COVID-19 has affected the operations and projections of many portfolio companies of middle market private equity funds. For some companies, the COVID-19 pandemic has resulted in reduced liquidity and less headroom under existing financial covenants, while other companies have been forced to consider delaying principal and interest payments and are likely to trip financial covenants on the next testing date. Having an effective strategy for managing defaults is key for private equity sponsors and their portfolio companies navigating this uncertain market.
Although middle market financing documentation does not generally provide all of the flexibility that is available to larger market companies, there are a number of potential strategies a sponsor and its portfolio companies may use to maintain compliance and solve for defaults. This may include (i) proactive measures to avoid default, (ii) amendments and waivers to realign with a company’s revised outlook, and (iii) sponsor support through equity cures and lender forbearance.
Anticipating Potential Defaults
Maintaining sufficient liquidity is key for sustaining operations, and some lower middle market financing arrangements may even require maintenance of a minimum liquidity level. As cash flow is affected by the COVID-19 pandemic, companies should examine all liquidity options permitted by their financing documentation. The most obvious source of liquidity is the revolving credit line, but there are often other options, such as delayed draw term loan facilities (depending on permitted use of proceeds thereof), carve-outs to debt covenants permitting the incurrence of additional tranches of senior debt, and subordinated debt.
As a general matter, portfolio companies should strongly consider drawing down existing revolving credit lines. Revolving advances are generally subject to no default tests and bring-downs of representations and warranties (including no “material adverse effect”). The potential for market conditions to deteriorate in general and lead to defaults down the road means that revolving advances may be delayed or even cut off if a company waits too long to make a borrowing request.
For asset-based credit facilities subject to a borrowing base, portfolio companies should closely monitor the value of the underlying eligible collateral to ensure that market deterioration does not result in a collateral shortfall and a corresponding mandatory repayment. Also, in order to take advantage of valuable collateral not included in the borrowing base calculations, negotiation of over-advance facilities with lenders may be possible, subject to dollar sub-limits and increases to loan pricing, among other things.
Portfolio companies should be particularly vigilant about complying with all technical requirements in their financing documents. Some lenders have begun to change their internal policies regarding waivers and extensions, and matters that traditionally are waived by lenders in the ordinary course of business, are more likely to become defaults in this environment.
One new item of concern are third party matters and post-closing obligations. Most secured financings require third party items, such as collateral access agreements, insurance endorsements and account control agreements, the timing of which are out of the control of the lender and borrower. Many transactions also include obligations to seek additional consents from, or amend contracts with, third parties within agreed timeframes. The pandemic has resulted in delays with third parties and lenders are generally not obligated to provide extensions or waivers. While these matters are often deprioritized, companies should ensure that they do everything they can to resolve them within the original agreed time frame.
Also, a default under a material contract or other material indebtedness with a third party will often cross default a company’s credit facility. The loss or material modification of material contracts may also constitute its own default.
While lenders are unlikely to accelerate a credit facility over “foot-faults”, such defaults provide lenders with the ability to deny additional borrowings or invoke other rights, such as increased oversight and default interest.
Many leverage-based financial covenants also allow netting of unrestricted cash from the calculation of a company’s debt, often up to a dollar cap. Consistent with the general approach of maintaining a healthy cash cushion on the balance sheet, sponsors and their portfolio companies should ensure that they are taking full advantage of cash netting to ease financial covenant pressure by making sure that cash is maintained in the correct company accounts when necessary to comply with financial covenants. Sponsors may also consider equity contributions to portfolio companies prior to the occurrence of financial covenant defaults, in part for cash netting purposes. So long as the applicable credit agreement does not include a mandatory prepayment of loans with the proceeds of any such equity contributions, these proceeds may also be used by the company for operating and other expenses after financial covenant testing.
It is advisable to make sure that every EBITDA addback with respect to non-recurring or extraordinary items contained in the financial definitions of credit agreements is fully vetted. Note that many middle market credit agreements contain general baskets for non-recurring or extraordinary items (typically subject to a percentage of EBITDA based cap), which may prove particularly useful now.
