In one of a number of encouraging signs of life in the PE financing markets earlier in the spring, so called “covenant-lite” Credit Agreements, which had practically disappeared between 2008 and 2010, have become fashionable again. Indeed, according to the Financial Times, in April 2012, 40% of all institutional loans in the U.S. were “covenant-lite”, which is the highest monthly proportion since May 2007. Whether this trend will continue remains to be seen given the recent cooling in the financing markets.
“Covenant-lite” describes a Credit Agreement for non-investment grade Borrowers which does not contain certain protective covenants for the benefit of the lenders that used to be customary in Credit Agreements. A “covenant-lite” Credit Agreement typically has no financial maintenance covenants on any Term Loans. A “covenant-lite” Credit Agreement sometimes also has bond style negative covenants. However, in cases where a Credit Agreement includes a revolving facility, the Revolving Lenders virtually always require some financial covenant protection. Such protection kicks in only under certain circumstances, however, giving rise to the industry term “springing covenants” to describe these type of “covenant-lite” deals.
Bond Style Covenants
Bond style negative covenants are desirable for PE sponsors because they give a Borrower more flexibility than the negative covenants typically found in Credit Agreements. Such relative flexibility can be used, for instance, to incur additional debt, make investments, pay dividends and take other actions that could arguably increase operational risk and that would sometimes not be permitted under a traditional Credit Agreement. While such flexibility can prove very valuable to Borrowers, especially Borrowers controlled by private equity sponsors, the primary focus of “covenant-lite” loans is often on the absence of financial maintenance covenants.
Financial Maintenance Covenants
Financial maintenance covenants differ from the other negative covenants because, instead of precluding the Borrower from taking certain actions, they require a Borrower to maintain certain ratios, such as a leverage ratio or an interest coverage ratio. As a result, events outside a Borrower’s control can easily lead to a breach of a financial maintenance covenant. These ratios are set at levels designed to “stress test” a Borrower and to trigger an event of default under the Credit Agreement if they are breached, thereby allowing Lenders to intervene if a Borrower’s financial condition deteriorates even absent any affirmative action of the Borrower. The absence these type of financial maintenance covenants for the benefit of the Term Lenders in “covenant-lite” deals is therefore a particularly significant part of the appeal of these facilities to sponsors.
Recent Market Activity
Earlier this year, in exchange for a premium that is often between 25 and 50 basis points relative to the margin applicable to a comparable Credit Agreement with traditional financial covenants, Term Loan Lenders have been willing to go “covenant-lite”, and to agree to the absence of financial maintenance covenants, for the right Borrowers and the right leverage profile. But Revolving Lenders typically continue to require some financial covenants on the Revolving Loans.
This article focuses on current market practice with respect to key provisions in “covenant-lite” deals with a revolving credit facility and the sometimes tricky interplay between the rights of the Revolving Lenders in these deals, who enjoy the direct benefit of the financial maintenance covenant protection, and the Term Lenders, who do not.
What Types of Financial Covenant are Used?
“Covenant-lite” Credit Agreements with a revolving tranche typically include a maximum senior secured leverage ratio only. We would not expect to see a minimum interest coverage ratio.
Even when a “covenant-lite” Credit Agreement includes a financial covenant for the benefit of its Revolving Lenders, the covenant becomes binding on the Borrower only if the revolving tranche of the Credit Agreement is drawn whether because Revolving Loans are outstanding or Letters of Credit have been issued. This explains why these financial covenants are referred to as springing covenants in the nomenclature of the industry. A point for negotiation is whether Revolving Loans can be drawn and Letters of Credit can be requested to be issued up to a certain dollar amount before the covenant springs to life.
Because Letters of Credit are sometimes required for specific purposes, effectively giving a Borrower little control, if any, over the decision to request an issuance of a Letter of Credit, a negotiating cushion applicable to Letters of Credit before the financial covenant “springs” to life is very useful. A number of recent major sponsor Credit Agreements contemplate a cushion allowing Letters of Credit to be issued up to 10% or 15% of the Commitments before the covenant is tested.
A cushion applicable to Revolving Loans may also be negotiated on a case by case basis although such a cushion is clearly not as common as a cushion applicable to Letters of Credit. On occasion, a cushion that can be used both for Letters of Credit and Revolving Loans (in which case the covenant springs to life when the aggregate amount of issued Letters of Credit and outstanding Revolving Loans exceeds the cushion), enabling a Borrower to draw some Revolving Loans without triggering the applicability of the covenant if the amount of outstanding Letters of Credit is below the cushion.
When is the Springing Covenant Tested?
