In this Ropes & Gray podcast, Joanne De Silva and Alyson Gal, partners in the finance and capital solutions group, discuss the issues lenders are considering in amendment and forbearance discussions with borrowers in light of the current global COVID-19 crisis and growing pressures borrowers face under their credit agreements.
Transcript:
Alyson Gal: Hello, and welcome to this Ropes & Gray podcast. This is the latest in our series of podcasts on issues of concern to credit funds, and one in a series of podcasts on issues that have grown out of the current crisis and global shutdown.
I'm Alyson Gal, and I'm here with Joanne De Silva. We are both partners in Ropes & Gray's finance and capital solutions group, and we spend a lot of our time working with credit fund lenders. Our focus today is how the economic situation is playing out in credit documents, given the strain that the shutdown is placing on borrower liquidity and covenant compliance.
First, to set the stage, let's talk about the sort of problems that the current situation is causing under credit documents.
Joanne, would you like to talk about some of the issues that borrowers are confronting under their credit documents?
Joanne De Silva: Thanks Alyson. Where to begin? Well, first and foremost, borrowers are worried about liquidity. Understandably, many companies are suffering huge hits to their revenues and are very-very focused on ensuring they have sufficient liquidity to get through the coming weeks and months. There was a lot of concern about whether lenders would honor revolver draws or would possibly invoke MAC clauses to avoid funding.
Alyson Gal: Just to pause on that, MAC clauses, for those who could use a refresher, is a reference to representations that a borrower is commonly required to make before it can borrow under a revolving credit facility. Those clauses require that the borrower represent that there hasn't been a material adverse change in the borrower's business, or, under some formulations, in the borrower's ability to repay or otherwise perform under its loan documents.
There certainly has been a lot of concern amongst borrowers that they wouldn't be able to make these representations, or that lenders would say that they don't believe they're accurate if they were made.
Many borrowers drew down on their revolvers in March, both to ensure that they had sufficient liquidity, and out of concern that lenders were getting increasingly focused on a borrower's ability to make representations that no MAC had occurred. Most of those situations have resolved, though there have been some where lenders either stated or signaled their concerns and the parties had to sit down and work something out.
Joanne De Silva: In order to conserve liquidity, borrowers are also looking for lenders to defer principal payments and to PIK interest. They may also be looking for additional funding, either from their lenders or from PE sponsors, and they may they ask for concessions from existing lenders to make that funding more attractive.
Alyson Gal: Yes, liquidity is a huge area of focus right now. Another area where borrowers are focusing hard is avoiding covenant defaults. Borrowers with financial covenants are looking hard at their financial definitions, to try to figure out ways that they can make adjustments to their EBITDA calculations to avoid default. Since EBITDA is tested on a rolling four quarter basis typically, many companies that were okay under their March 31 tests are likely not going to be in compliance as of June 30, at least not without making some pretty aggressive and creative adjustments. Those borrowers have a few months to game plan to avoid a June 30 default, either by adjustments to calculations, equity cures or amendments.
Joanne De Silva: Another thing to bear in mind is that this is the season where audited financials are either due or soon will be. As you know, some reporting covenants require delivery of so-called clean audits, with no "going concern" qualifications. Many credits that do permit going concern qualifications limit those to forward-looking covenant breaches and upcoming debt maturities. Going concern qualifications that are based on other factors are not permitted. This can be a challenge in the current climate, where auditors have expressed concerns about management's ability to forecast when the current crisis will ease.
Alyson Gal: So borrowers are coming to lenders with a number of requests – to delay audits or accept audits with going concern qualifications, to provide temporary covenant relief or accept adjustments that ease the impact of the crisis and even to defer payments.
What are lenders looking for in the face of these requests?
