Investors have different theories as to why the past decade has resulted in so few restructurings, but all agree that the abundance of liquidity that has flooded the market (in large part due to private debt) and the benign interest rate environment which encouraged high levels of borrowing without debt service ramifications are no doubt at the heart of it.
Now, faced with a potential recession and ongoing geopolitical issues affecting labour markets and the supply chain, things look very different. When paired with the steep rise in reference rates and record inflation – factors that will play a significant role in borrowers’ cashflows – market players seem to finally agree that 2023 is likely to see an uptick in special situations.
Do finance documents help predict stress?
Despite the continued debate around the benefit of financial covenants in loan documents, these play a central role in detecting early signs of stress. The evolution in the private debt space of ‘cov-loose’ (limited financial covenants) and, in some cases, ‘cov-light’ (absence of financial covenants) has reduced the protection of investors. No financial covenant means early distress signs are more difficult to spot.
With ‘cov-lite’ only testing leverage upon a certain percentage of revolvers being drawn, the ability to paper over cracks is a constant. Where headroom on the covenant is very wide a borrower will likely experience a liquidity issue before breaching leverage. In such structures, term loan lenders are reliant on revolving facility lenders (usually relationship banks) to initiate any action for a covenant breach. If no action is taken, term lenders will not get a seat at the table. Where no action is taken, time can erode value that could otherwise have been maintained had a holistic balance sheet solution been found earlier.
Private debt has generally managed to maintain its position that at least one covenant be required, but headroom and testing flexibility afforded to the borrowers determine how early financial stress can be spotted. The EBITDA definition (or recurring revenue in ARR-deals) and adjustments through both add-backs and look-forward projections may mask signs of stress. In this market, unsurprisingly, having a cleaner EBITDA definition seems to be of primary focus for direct lenders.
Where high (and more unpredictable) foreign exchange spreads are becoming normal, it is important to assess the impacts of cross-border generation of revenue/EBITDA vis-à-vis the repayment obligations and currency of the underlying loans. FX rate fluctuations may contribute to a lower liquidity profile that may have a knock-on impact for financial covenant testing.
While a financial covenant will not get lenders repaid, its purpose as an early warning trigger allows stakeholders to get together and work out what is best for the business going forward. Early discussions are much more likely to protect all stakeholders’ interests while waiting until the very last minute may result in insolvency. Thus, a good relationship between the sponsor, the borrower and creditors usually results in better flow of information and allows problems to be tackled before becoming insurmountable.
Identifying remedies to stress
A waiver or covenant reset is a quick, and sometimes temporary, solution to fix financial stress. There is a balance to be struck between ensuring requisite runway is given to allow the business to prosper and keeping the borrower’s “feet to the fire”. Where borrowers are repeatedly seeking waivers or amendments, it is likely lenders will require additional incentives, such as clarifying add-backs and pro forma adjustments as part of the negotiations.
Cure mechanisms through equity injections (often paired with a covenant holiday or loosening of covenants) are available in most documents to either reduce debt or count towards EBITDA/revenue. FX rate impacts can be addressed through creative cure mechanisms, whereby a breach of financial covenants due to FX spreads can be considered cured if, based on pre-agreed conversion rates, the financial covenants would have otherwise been complied with.
Deferral of interest payments is invaluable for companies because it boosts liquidity to be used elsewhere, but companies should ensure that any deferred coupon can still be paid, potentially even on a compounded basis.
Alternatively, the ability to turn off cash interest, to conserve cashflow, for a limited period of time is seen regularly in mid-market private deals. While such PIK rates are likely to be higher, borrowers may be willing to incur additional long-term cost to ensure short-term survival, or at least provide time to implement new measures.
For impending maturities in difficult market conditions, an “amend and extend” is a useful liability management exercise where refinancing is not an option – again, however, with an economic cost to such a process on fees and pricing.
Other potential solutions could involve sale of non-core assets (and reinvestment of net proceeds in the business), opportunistic acquisitions to grow EBITDA, or debt buy-backs. When a larger restructuring of the balance sheet is required, the UK remains (for now) an attractive market due to the certainty afforded by the scheme of arrangement and, increasingly, the restructuring plan.
Where liquidity is the issue, borrowers may look for ways to source additional funding. Leveraged loans allow for flexibility to incur additional indebtedness by using incremental debt and a number of permitted baskets. While this capacity exists, it is not committed and the market itself will help regulate incurrence ability. Pricing of such debt will be a key factor to sustainability of the capital structure especially if borrowing at times of stress. The ability to bind new creditors vis-à-vis their interaction with other creditors, through intercreditor arrangements, remains paramount in any restructuring negotiations.
Understanding legislation is key
Implications of laws such as NSIA need to be understood.
Lenders will set their own prudent financial trigger points as a way to mitigate their investment risks. This can be dependent on selling the debt and reducing their exposure. Transfer restrictions have become tighter in recent years, with borrowers often controlling the make-up of the lender group through tight consent rights and prohibitions on selling to stressed investors. That said, it may be in the sponsors’ interest to let such investors in at discounted prices as, through new money of equitisation of debt, they may help assist in the turnaround.
In a similar vein, as valuations have increased, so too has financial sponsors’ ‘skin in the game’. Given sponsors will be willing to protect the business as a going concern, both sides can work hand in hand to ensure the investment is maintained.
Understanding legislation for distressed scenarios is fundamental. The restructuring plan has introduced a cross-class cram down and potential reduction in minority hold-out value. Implications of the National Security and Investment Act 2021 should be considered. ‘Acquiring control’ of shares subject to NSIA may trigger a mandatory notification regime. The effectiveness of the exemption in the legislation for security over shares remains unclear, but if such control passes to lenders, advice may be needed to avoid impacts on timing and enforcement strategies.
Mark Fine is a partner and Giulia Venanzoni a senior associate at law firm McDermott Will & Emery in London