The global pandemic and its subsequent effects have caused disruption across most sectors of the economy. Resulting lockdown measures, declining demand and profit erosion have significantly impacted businesses, causing many to close their doors for good. In private equity, professionals are navigating continuing uncertainties and unprecedented market volatility. Firms are overcoming adversely affected aspects of portfolios while looking out for emerging trends.
As well as this, sponsors and lenders in the space are increasingly having to turn their attention to the financial covenants in place with portfolio companies. As the coronavirus crisis continues, we expect to see a greater number of disputes arising in relation to covenant breaches and the new behaviours being seen in this space. Now is the time for sponsors to review their finance documents and to analyse the impact of the pandemic on the operations and financial results of their portfolios as well as their ability to remain in compliance.
Typically, financial covenants allow lenders to monitor a borrower’s financial position and breaches of these serve as a warning indicator of the financial health of a borrower. However, towards the end of 2019, lenders began loosening the reins on such commitments and we saw a rise in ‘covenant-lite’ leveraged finance agreements that did not contain ongoing financial covenant maintenance requirements. For those with covenants in place following the effects of a public health emergency on businesses, it is hard to avoid the fact that breaches are now more likely to occur. PE professionals must identify which covenants are likely to be breached, when they will be breached and what steps must be taken to address issues that arise.
Covenants testing the value of a lender’s security are usually measured against an assessment of value on a given day, while performance covenants tend to look backwards or forwards over a period of time to assess whether a borrower’s business is showing signs of distress. Each quarter, portfolio companies are usually asked to certify compliance with the financial maintenance covenants in their debt instruments. Continuing market deterioration is presenting challenges for companies’ EBITDA and therefore compliance with such covenants.
To assess the impact of a breach, the following issues should be taken into consideration:
- How the particular borrower is affected by virus-related economic disruption
- What are the deadlines for meeting requirements in the covenant?
- The frequency of testing for any financial covenant
- The measurement period for the financial metric at issue
For EBITDA-based covenants, parties should review allowed EBITDA add-backs and consider the extent to which any permitted add-backs for extraordinary, non-recurring losses, charges or expenses would apply to losses and expenses associated with covid-19 and a borrower’s response to the outbreak.
Material adverse change clauses in finance documents are also a cause for concern as they may give lenders further leverage to negotiate in a situation of distress. Whether or not covid-19 will trigger a MAC event of default will depend on the drafting of the clause, the specific circumstances and the impact that this has on the borrower. It is still unlikely that a lender would call an event of default based on a MAC – lenders generally want certainty before calling an event of default and reputationally a lender may be reluctant to take enforcement actions against a previously performing borrower solely on account of covid-19.
What action do PE professionals need to take to reduce the risk of disputes?
Early engagement with involved parties is key, by reaching out to companies for updates to explore options ahead of time. PE sponsors and portfolio companies may consider engaging with lenders to obtain financial covenant holidays, resets, waivers or amending the financial covenant provisions. As well as this, they should check for any applicable thresholds, grace periods or reliefs for non-financial, general covenants in agreements. Where amendments to financial agreements are agreed, it is important to strike a balance between providing lenders with the comfort that they may require and tightening terms to such an extent that borrowers find themselves unable to effectively manage their business. Sometimes, enforcing or abiding by covenants can negatively affect both parties as the restrictions may lead to reduced efficiencies and lower profits than expected.
Some investors have adjusted their methods for evaluating companies by tracking liquidity and suspending financial covenants such as leverage and cash cover covenants. Lenders are asking for minimum liquidity tests and weekly/fortnightly cashflow forecasts in lieu of those covenants. PE sponsors are also encouraged to carefully consider the use of any available equity cure provisions, particularly whether any such equity cure proceeds will be required to prepay outstanding loans. Sponsors and portfolio companies may wish to seek guidance from legal advisors in assessing existing adjustments to EBITDA and evaluating the correct approach when seeking to explore covenant relief options.
What the future holds
As uncertainties continue, industry trends show flexibility among lenders with generally supportive attitudes. Liquidity covenants have increased in popularity and are now more prevalent in agreements entered into mid-pandemic. The enforcement of breaches is generally rare, with lenders opting for more constructive approaches, demonstrating a continued desire to help companies manage a challenging period.
Sukh Ahark is a London-based partner at law firm RPC