Covenants: Lofty leverage levels and aggressive addbacks

Many deals today are producing the same outcome as a college student sleeping through every class: one bad term after another.

After last week’s annual New York Forum, where fund managers repeatedly bemoaned the borrower-friendly market, Private Debt Investor decided to canvas the market for examples of the more egregious deal terms – including those that were bordering on reckless and irresponsible.

The anecdotes we uncovered paint a picture of just how extreme some of deal terms have become and validates the concerns many managers have expressed. EBITDA adjustments and leverage ratios were two of the most discussed of these terms.

EBITDA adjustments have expanded beyond conventional add-backs like the cost of headcount reductions. For example, one of the more aggressive add-back that firms now request includes taking into account the projected revenue generated from a new product or customer over the next 12 months, says Randy Schwimmer, senior managing director and head of origination and capital markets at Churchill Asset Management.

When all these EBITDA adjustments are stripped away, aggregate earnings are a whopping 23 percent lower, Wells Fargo managing director and analyst Jonathan Bock at the conference.

One source said more mid-market deals are starting to contain provisions with anticipated synergies from an acquisition being added back into the EBITDA before the deal even closes, potentially artificially inflating that metric.

In an example of one particularly aggressive add-back, Schwimmer said, the client was asking for the ability to include EBITDA in new revenue to be generated over the next two years, and with no cap on the adjustments. Additionally, the company was not required to provide any third-party support for their calculations.

Outlandish leverage terms have become another source of heartburn for managers.

A market source this week highlighted a covenant for a healthcare services company, with EBITDA in the $75 million-$100 million range, that had a covenant capping leverage at 9.5x EBITDA. The provision would be tripped if the business’s revolving credit facility was funded to a certain point. Another source told PDI of a distressed borrower that had won a covenant capping leverage at 7.5x.

Bill Brady, partner and the leader of at Paul Hastings’ alternative lender and private credit practice, told PDI earlier this year more deals now have a net leverage rather than a total leverage covenant. Under a net leverage covenant, the borrower can apply cash on hand to reduce its effective leverage as calculated by the covenant.

“The big thing is when you go in as a credit investor, your expectation is the company is going to de-lever [over time],” one fund manager said, explaining now many companies’ leverage levels stay constant or increase. “The big thing is the ability to layer in other debt now is almost unlimited.”

Even traditional maintenance covenants aren’t what they once were, the source said. The latitude borrowers are given has risen, as is also the case for incurrence covenants, through which the borrower is only held to a financial test if additional debt is incurred.

Schwimmer said in some cases, borrowers’ incurrence tests could be measured on either leverage levels as of the date of the deal’s documentation or as of the deal’s closing date, whichever maximises the borrower’s leverage level.

Covenant-lite loans made up 72 percent of the outstanding leveraged loans at the end of September, and some 70 percent of loans in the new-issue market year-to-date were covenant-lite, according to S&P Global Market Intelligence. These figures show managers are right to be selective in the deals they do, as many have professed.