Four key trends in US covenants

As in Europe, the US is seeing loan terms trend in favour of sponsors at the expense of lenders.

Across the other side of the Atlantic, it’s a story familiar to the one in Europe as borrowers revel in market conditions tilted in their favour. Stephen Hazelton, founder and chief executive officer of New York-based data and analytics company Street Diligence, identifies four key trends:

1. A cure for all ills: An equity cure is an infusion of cash by a private equity sponsor, mainly due to a breach of a financial covenant. It allows the sponsor to more effectively manage extraction of cash from the balance sheet in the form of special dividends while still adhering to the provisions set by the lenders. Traditionally three to four lifetime cures have been allowed, but the market is now moving towards five to six – giving sponsors more flexibility.

2. EBITDA doesn’t add up: Critics accuse ‘addbacks’ of being a way of artificially boosting EBITDA. For example, sponsor/management fees and cost savings based on pro forma financials may be added to EBITDA. In the past, such addbacks have been restricted to a 12-month look-forward and capped at 20 percent of total EBITDA. The market is trending to longer look-forwards and higher percentage caps (or, in some cases, no cap at all).

3. End of the broad sweep: The excess cashflow (ECF) sweep governs how excess cash must be used. As excess cash is generated, typically half of it must be used to prepay lenders. However, provisions known as a ‘downward stair step’ may – based on balance sheet deleveraging – drop this 50 percent provision to 25 percent and then to zero percent. The stair step is detrimental to lenders as prepayment requirements go down as the company deleverages. In recent times the leverage metrics that trigger a decrease in the ECF sweep to lower levels have been softening – meaning lenders are getting prepaid in smaller amounts over time.

4. A dangerous basket case: The restricted payment covenant governs cash leakage from the balance sheet. Sponsors can use so-called ‘basket exemptions’ to, for example, pay themselves a special dividend to the detriment of the lender. In recent times, sponsors have increasingly tweaked this covenant to their benefit by increasing the ‘starter value’ (as a percentage of the borrower’s EBITDA) in the restricted covenant build-up basket. This is a trend favourable to the sponsor.