Advanced Negotiation Issues in Financial Covenants

Key financial covenants ratios used by Lenders and typical LMA ratios in leveraged deals

• Market-based financial covenants ratios

• The four LMA covenants in leveraged deals of springing leverage covenant

• Leverage ratios (Balance sheet and P&L ratios) Total (Net) Debt / EBITDA

• Senior (Net) Debt/ EBITDA

• Senior Secured Net Leverage

• Springing Leverage Covenant

Interest coverage ratios

• EBITDA to [Net] Finance Charge

• EBITDA to Senior [Net] Finance Charges

• Other variations

Cash flow cover (DSCR)

• Cash flow Covenant to Debt Service

The Capital Expenditure (capex) covenant

• LMA vs Market approach

• Carry forward / carry back amounts - LMA vs Market approach

• Add-backs – LMA vs Market

Springing Leverage covenants (not LMA)

• Use and application

• When should the ratio spring

• Calculating the constituents of the springing financial covenants

• When is the springing financial covenant tested

• Potential problem areas

Calculation of EBITDA and Cashflow

• EBITDA Simplistic calculation of EBITDA

• Consistency of application (Accounting changes under IFRS, GAAP etc.)

• Exceptional items – LMA approach, UK GAAP vs IFRS

• Discontinued Operations – LMA, different approaches of UK GAAP vs IFRS

• Derivative & Financial Instruments - UK GAAP vs IFRS

• Pension Items - UK GAAP vs IFRS

Current trends affecting EBITDA (aggressive add-backs)

• Anticipated synergies and cost reductions

• What are the “typical” requirements for “anticipated synergies”

• Business optimisation expenses

• Run-rate EBITDA – how is this calculated

Definition of “Cash Flow Covenant”

• Why ‘cash flow’ is not all it seems in the LMA

• Typical adjustments

• Sponsor friendly adjustments

• Potential problems with “cash-flow Covenant”

Leverage Covenant Headroom Calculation of Debt, Borrowings and Finance Charges

• “Total [Net] Debt” and “Senior Total [Net] Debt” “Borrowings” per the LMA

• Simplistic Calculation of Net Debt

• Examples of net debt items

• Treatment of PE “Debt”

• Vendor Loans – do they matter

• Impact of Debt Buybacks and impact on “Debt”

• Treatment of “trapped” cash on Debt

• What does “senior” only exclude?

• What about PIK loans – should they be included in Total Debt?

“Borrowings”

• Treatment of receivables

• Redeemable shares

• “Sweeper” clause

Finance Charges & Net Finance Charges

• Impact of “PIK”

• Hedging impact

Navigating covenants in distress scenarios

• The Compliance Certificate Typical requirements per LMA Sch 9

• Current commercial requirements

• When does the breach of springing financial covenants occur?

How should borrowers react in distress situations?

• Strategies in cov-lite syndicated loans

• Strategies in bilateral, club or Unitranche deals

• Relevance of jurisdiction

What can lenders do?

• Revised threshold on due diligence on unrealised EBITDA addbacks

• Suspension of covenants

• Minimum liquidly test (in some sectors)

• Increase in Headroom?

• What about waivers on some covenants?

Equity cures

• Equity cures - What are they, good or bad

• What should be cured (EBITDA cure, Cash flow, Debt)

• Treatment of “overcures”

• Is the cure EBITDA? And if yes, what effect will this have

• How should the cash be used? (Why repayment of debt is not appropriate)

• Deemed cures – what are they and are they worth having?

• Case: Review of recent lessons from Ideal Standard

Covenants used in Real Estate deals

• Interest cover – constituents, pros and cons Historical

• Projected

Key differences from the leveraged ratio

• Covenant Cushion Calculation periods

• “Passing Rental” – what is included and what is excluded

• Difficult/contentious aspects - break clauses, non-rental income, costs/expenses

• “Finance costs” – treatment of hedging

Financial Covenants in Loan Agreements to Value Convent

• Constituents, pros and cons

• Items to be netted off in loan to value convent

COVID issues

Is COVID force majeure event in Real Estate deals

Can Valuations be relied on as an EoD in a COVID environment

Appendices (Not covered in the course but included in an appendix of the materials)

Finance Leases v Operating Leases – problem areas

• Current approach

• Impact of proposed changes to IFRS

• Which sectors will be affected by the changes

• Potential problem areas (& solutions) with the new regime

• Sectors posing particular problems with operating leases

Overview of financial covenants ratios used in Project finance / Infrastructure

• Annual Debt Service Coverage Ratio (“ADSCR”)

• Loan/Bond Life cover

• Project Life cover

• Using the Buffer test

Training Objectives

• Understanding the financial covenants and their application – The programme explains the critical financial covenants set out in the LMA Leverage precedent and analyses the pros, cons & application of each covenant.

• Fragmented European loan market undermines the ‘traditional’ LMA approach – The European leverage-loan market has fragmented into four segments (i.e., bilateral loans; club deals, cov-lite deals and unitranche) with differing commercial terms across each deal type. The programme explains the key differences in approach to the financial covenants between these segments, including springing leverage covenant funds in cov-lite deals.

• Accounting issues – interpreting the financial covenants requires some knowledge of accounting treatment of certain issues; for example, the treatment of leases (IFRS 16); the meaning of “exceptional items” and “discontinued operations’ (IFRS & UK GAAP pose differing treatment for both these items). The programme explains the key differences and their ramifications.