Joanne De Silva: Well, first, let me say that there are a range of approaches that borrowers seem to be taking. Some want to kick the can down the road and put a forbearance in place to revisit covenants after it becomes clearer what the long-term impact of the crisis may be. If all that borrower is looking for is a short-term forbearance from covenants, lenders may not be looking for much in return right away. The more that borrowers are looking for from lenders though, the more they are going to feel it is fair to ask for in return.
Alyson Gal: And what about a situation where borrowers are asserting they're entitled to adjust EBITDA to add back, say, their rent and employee expenses because they're no longer generating revenue to offset that? We know that this is an area of intense focus right now, in terms of what adjustments are justifiable in these really unprecedented times.
Joanne De Silva: Even where lenders are totally on board with giving the borrower breathing room, acquiescing in borrower interpretations that make covenants even less meaningful than they already have become may have long-term impacts. Under this circumstance, at least where loans are concentrated, it might be better for lenders to provide an express covenant waiver rather than just go along with an interpretation that might have unforeseen implications for future covenant testing once the crisis has passed.
Alyson Gal: And where lenders are forbearing for a significant period or providing a waiver of covenants for several quarters, certainly if lenders are being asked to defer payments, in addition to likely charging a fee for the amendment, they are going to want to look through the negative covenants and think carefully about what flexibility the borrower should no longer have under the circumstances. Debt baskets, baskets that permit investments outside the credit group, covenants that allow the borrower to dispose of assets without paying down debt – all of these are areas where lenders are likely to be focusing right now.
Joanne De Silva: I agree Alyson. On top of that, lenders that are prepared to forgo covenant testing may also want to impose some other test of the company's financial health, such as a minimum liquidity covenant, for example.
If lenders are essentially providing liquidity through deferring payments, they may also be looking to ensure that the sponsor management fees will be deferred as well. In most cases, sponsors are likely to be agreeable to this.
Alyson Gal: Where lenders are being asked to PIK their interest, they may look for increased yield as well, whether in the form of higher rate when the PIK is effective, or in the form of equity upside, or both. In terms of how much extra yield lenders are likely to look for when they are asked to PIK, well this varies. If we had to put a rough number on it, I'd say that the midpoint in these middle market sponsor deals seems to be around 150 basis points of rate differential in order to PIK interest, but that is just a rough cut based on some recent amendments – individual situations will vary widely of course.
Joanne De Silva: And in situations where lenders are being asked to provide additional funding, whether by loosening up borrowing capacity, lifting reserves or deferring payments, they may well look to the sponsor to show its support by committing additional equity to the company, either through an outright contribution or through a keep well. Certainly, where sponsors are providing additional equity, lenders are likely to be more accommodating. Cash really speaks loudest in situations like this.
Alyson Gal: We should note that deferring payments, whether it's suspending amortization payments or PIKing interest, is really a sensitive point for many lenders, and in most cases all lenders need to consent to have those payments deferred. Particularly in large, widely held credits, it is going to be difficult to get that unanimity.
Joanne De Silva: That's right. Lenders are not necessarily all going to be on the same page, and for some of these measures, lenders cannot be dragged along. There could be a group of majority lenders that are willing to defer payments or to provide additional funding, and a minority that are not. In those cases, the lenders that are deferring or providing additional money might get preferred treatment, either more economics or a priority, or both. It can really vary based on what the documents permit.
Alyson Gal: This is an evolving situation, and we will continue to monitor market developments and work with our clients to achieve reasonable and fair outcomes.
Thanks very much for listening, and we would love to hear from you what you are seeing as well. For more information on the topics we've discussed today, or other topics of interest to credit funds or institutional investors, please visit our website at www.ropesgray.com. And of course, if we can help you navigate any of these areas, please don't hesitate to contact any one of us.
You can also subscribe and listen to other Ropes & Gray podcasts wherever you regularly listen to podcasts, including on Apple, Google and Spotify. And from both of us and all of us here at Ropes & Gray, we hope that all of you listening are well, and that you and your families are safe and healthy.
Thanks again for listening.
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