Debt buyback provisions, although less common in the lower middle market, allow a sponsor, a debt fund affiliate of a sponsor, or the portfolio company itself, to directly purchase portfolio company term loans. Such purchases may potentially be at a discounted price to par. Where available, these term loan repurchases, in addition to potentially being good investments for sponsors or their debt fund affiliates in the long run, are an efficient way to de-lever a portfolio company and solve for non-compliance with financial covenants. Loans purchased by the company are automatically retired and depending on the terms of the debt buyback provisions, loans purchased by the sponsor or a debt fund affiliate may be optionally retired, in whole or in part, as necessary. Voting rights of the sponsor, other than certain sacred rights with respect to the term loans, are typically eliminated and sponsor purchases are usually capped at 25-30% of the then outstanding term loans. As a practical matter, such purchases are generally made from existing lenders via Dutch auctions, reverse Dutch auctions or open market purchases.
Most middle market financing documentation provides lenders broad rights to request financial information in addition to regular required reporting. Companies should be prepared to respond to preemptive inquiries from lenders, especially following any negative news regarding related industries or competitors. In addition, lenders will be looking for revised projections reflecting the effects of the pandemic in connection with any requested payment deferrals or other amendments related to changes in financial performance, especially with respect to the re-set of financial covenants.
If audited financials are required to be delivered during this time, sponsors and their portfolio companies should carefully review the reporting provisions of their financing documentation for compliance. It may be prudent to include COVID-19 related disclosure as part of audited financials or MD&A in a manner not in conflict with the credit agreement requirements. It is customary for credit agreements to prohibit the delivery of financials that include a “going concern” qualification, so it is of note that it may become more common for auditors to include “going concern” qualifications as a result of the pandemic and general market uncertainty.
Sponsors and their portfolio companies should also carefully review notice requirements contained in financing documentation. Financing documentation often requires companies to provide written notice of material events, such as amendments to or defaults under material contracts and disputes that may be implicated by the pandemic.
Amendments and Waiver
Required Payment Amendments
If a payment default is likely to occur in respect of an upcoming interest or principal payment, or the making of such payment would have a major strain on a portfolio company’s liquidity, sponsors and their portfolio companies should explore amendments to waive or defer such payments. Lenders are unlikely to waive these payments altogether and the period of any deferral will need to be supported by revised projections. The sentiment in the market, and the nature of middle market loan investing in general, continues to be that lenders and borrowers are in this together and that lenders are willing to work with borrowers to avoid near term issues that borrowers are facing. This is of course determined on a case by case basis, but interest and/or amortization holidays on a one or two quarter basis may be achievable.
With respect to mandatory prepayments, lenders may also be willing to waive or defer such prepayments in an effort to assist a portfolio company maintain liquidity. Sponsors and their portfolio companies should seek to retain any insurance proceeds, disposition proceeds or proceeds of an equity issuance that may otherwise be subject to a prepayment by utilizing reinvestment rights that may be available. Similarly, sponsors and their portfolio companies may consider seeking a waiver of any excess cash flow mandatory pre-payment based on the previous fiscal year’s financial performance.
With market conditions affecting performance, companies are likely to have trouble complying with financial covenants. Likewise, companies with springing financial covenants, or companies that have otherwise drawn down on their revolver in order to shore up liquidity, may find themselves in default of their leverage ratio or fixed charge coverage maintenance covenants. Sponsors and their portfolio companies should be proactive in their coordination with lenders regarding revisions to required covenant levels, consistent with revised company projections.