• Legal issues – the definitions that comprise the financial covenants include various defined terms which are not recognised in formal IFRS/GAAP. This is one of the key negotiating areas and matters to both lenders and borrowers.  “EBITDA” is the most important definition since it is a purely defined term and can be subject to numerous addbacks (e.g., run-rate, Pro-forma and various ’synergies’) all of which can undermine the effectiveness of the covenants (from the lender’s perspective). “Senior Secured Net Leverage” is another term of art which may vary across different credit agreements.

• Market practice – Market practice varies across the various segments in relation to a wide range of issues including which financial covenants are used, equity EBITDA cures, financial covenant ratios headroom/cushion, and addbacks. The programme explains the current market practice of these items.

• Negotiating key commercial issues – whilst the market has developed broadly similar approaches within the various market segments, there are numerous areas which are subject to financial negotiation partially in cov-lite and Unitranche deals where borrower-friendly terms can be accommodated (at a price!)

• Managing covenant pressure & distress – Looming increases in both interest rates and energy costs (hard on the heels of covid) seem likely to trigger a recession and a rise in distressed borrowers. The programme guides how both borrowers and lenders should approach these situations.

• Analysis of the Financial Maintenance covenants in Real Estate deals – Two items have been published for two precedents on real estate deals (portfolio and development companies. The programme reviews and analyses these covenants and the key issues that arise.

Training Course Summary

The market in Europe has bifurcated into two main approaches for loan documentation; smaller club and bilateral deals which broadly follow the more lender-friendly LMA approach, and larger syndicated TLB-style deals which are increasingly influenced by high-yield bonds and invariably are structured on a cov-loose or cov-lite basis. These larger deals also include a far more eclectic approach to the key definitions comprising the ratios with many add-backs taken copied from high-yield bonds.

Our course covers springing financial covenants in leveraged loans and real estate deals and includes specific references and covenants analysis, terms and definitions in the LMA Senior Facilities Agreement for Leveraged transactions and LMA Real Estate precedents. The programme uses information from the Reorg Debt Explained database to review the current trends in the market in the larger syndicated (TLB-style) deals which so often include springing leverage covenants and high-yield-bond style breach of financial covenant packages.

The larger syndicated TLBs also vary in approach depending on whether they apply English law or NY law (for example, the latter do not usually permit over EBITDA ecures or require prepayment of loans from equity cure cash). Direct lenders, which typically use the LMA springing leverage covenant precedent as a starting point, also tend to adopt a more borrower-friendly approach to the terms in the loan-to-value covenant and the financial covenants for banks.

Financial covenants and loan-to-value covenants are arguably one of the most heavily negotiated aspects of Financial Covenants in Loan Agreements.

Too often; some parties fail to understand the key negotiating issues that really matter. For example, they view the breach of financial covenants in isolation rather than appreciating that they must be seen in the context of the particular capital structure. Secondly, too much time is spent on which covenants apply rather than focusing on the key constituents of the key terms in the springing financial covenants ratios. Finally, many parties fail to appreciate that, even in cov-lite deals, the financial covenants and/or the components of those covenants play an important role as they also affect a wide range of other critical matters in the loan. This usually includes the various “ permitted ” actions such as debt incurrence (security and guarantees), sponsor payments, cash sweeps, guarantor coverage and grower, scalable and/or builder baskets where these appear.

Our course provides a detailed look at commercial aspects of breach of financial covenants and looks under the bonnet at the critical issues that arise in practice. This advanced negotiation issues in financial covenants training - online version provides an in-depth look at the covenants as set out in the Loan Market Association precedent together with other covenants that might be used in practice. Reference is made to the Reorg Debt Explained loan to value convents database which tracks key terms in the larger syndicated TLB market.

Participants will gain an in-depth view of which covenants should be used together with a detailed covenants analysis of the constituents of the covenants, the sponsor-friendly add-backs, and other sponsor-friendly techniques used by borrowers to manipulate the covenants.

Our programme will appeal to practitioners involved in leverage, real estate and infrastructures, such as Lawyers, Private Equity professionals, Bankers in Lending (all departments), corporate financiers, M&A advisors, Debt Advisory and Restructuring. Accounting professionals looking to expand their knowledge of this topic will also benefit as many of the issues embrace legal /documentary considerations. The presenter adopts a pan-European approach to the topic but the presenter is able to discuss issues relevant in the USA in view of his exposure to those markets.

Our advanced negotiation issues in financial covenants training programme will derive full benefit from attendees who have a basic understanding of the main / headline elements of a Profit and Loss account (Sales, EBITDA, EBIT etc.) and a basic understanding of the differences between P&L /Accrual Accounting and Cash flow covenant accounting. It is emphasised that participants DO NOT require an understanding of IFRS or GAAP.

A short module summarising the key differences between P&L /Accrual Accounting and Cash Accounting is available on request prior to the programme by our covenant financial consultant.

The advanced negotiation issues in financial covenants training programme will review the draft ECB guidance on leveraged transactions published in November 2016. The course will examine which types of transactions are covered, which lenders are affected, the approach to EBITDA and the potential implications for players in the debt markets.

Case Study: Participants will be required to:- (a) calculate how to derive the key elements of the various covenants (b) identify some of the more problematic components in the covenants (c) calculate the various covenants and (d) explain the pros and cons of each of the covenants and why they may be appropriate for one deal but not another. The covenant headroom calculations are relatively simple and are designed to explain the basic principles and reinforce learning.