New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

It's hard to ignore the growth of covenant-lite lending in private equity deals, when even famous investment gurus like  Anthony Bolton remark on it, and at his farewell dinner no less.  Here is what Mr. Bolton had to say on the topic:

“I think the phrase is ‘covenant-lite’, but in many cases it appears to mean no covenant at all,” Mr Bolton said. He added: “Covenant-lite borrowing ... will come back at some stage to haunt the banks,” he said.

Quotes about covenant-lite lending are usually paired with a dire prediction, such as the premonition of another financial bubble.  But will covenant-lite lending really come back to haunt the banks?   

In a typical covenant-lite deal, the lenders give up what are called "maintenance" covenants.  As the name suggests, these are requirements that the borrower maintain certain financial standards at regular intervals.  For example, a borrower might be required to certify that at the end of each quarter, it has maintained a certain ratio of EBITDA to total debt.  These covenants are designed to be an early warning system that the borrower's earnings are deteriorating, and it might become unable to meet debt service requirements at some time in the future.  With these maintenance covenants gone, the lenders rely solely on what are called "incurrence" covenants.  These require that a borrower meet defined financial standards not on a regular basis, but only when there is a specific event, such as an acquisition.  For example, if the borrower wants to make an acquisition, it must certify that it will meet a specific EDITDA coverage test after the acquisition is taken into account.   

Finally, in covenant-lite deals, the other covenants are less restrictive, for example allowing for more extensive dividend payments or larger capital expenditures.

How bad are covenant-lite loans?  Despite the publicity these deals receive, they appear to be limited to large private equity deals involving companies with earnings cycles that are relatively well known or at least fairly predictable.  With companies like these, perhaps the function of maintenance covenants -- to provide an early warning system -- isn't necessary.  What good is a warning when the funds have already been loaned?  Perhaps maintenance covenants aren't really needed, and their elimination is simply a matter of efficiency.

Perhaps the traditional way of lending, where a borrower is required to certify periodically that it remains healthy enough to maintain its debt, is out of date.  Then again, if it is merely out of fashion, we may see it come round again.  Time will tell.

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This is from an article in the Boston Globe quoting Scott Sperling and Kevin Landry of TA Associates:

"The reality is the markets are willing to provide extraordinary amounts of debt, almost indiscriminately," says Scott Sperling , copresident of Thomas H. Lee Partners, the big Boston private equity firm. "It's hard to put these companies into default. I can't think of the last time we had a real covenant in one of our deals."

Landry told me about the terms TA Associates secured recently to fund the purchase of a company. In particular, the interest rate was set at 2.25 percent over the floating London Interbank Offered Rate, or LIBOR. But TA Associates doesn't have to make all its payments in cash if the acquired company runs into trouble. It can make something known as a toggle payment, or "payment in kind," essentially borrowing more to make the regularly scheduled loan payment. The only penalty: an interest rate that rises 0.5 percent."

Covenants are a thing of the past.  The toggle payment, payment-in-kind and similar default-avoidance provisions, make even failures to pay interest a non-event. 

You could argue that what the lenders are doing is pre-agreeing to terms of a default work-out program.  They are saying, "we like the horse we rode in on, and are willing to give them time to get back on track when problems arise."  It is a show of faith in the ability of the PE sponsors to work out any problems or ride out short term economic issues.

Is it a bad idea for lenders to be handing over traditional lending rights to PE sponsors?  Maybe.  But is the cost and outcome of bankruptcy any better?

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Several recent deals illustrate the extent to which financial covenants have all but disappeared from senior loan agreements in private equity transactions. The following transactions were chosen at random.

• In the October 2005 acquisition of Neiman Marcus by Texas Pacific Group and Warburg Pincus, the $2 billion senior loan facility provided by Credit Suisse and Deutsche Bank Securities had no financial covenants. The agreement did have the usual negative covenants, but even these were significantly weakened. For example, the restriction on incurring other indebtedness had 23 exceptions.

• In the November 2005 acquisition of the Vitamin Shoppe by Bear Stearns Merchant Banking, the senior revolving loan facility provided by Wachovia Bank had one financial covenant. It said that if the availability on the revolver was nearly tapped out (less than 10% remaining) then during the four preceding quarters the Fixed Charge Coverage Ratio had to be at least 1.1 to 1.0, or barely enough to cover the charges.

• Finally, in the January 2006 acquisition of AMC Entertainment by J.P. Morgan Partners and Apollo Management from Bain Capital Partners, the $850 million senior credit facility provided by Citicorp had one financial covenant. This covenant provided that as long as the revolver remained outstanding, the company had to maintain a ratio of Senior Debt to EBITDA, on a pro forma basis (!), of at least 3.25 to 1.0.

These random selections from the credit agreements of large and mid-market deals illustrates the extent to which lenders have turned over the risk of defaults to the ultimate purchasers of the debt, namely, the CLO pools.

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The ratio of total debt to EBITDA in mid-market private equity transactions is now as high as it was in 1997 – 4.7 times for companies with less than $50 million in EBITDA and 5.4 times for companies with more than $50 million of EBITDA (Source: Standard and Poors). The ratio of EBITDA less CapEx to Cash Interest in highly leveraged loans is also falling – in the 4^th quarter of 2006 the ratio fell to 2.2 times (Source: Standard and Poors).

