Dusting Off Financial Covenants

Covenant-lite loans are dead. So what’s taken their place?

On mega-deals, where covenant-lite loans had become most prevalent, it’s tough to say. That market has been just about shut down since the credit crunch started early this summer. But you can bet that, when the market re-ignites, underwriters will be holding much stronger cards given how much harder it’s become to find institutional buyers of leveraged loans.

Terms never got as borrower-friendly on the smaller transactions. Nevertheless, by early this year sponsors were regularly securing covenant-lite loans on upper-mid-market deals with transaction values of $500 million to $1.5 billion. (Definitions of covenant-lite loans vary. But for purposes of this piece they include deals lacking financial covenants, having them on the revolver portion of the loan only, or having them kick in only after the borrower draws down on the revolver.)

Upper-mid-market deals continued to get done this summer and fall, if at a subdued pace. There we’ve seen the return or strengthening of a variety of financial terms designed to give lenders an early warning should performance start to deteriorate, and to give them additional recourse when it does. For lower-mid-market deals of roughly $100 million to $500 million, lenders have also been negotiating stronger financial terms. However, they had given up less ground than those working on larger deals during the boom times that ended this summer.

For the analysis that follows my main source on the upper-middle-market is Christopher Butler, partner in the Chicago office of Kirkland & Ellis LLP; for lower-middle-market deals it’s David Brackett, a senior managing director at GE Antares Capital, Chicago; and Devon Russell, managing director, Madison Capital Funding LLC.

Across the middle market, “Market MACs” have made a comeback after largely disappearing earlier this year. Such clauses let lenders back out of their financing commitments should there be a materially adverse change in, say, their ability to syndicate a senior loan. Market MACs appear in roughly half the deals Brackett works on, and, when they don’t, lenders expect to be compensated with better terms for agreeing to the omission.

All upper-mid-market senior loans now feature leverage ratio and interest coverage ratio covenants, according to Butler. The leverage ratio, typically a total debt-to-EBITDA multiple or senior debt-to-EBITDA multiple, marks a ceiling above which the company lands in technical default on its loan. The interest coverage ratio, often a EBITDA-to-cash interest cost multiple, marks a floor for the borrower.

On all middle market deals, the leverage ratio covenant incorporates the concept of a cushion. Before the market correction, borrowers might agree not to go more than, say, 30 percent above the opening total leverage ratio for the life of the transaction. Now, according to Butler and Brackett, it’s not uncommon for borrowers to agree to a smaller cushion of 20 percent or 25 percent. In addition, the leverage ratio now typically steps down every year for several years to match the company’s plans to de-lever the company. Senior loans made before the credit crunch often either didn’t feature step-downs or they lasted only a year or two.

The fixed-charge covenant, a free-cash-flow-to-interest-and-principal-payments multiple, remains a staple of lower-middle-market deals. However, whereas earlier this year you might have seen a floor of 1.0 on the better credits, today it’s usually in the 1.10 to 1.20 range, Brackett said. Meantime, interest coverage ratio covenants or minimum EBITDA covenants—a minimum EBITDA that a company must generate—now appear in about half of lower-mid-market deals, up from just a small percent earlier this year.

Below is a rundown on other significant changes in loan terms to look for:

• Capital Expenditure Limit Covenants: Lenders now insist on a cap on the dollars that capital-intensive borrowers can spend on capital expenditures in more than half of upper-middle-market deals, Butler said. In the lower-mid-market, such covenants have returned to about half of capital-intensive deals, up from 10 percent to 20 percent before the credit crunch, according to Brackett.

• Equity Cures: Fall out of compliance with the leverage ratio covenant? No problem if you have an equity cure—a common feature of covenant-lite deals that lets borrowers infuse equity into a deal to return to compliance. You’re still seeing equity cures negotiated in upper-mid-market deals, although lenders may want concessions (such as a higher interest rate). They’ve disappeared in the lower-middle-market, according to Brackett, whereas earlier this year he’d see them in 10 percent to 20 percent of deals.

• Do Not Call Lists: On upper-middle-market deals before the credit crunch, lenders would typically contractually agree not to sell their loans to investors known for aggressive loan-to-own tactics. You still see do-not-call-lists in larger deals, but they’re much more narrowly defined: For instance, lenders may insist on a list of no longer than five names. In the lower middle market the practice hadn’t been nearly as pervasive. Today, lower-middle-market lenders still verbally agree to do their best on this score, but no one is putting it in writing, according to Russell.