In addition, sponsors and their portfolio companies may solve issues with financial covenants by amending financial definitions to reflect the extraordinary impact of COVID-19 on operations. This will principally involve ensuring that the definition of EBITDA sufficiently adds back one-time expenses relating to the pandemic. As noted above, many credit agreements include capped addbacks for non-recurring or extraordinary expenses; however, in the event that such general caps are exceeded or lenders are not otherwise comfortable agreeing that an item falls into such general add-back, separate specific addbacks relating to COVID-19 items may be negotiated. Although EBITDA addbacks will help smooth out the effects of unusual costs, they will generally not make up for lost income that had been previously projected. Potential new COVID-19 addbacks include the below:
- Increased production costs
- Increased supply costs
- Cleaning costs
- Cost of obtaining new supply chains
- Temporary store and facilities closure and reopening costs
- Employee compensation costs during a temporary closure
Material Adverse Change
It is customary for financing documentation to include a “material adverse change” or “material adverse effect” representation that no such change has occurred since a specified date. For transactions in the lower middle market, the occurrence of a material adverse change may also be an immediate Event of Default. Sponsors and their portfolio companies should review the definition of material adverse change for inclusion of “prospects” or other forward-looking language, which may provide a lender the ability to determine that a default has occurred due to an adverse event being likely to occur in the future. If such prospective language is included in a credit agreement, sponsors and their portfolio companies should consider requesting an amendment to limit adverse events to those that have actually occurred, including carve-outs relating to COVID-19 and pandemics generally.
Following an Event of Default
Most middle market credit agreements contain the right of the sponsor to cure financial covenant defaults by making equity contributions to a portfolio company (or sometimes also the issuance of sub debt by a portfolio company), which contributions or issuances count as a corresponding increase to EBITDA for the applicable period. Sponsors and their portfolio companies should review equity cure rights to determine applicable restrictions. Common restrictions include: (i) limitations on the number of cures during the term of the loans, (ii) not more than two cures in any four quarter period, (iii) a cap on the dollar amount of cure proceeds, (iv) no cures in consecutive periods, (v) a limited time period post default for exercising cure rights, and (vi) the application of cure proceeds to the term loans. To the extent cure proceeds are required to be applied to repay the term loans, sponsors and their portfolio companies should consider requesting a one-time waiver of the application of these proceeds to improve company liquidity post-cure. While equity cures are often exercised as a last resort, we anticipate that these may be used with more frequency now or otherwise more frequently required as a condition to covenant resets.
Lender Forbearances in Lieu of Amendments and Waivers
To the extent that a portfolio company is not able to avoid or cure an “event of default” under its financing documentation or otherwise come to agreement with its lenders with respect to waivers or amendments of the financing documentation, sponsors and their portfolio companies should consider securing a forbearance agreement from the lenders during the post-default period prior to agreement on permanent waivers or amendments. A forbearance agreement will generally require a company to acknowledge the occurrence of defaults, but will also include a binding undertaking by the lender to refrain from taking any enforcement actions or exercising rights as a secured creditor prior to an agreed forbearance date.
Similar to waivers and amendments, lenders will often only grant forbearances in exchange for fees and the imposition of lender-friendly restrictions and requirements. Some lenders will ask for increased oversight, bringdowns of collateral disclosure, more frequent reporting, minimum liquidity requirements and satisfaction of performance milestones during the forbearance period. If the requirements of the agreement are not met, or additional defaults occur under the financing documentation during the forbearance period, the forbearance period will generally immediately lapse, and the lender will be free to exercise its remedies.
Sponsors and their portfolio companies should carefully weigh the value of a forbearance agreement against the costs associated therewith. While it is of course helpful for portfolio companies to have a period of contractual breathing-room, sometimes the terms required by the company’s lenders may not be worth it. If there are likely to be additional defaults that may end a forbearance period early, or a potential refinancing or change of control transaction is on the horizon, a portfolio company may be overall better off living with an ongoing event of default without taking on additional restrictions or paying additional fees. This of course needs to be weighed against the risk that the portfolio company’s lenders could exercise remedies under the loan documents, including sweeping cash from controlled accounts or otherwise foreclosing on assets of the company, and how this may impact the marketing of a sale or refinancing transaction.