintenance financial covenants in high
yield bond/super senior RCF deals

Equity cures

• Current status:
– no EBITDA cure (except in “cov-lite” deals?) – stops
multiplier effect

– Net Debt cure – 50% prepayment may be required?

– Interest cover – deemed reduction in borrowings for
LTM period

– Right to “over-cure” – generally not restricted

– Limitation on number of cures remains more restrictive?

“Covenant-loose” LBO financings

• No Cashflow Cover or Capex covenants

• Leverage and Interest Cover covenants tested quarterly

• Headroom of up to 30-35%

• Covenants may be set at a “flatline” level (rather than
requiring deleveraging)

• Flexibility to incur incremental debt and/or make
acquisitions subject to compliance with an incurrence
covenant

Incurrence/maintenance covenants in high yield/RCF deals

• High yield bond indentures contain “incurrence”-type
financial covenants only

• Where a borrower has a “super senior” RCF alongside the
bond, what covenants should be included in the RCF?
– incurrence covenants which follow the bond?

– “maintenance” leverage covenant (in respect of drawn
RCF only)?

– minimum EBITDA/cash balance covenants?

– “deemed cure” of covenant breaches?

Speaker contact details

Edmund Boyo
Partner
+049 69 71993324
[email protected]

65481-5-5467