In a typical “covenant-lite” Credit Agreement with a revolver, the financial covenant is tested only on a maintenance basis at the end of a fiscal quarter if at such time Revolving Loans are outstanding or Letters of Credit have been issued, in each case in excess of any applicable cushion. A key point of contention, that is not quite settled in the market, is whether the covenant should also be tested on an incurrence basis when Revolving Loans or Letters of Credit are requested. Testing the covenant on an incurrence basis would enable the Lenders to refuse to make Revolving Loans or issue Letters of Credit if the Borrower is not in compliance on a pro forma basis with the financial covenant at the time a drawdown or a Letter of Credit is requested. Revolving Lenders argue that unless the covenant is tested on an incurrence basis, a Borrower would be able to draw on its revolver during a quarter and repay the Revolving Loans before the end of the quarter without the covenant ever been tested. A Borrower would argue that the fact that it is able to repay outstanding Revolving Loans periodically is evidence of its financial health and eliminates the need to test the financial covenant.
Beneficiaries of the Springing Covenant?
Given that the demand for the springing financial covenant comes from the Revolving Lenders, it is important in a “covenant-lite” Credit Agreement that includes a revolving tranche, that the springing financial covenant should be given only for the benefit of the Revolving Lenders. To this end, these Credit Agreements should provide that the covenant default that is triggered by a breach of the springing financial covenant is an event of default only with respect to the Revolving Loans. In addition, Revolving Lenders should control the springing financial covenant and the requisite percentage (typically a majority) of the Revolving Lenders should be able to amend or waive the financial covenant without the need to seek approval from the Term Lenders. If such an event of default is triggered the Required Revolving Lenders should have the right to terminate the revolving commitments and accelerate outstanding Revolving Loans. Term Lenders should have no rights growing out of the default, subject to the cross default provision discussed below.
Can the Term Lenders Indirectly Get the Benefit of the Springing Covenant?
Even assuming a Credit Agreement contains all of the provisions above, the Term Loan Lenders under the “covenant-lite” Credit Agreement can potentially get the benefit of a Borrower’s breach of a financial covenant given for the benefit of the Revolving Lenders indirectly in a number of ways.
Cross-Defaults within the Credit Agreement
The parties will need to consider whether the Term Loans should cross default to the Revolving Loans when the Revolving Loans are in default due to a breach of the financial covenant. In a non “covenant-lite” Credit Agreement context, a financial covenant breach usually triggers an immediate event of default subject to the grace period available to exercise equity cure rights, typically 10 Business Days following the due date of the relevant financial statements. While a financial covenant breach rarely catches a Borrower by surprise, Borrowers nonetheless do not have much time to negotiate a waiver or an amendment before the financial covenant breach matures into an event of default and those discussions often take place after the event of default is triggered. Giving the Term Lenders an immediate cross default under a “covenant-lite” Credit Agreement would greatly complicate those discussions. While some Lenders in “covenant-lite” deals request a cross-default after a relatively generous grace period, cross-acceleration appears to be market.
Cross-Default to Other Debt
A breach of the springing financial covenant may cross default other material indebtedness of a Borrower permitted under a “covenant-lite” Credit Agreement. This may indirectly cross default the Term Loans, unless the cross-default to such other material indebtedness carves out a default in such other material indebtedness triggered by a cross default to the Revolving Loans when the Revolving Loans are in default due to a breach of the springing financial covenant.
Borrowers whose financial condition deteriorates may have difficulties receiving an unqualified audit opinion. The failure to timely deliver annual audited financial statements not subject to a “going concern” or similar qualification would typically be an event of default enabling the Term Lenders to take action. Some Credit Agreements, therefore, provide that the requirement to deliver unqualified annual audited financial statements will not be breached if the audit opinion includes a qualification based only on the potential inability to satisfy the financial maintenance covenant.
Cash Collateralization of Letters of Credit
As discussed, in “covenant-lite” Credit Agreements with a revolving tranche, the financial covenant springs to life only when Revolving Loans are outstanding or Letters of Credit are issued, sometimes in excess of a cushion. With that in mind, “covenant-lite” Credit Agreements typically contemplate that the financial covenant is not tested if Letters of Credit are cash collateralized. Indeed, cash collateralizing Letters of Credit eliminates the related credit risk and puts the Revolving Lenders in the same position as they would have been in had the Letters of Credit not been issued.
One needs to keep in mind that cash collateralizing Letters of Credit for the benefit of Revolving Lenders is an action that benefits one group of Lenders (i.e. the Revolving Lenders) without the same benefit being extended to the Term Lenders. Indeed, the cash posted to collateralize Letters of Credit obligations is intended to be held for and applied to the satisfaction of the specific Letters of Credit obligations for which the cash collateral was provided prior to any other application of such cash to satisfy other obligations under the Credit Agreement. On a deal by deal basis, one needs to consider whether this arrangement is consistent with the requirement to treat all lenders pro rata, as that provision is drafted in the relevant Credit Agreement (formulations vary). If it is not, the ability to cash collateralize Letters of Credit on a voluntary basis without breaching the “treat all lenders pro rata” requirement should be specifically provided for in the Credit Agreement.
* * *
“Covenant-lite” Credit Agreements come in and out of fashion as quickly as the market moves from good to bad. What is settled one day may become too aggressive the next day and Borrowers will no doubt find new ways to push the market when it is favorable. Given the crucial importance of the “covenant-lite” market to private equity sponsors and the fluidity of the market, we will continue to monitor market terms and update our readership accordingly.