A loan transaction is structured in part based on a model of the borrower's performance projections over the term of the loan. However, surging interest rates and other post-pandemic business challenges have created a gap between these projections and the current business reality of borrowers. How can they maneuver in these circumstances?
While we cannot predict how long these conditions will continue, there are a number of tools borrowers facing such challenges can use to address these issues.
Compounding challenges for borrowers
The loan transaction model looks at projected performance and operational expenses to ensure that the borrower is able to service interest payments under the loan and to set certain financial covenants, which can either measure the borrower's operational health or limit its ability to take certain actions, such as incur debt, make payments to equity or make capital expenditures. Key to the reliability of the business model is the projected cost of funds to the lender and, as a consequence, the borrower and sponsor (if applicable). But as recently as two years ago, few people would have predicted the increase in interest rates that we have seen today.
In response to skyrocketing inflation, the U.S. Federal Reserve, along with other central banks globally, raised its benchmark rate 10 times between March 2022 and May 2023. Because many borrowers (and their lenders) did not predict such a rapid and steep increase, the actual interest expense of those borrowers is much higher than modelled. Most commercial loans accrue interest based on floating rates (such as the Secured Overnight Financing Rate), so borrowers' interest expense has automatically increased as the benchmark rates have risen.
Because many borrowers (and their lenders) did not predict such a rapid and steep increase in interest rates, the actual interest expense of those borrowers is much higher than modelled.
Even a borrower with steady earnings would need to allocate more of its earnings to debt service than originally projected. Some borrowers face additional strain as their business faces challenges, such as labour shortages, inflationary pressures and reduced demand from customers who are facing inflationary spending decisions of their own.
How can borrowers navigate choppy financing conditions?
If a borrower is projected to be offside of any upcoming financial maintenance covenants, the borrower should carefully review the financial definitions to ensure that it is taking full advantage of the add-backs it negotiated in its credit agreement at closing. Some borrowers find that they have not fully used permitted add-backs in earlier periods when they had plenty of cushion on ratio calculations. This is also a good reminder for borrowers to fully use add-backs in healthy times, even when they are unnecessary, to build a record of course of dealing with their bank groups.
If a privately held borrower is still projecting to be offside, it should also review any equity cure provisions in its credit agreement. These provisions allow equity holders to put in additional equity, which is treated as EBITDA for ratio calculations for four fiscal quarters. If an equity sponsor has a low-cost source of funds (such as a fund-level credit facility) to pay for the equity infusion, an equity cure may be an attractive option when compared with the costs of an amendment or waiver. New equity can often be returned as a distribution when ratios improve, depending on the terms of the relevant credit agreement.
If an equity sponsor has a low-cost source of funds to pay for the equity infusion, an equity cure may be an attractive option when compared with the costs of an amendment or waiver.
Finally, a borrower can seek an amendment or waiver. Lenders may charge a consent fee or seek to renegotiate interest rates or other terms in exchange for the amendment or waiver, depending on the facts and severity of the breach. Circumstances vary widely, so there is no one-size-fits-all answer to what's market for an amendment or waiver.
Future outlook
Despite the elevated risk of the current economic climate, we have not seen a dramatic shift in covenant patterns for new deals. Instead, lenders have protected themselves through tighter credit review—leverage levels have decreased, and EBITDA add-backs have received greater scrutiny. We have also seen greater resistance to longer commitment periods in acquisition finance debt commitment letters. In the near future, we recommend that borrowers with existing loan facilities review their credit agreements and remain in close communication with their lenders to work through potential defaults until economic conditions improve.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
