It’s no secret that it’s a borrower’s market and companies can easily tap market liquidity for their capital needs. Debt leverage multiples, one measure of a lender’s appetite, have climbed as high as seven times EBITDA and show no signs of abating. At the same time, more companies are beginning to experience earnings shortfalls and seek loan covenant relief.
According to Standard & Poor’s/LCD, default rates increased in 2005, while there were 51 borrowers that reported leveraged loan covenant amendments, up from 29 for all of 2004. These figures may be even higher since they exclude private companies and non-reporting public companies.
Covenant amendments are expected to increase primarily due to pricing compression in certain sectors, rising raw material and energy costs, rising interest rates and potentially adverse fluctuations in foreign exchange rates.
Loan covenants will likely be more of an issue in certain industry segments. The auto industry was the leading source of reported amendment relief in 2005, accounting for 20% of the total. Forest products was second, at 10%, followed by the healthcare, entertainment and leisure sectors at eight percent each, and the chemicals, food and retail sectors at six percent each.
How lenders respond to a covenant violation varies depending on how severe it is or how frequently it occurs. Given the level of market liquidity, however, borrowers will likely find asset-based and cash flow lenders offering a fair amount of flexibility.
Covenants are conditions of a loan that provide the lender with a sufficient level of downside protection. They can take the form of affirmative covenants (e.g., maintaining certain financial ratios) or negative covenants (e.g., limiting the sale of assets). The most common covenants in cash flow or corporate bank loan agreements include:
•Minimum fixed charge coverage (EBITDA minus capital expenditures and cash taxes divided by the sum of interest expense and scheduled principal payments on indebtedness)
•Minimum interest coverage (EBITDA divided by interest expense)
•Senior or total debt-to-EBITDA
•Minimum net worth
In 2005, the average total debt/EBITDA covenant on leveraged loans was 4.8 times, while the average minimum interest coverage and minimum fixed-charge coverage covenants were 2.3 times and 1.34 times, respectively.
The total debt or leverage covenant is frequently the first one violated by companies, particularly when leverage ratios are near historic highs. The first time there is a violation, a lender may charge a nominal fee or elect to waive it if there’s a reasonable explanation. The lender will likely charge a higher fee and impose an interest rate increase on the credit facility if covenant breaches continue.
Once a borrower has revised its forecasts and knows it’s not going to meet its existing covenant requirements, management will generally ask for covenant amendments. If more than one lender is involved, the process can take some time and may require several proposals to satisfy the lender group.
Despite the increase in amendment activity, fees for covenant violations remain fairly low in both the cash flow and asset-based lending markets. In 2005, the average reported fee was 21 basis points. Aside from fees, other pricing enhancements are also being used. In return for loosening financial covenants, some borrowers have offered lenders improved economics such as an additional 25 basis points of interest spread and/or a one-time fee.
Persistent covenant defaults and amendments can have negative consequences. This could include a reduction in credit facility size, restricted access to the revolving line of credit, or possibly termination of the credit facility and demand for repayment. Before it comes to that, many borrowers elect instead to refinance or restructure existing debt.
The flexibility of asset-based loans is particularly attractive to borrowers who are restructuring or those who operate in a volatile industry where it can be difficult to maintain steady earnings or cash flow. Asset-based lenders can offer borrowers operational flexibility through an availability block, where a set amount of liquidity is blocked from use in exchange for the absence or loosening of other financial covenants.
Common today are asset-based loans with no covenants or springing covenants—i.e., covenants that apply when liquidity, as measured by excess availability under the revolver, drops below a certain level. When there are financial covenants in an asset-based facility they are usually limited to a fixed-charge coverage requirement generally at 1.0 to 1.1 times.
In asset-based facilities, the concept of less restrictive covenants goes beyond just the financial ratios. Negative covenants—those that restrict the borrower’s ability to make acquisitions, retire subordinated debt or high yield bonds, repurchase stock, make dividends or other distributions—are usually less restrictive than those in a cash flow structure. As long as the borrower has a minimum level of pro forma excess availability in its asset-based revolver after factoring in the impact of the transaction, the borrower has greater flexibility and discretion regarding these business decisions.
Even if covenant relief is not currently an issue for a borrower, an asset-based loan may be a better alternative for many companies such as those in cyclical industries where earnings can ebb and flow dramatically. It simply takes some of the pressure off when the business moves into a down cycle. For companies that have used asset-based loans, the ability to avoid quarterly covenant anxiety has been very attractive. As a result, management can focus more time on running the business rather than covenant waivers and amendments.
Pricing on asset-based and cash flow loans are competitive today. The difference is usually in the number and degree of loan restrictions. For example, a cash flow facility might have a maximum total debt/EBITDA covenant of 3.5 times, maximum senior debt/EBITDA covenant of 2.0 times, a minimum asset coverage requirement and a minimum fixed-charge coverage covenant of 1.25 times. In contrast, an asset-based facility may require only a fixed-charge coverage of 1.0-1.1 times if availability falls below a certain threshold. For many companies and situations, asset-based loans offer greater operational flexibility.
Leverage covenant levels are expected to remain loose in the near term due to excess market liquidity, increased lender competition and low default rates. However, as more issuers fall behind projections, default rates are expected to climb.
For companies experiencing or anticipating financial covenant violations under cash flow or other corporate banking facilities, an asset-based loan is often an ideal alternative. It can enable managers to run their business, focus on operational issues, and avoid quarterly covenant anxiety.
By Ira Kreft, Executive Vice President, and Jason Krieg, Assistant Vice President, Bank of America Business Capital.