At the same time, the covenants being written for leveraged loans are becoming more “lite”: several years ago, loan covenants were written at a 15% discount to model; now they are being written at a 25% discount.

“Covenant-lite” transactions come in many forms. In their most direct form, the covenants that require the borrower to “maintain” certain financial ratios are eliminated altogether, and the lenders are left to rely only on covenants that restrict a company from “incurring” or actively engaging in certain action. For example, a covenant that requires a company to maintain a ratio of debt to EBITDA can be breached if the financial condition of the company deteriorates, as the covenant is measured periodically, usually quarterly. But a covenant that only restricts a company from incurring new debt cannot be violated simply by a deteriorating financial condition, the company has to take affirmative action to breach it. 

Less direct forms of “covenant-lite” include carve-outs in traditional maintenance covenants that forgive in advance a certain measure of deviation from the standard. It is sometime more palatable to embed these carve-outs in a traditional loan covenant than discard the covenant altogether.

In addition to covenant-lite structures, private-equity sponsored deals have started to include a greater number of “equity cure” provisions. These enable a borrower to cure a covenant deficiency by adding more equity into a deal to count as EBITDA, thereby curing the breach. The additional equity does not have to be used to pay down debt and can be used for different purposes such as capital expenditures. In effect, the private equity sponsor is pre-negotiating an equity infusion without having to get lender approval.

This trend is of course a function of the amazing amounts of liquidity available in the credit markets to fund acquisitions.  The impact of these covenant-lite transactions will be to retard the speed with which lenders will be able to take control over troubled deals.  That may not be such a bad thing.  Lenders are not equipped to own a business and typically sell too quickly when forced to take over a company.  The next downturn may provide less opportunity for distressed debt investors than previous business investment cycles, as fewer private equity sponsors may be handing over the keys to their lenders.  

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The purpose of having the financial and affirmative and negative covenants in senior loan agreement becomes clear in the Defaults section of the agreement. It’s here that they get their teeth. 

The first events of default are non-payment of principal or interest. There is generally no grace period for principal payments. Interest payments are usually given a short grace period of five days. After that, nonpayment results in immediate default of the entire loan.

Another category of defaults occur if any representation made by borrower proves to have been incorrect in any material respect at the time it was made. This is a static test, looking only at the representation on the date it was made and asking if it was true or false in all material respects on that date. The limitation to material issues is intended to rule out minor inaccuracies as a cause of loan defaults.  What constitutes materiality is not usually defined in much detail.

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Affirmative covenants are those things the borrower must affirmatively do during the term of the loan agreement. Most of these requirements are things the borrower would do in any case without being instructed by a lender, such as pay its taxes, comply with laws, and meet its financial obligations. Other covenants are matters that work to conserve the borrower’s cash flow, focus borrower on a specific line of business and generally keep its nose to the grindstone.

Negative covenants are the things the senior lender says that a borrower may not do. Most of these are things the borrower wouldn’t do anyway. The rest are designed to keep the borrower focused on running its business in the ordinary course and repaying the senior lender’s debt.

Here is a list of certain affirmative and negative covenants that are often negotiated in the credit agreement of a private equity transaction:

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Financial covenants are specific financial benchmarks that the borrower must satisfy during the term of the loan. The covenants generally change over the course of the loan, reflecting improvements in growth and financial condition that are expected to occur. The following are typical financial covenants in senior loans made in connection with private equity transactions:

• Leverage Ratio. Compares the borrower’s total debt from all sources to its EBITDA (earnings before interest, taxes, depreciation and amortization).
• Interest Coverage Ratio.  Compares the borrower’s EBITDA to its cash interest payment obligations.
• Fixed Charge Coverage Ratio. Compares the borrower’s EBITDA minus capital expenditures to its fixed obligations for interest, principal on debt, cash dividends of preferred stock and income tax liabilities.
• Capital Expenditures. The amount the borrower can spend on capital expenditures.

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The closing conditions in a senior loan agreement spell out what hoops the borrower must jump through before it is able to draw down the loan proceeds. The first condition is that borrower must sign all the contracts diligently prepared by the bank’s lawyers to document and secure the transaction. In addition to the main credit agreement, the bank’s lawyers prepare the following documents:

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Senior credit facilities in private equity deals generally include one of more term loans and a revolving credit facility. The term loan is a fixed amount that is loaned for a defined term. The loan is usually repaid in fixed installments of principal and interest so that the loan balance decreases with each payment.  

The revolving credit facility is a commitment to loan funds from time to time based on the borrower’s inventory and accounts receivable. The facility will have an upper limit of availability, but the actual amount that can be borrowed will vary from month to month based on the amount of inventory and receivables. Each month the borrower has to pay interest on the outstanding balance and, if the loan balance exceeds the borrowing base, and amount of principal equal to the excess. When the facility matures, usually in a year, the entire amount becomes due and payable. If conditions are good, the facility is generally renewed. 

A portion of the credit facility may be dedicated to providing letters of credit, if the borrower uses these instruments in its business. Senior credit facilities can be prepaid, thought there are often penalties associated with prepayments that occur other than at stated intervals. The facilities must be prepaid with the proceeds of assets sales, public offerings and other extraordinary transactions.

Interest rates may be computed on the basis of bank prime rates or LIBOR, with certain rights to switch back and forth between the two forms of loans as financial conditions may determine. Senior lenders also charge a number of fees on the initial borrowings and on the specific commitments that are made to provide ongoing financing.

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