Facing no-or-low revenue, midmarket looks to covenants for relief

Companies backed by private equity sponsors and their private credit lenders are gearing up for tough talks about how to bridge the abyss of revenue lost from coronavirus-related shutdowns. And lawyers are combing through loan covenants to identify how both sides may try to boost liquidity—including interest cuts, equity infusions, or added leverage.

Conversations between sponsors and lenders in the early days of the pandemic had been largely collegial and constructive, market participants say. The crisis has highlighted why direct lending is often easier than a broadly syndicated loan, with borrowers having to negotiate with one or a handful of lenders, instead of dozens.

With a shared goal of keeping borrower companies alive, the two sides have aligned, at least initially, over measures to defend liquidity. Lenders have been happy to offer up new revolvers, attracted by the prospect of fees and without alternative new investment possibilities as LBOs and sponsor-to-sponsor transactions have dried up.

But the next round of negotiations will likely be more difficult. These conversations are expected to heat up in the coming two to four weeks, as lenders and sponsors confront the prolonged impact of shutdowns on second-quarter earnings.

“The next 60–90 days is where it becomes more interesting: if the revolver doesn’t provide enough mid- to long-term liquidity for some of these borrowers, what’s the next step for private equity? One option sponsors will look at is the incremental facilities that exist in many of these deals,” said Bill Brady, head of the alternative lender and private debt group, and member of the special situations group, at Paul Hastings.

The size of these incremental facilities is key, and is dictated by features called starter baskets, also known as free and clear baskets, or an unlimited amount, based on leverage levels. Put simply, sponsors may have the ability to return leverage to levels at the close of debt facilities, erasing amortization since debt issuance. The level may be based on trailing-12-month EBITDA through year-end 2019, a calculation which could favor borrowers by excluding quarters hurt by pandemic shutdowns.

Proskauer Rose said its private credit data shows incremental facilities, also commonly called an accordion, had increasingly appeared in middle market credit documents.

“We have seen a continuing trend in the data in the traditional middle market to allow for both a starter basket and an unlimited amount, with 79% of traditional middle market deals in 2018 permitting both components of incremental facilities, compared to 62% in 2017,” said a 2019 report by Sandra Lee Montgomery and Michelle Lee Iodice entitled “Analysis and Update on the Continuing Evolution of Terms in Private Credit Transactions.”

What’s more, incremental debt may come from existing lenders, third-party lenders, or even private equity sponsors themselves. Debt can be subordinated or ‘pari passu’ with existing loans, allowing new lenders the potential to share, dollar-for-dollar, with the existing lender group, in case of bankruptcy or restructuring.

In recent years, some PE sponsors have even stepped into the business of lending, building up in-house teams and competence.

Covenant "holidays," away with cash sweeps

Among other tools in their arsenal to boost liquidity, lenders have been quick to offer up reduced cash interest, allowing borrowers to pay in-kind.

Lenders have sometimes agreed to relax cash sweep rules requiring sponsors to repay debt with excess cash in a given quarter. In some cases, lenders have allowed borrowers to rewrite definitions of EBITDA.

They have extended financials-reporting deadlines and waived audit requirements, giving borrowers breathing room.

“What makes many private credit providers different is the relationship with the PE sponsor. It helps prevent the PE sponsor from being aggressive and going to war because they know their private credit provider is going to be the important lender in four, five, or six of their portfolio companies,” said Ari Blaut, a finance partner at Sullivan & Cromwell.

“It mitigates the private credit provider from going to war for the same reason. It’s leading to a lot more constructive conversations,” Blaut said.

Private credit covenant packages have stayed more disciplined, relative to large-cap and broadly syndicated loans. But as in those markets, covenant packages in private credit agreements have loosened in recent years. One example of this loosening is a leverage ratio covenant set 30–40% above existing levels, meaning a borrower had the flexibility to increase total debt/EBITDA ratios by 30–40%.

Now middle market borrowers in industries affected by the pandemic are breaching those looser covenant levels. Lenders are trying to help by offering “covenant holidays,” according to Matt O’Meara, head of Mayer Brown’s global private credit group. A “covenant holiday” is a period in which a borrower is off the hook from complying with certain covenants.

“However, folks are trying to set a date later this year, or in 2021, when the financial maintenance covenants will kick back in,” O’Meara said. And they’re decreasing financial flexibility on new covenant terms going forward. “Lenders are really working hand in hand with sponsors to find solutions and set rational covenants, not 30 or 40% cushions.”

Still, it’s borrower-by-borrower, and lenders and sponsors will draw up bespoke solutions based on myriad factors. Cash burn rates will play a role in determining a borrower’s options. A lender’s relationship with a particular sponsor also is pivotal in considering alternatives.

“Private credit lenders do a lot of diligence—they keep up with a company. They may have board observation rights. They know their portfolio companies, and tend to be more aware of situations. That helps them be more nimble in responding,” said Neal McKnight, a finance partner at Sullivan & Cromwell. “Sponsors are doing a tremendous amount to support companies: They’re navigating the process. In some cases, they’re hiring restructuring experts to advise as needed across their entire portfolios.” 

There’s little doubt one option holds particular appeal for lenders: the billions of dollars of dry powder amassed in recent years by private equity sponsors. Calls are growing for sponsors to tap into these cash piles to relieve liquidity strain.

“There’s been a lot of tough conversations surrounding getting sponsors to put up equity capital. Those are conversations that are very credit-specific. They’re happening on every deal. Some are easier than others. Lenders want sponsors to be sharing in their pain, they want additional equity cushion if they’re going to be deferring amortization payments,” said Blaut.

But sponsors typically want this to be the last resort, particularly with extreme uncertainty over how the pandemic’s going to play out over the next six to nine months.

“Conversations seem to change every week. Many of these conversations continue to be very cooperative but some are certain to become more sharp-elbowed,” said Brady at Paul Hastings.

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Reprinted with permission from Leveraged Commentary & Data. By Abby Latour and Shivan Bhavnani.