IN THE KNOW - Leveraged Finance Newsletter

Introduction

According to the Financial Times since March 1, 2020, more than 130

companies in Europe and the United States have drawn-down at

least $124.1 billion from their lenders. Many of our private company

clients have also been drawing on their revolving credit facilities

(“RCFs”), although the true scope of this activity will only become

known following March 31 corporate reporting. Given the forecasted

reduction in revenue and profits resulting from the government

enforced lockdowns, this is prudent liquidity management for

companies at all levels of balance sheet strength. For the most part,

issuers are drawing-down on their existing RCF capacity which is

generally linked to a fixed amount under the permitted “credit

facilities basket” in their bond indentures. However, issuers are also

looking to raise additional debt above their existing RCF

commitments as they assess their liquidity positions for the next

12-18 months. Bank and fund lenders are also looking for

opportunities to deploy capital while mainstream event-driven

financings are at low levels in line with the reduction in M&A activity

as a result of the uncertainty surrounding the economic impact of

the COVID-19 pandemic. Accordingly, in this March edition of “In the

Know” we look at some potential short- and medium-term levers

that issuers can pull to access additional liquidity under a “typical”

high yield senior secured notes indenture and consider what options

issuers have under their covenants to maximize (or preserve) that

debt capacity.

What are the key debt baskets?

Below is a summary of typical permitted debt baskets that could be

used to raise additional liquidity. While each of the following baskets

offer additional capacity for debt that ranks pari passu with existing

senior secured notes, we have focused our review on those aspects

of a typical high yield bond covenant package that permit the

issuance or borrowing of new debt that is structurally or effectively

senior to the existing notes:

1. Credit facility basket: first port of call for issuers is the credit

facility basket. In addition to the fixed dollar (or euro) amounts,

credit facility baskets in senior secured notes indentures typically

provide for a grower component that is the greater of the fixed

dollar/euro amount and a percentage of total assets, total tangible

assets or EBITDA. EBITDA growers in particular have become more

prevalent and generally provide for up to 100% of last twelve

months (“LTM”) EBITDA or last two quarters annualized (“L2QA”)

EBITDA. The test date for the grower percentages is generally set

off the availability of interim or annual financial statements.

However, sponsor deals in particular now have the flexibility to

elect, at the option of the issuer, the use of internal financial

statements or in some cases management accounts. Given the

anticipated declines in EBITDA over the tail end of Q1 2020, issuers

will want to access the additional liquidity under the grower

portion of this basket before the March 31 quarterly financial

statements become available. European senior secured notes

structures are often secured on a security package which is shared

(“Common Collateral”) with term loan/RCF and hedging creditors,

which is regulated by an intercreditor agreement (“ICA”).

By Haden Henderson, Geoff O'Dea, Priyanka Usmani and Samantha Greer March 2020

IN THE KNOW

Leveraged Finance Newsletter

   HOW CAN ISSUERS MAXIMIZE (OR PRESERVE)

LIQUIDITY IN THE SHADOW OF COVID-19

In the Know | March 2020

Eric Platt, Laura Noonan, James Fontanella-Khan, Joe Rennison and Miles Kruppa. "Dash for cash: companies draw $124bn from credit lines." Financial Times. March 25, 2020.

Under these structures, working capital facilities like RCFs will

commonly rank ahead of the senior secured notes in right of

payment from the proceeds of security enforcement. This is an

attractive option for prospective working capital investors who

want to sit in a more senior part of the capital structure and also

provides a relatively quick execution option for the issuer as,

depending on the jurisdictions involved, the new creditor can

accede to the ICA to get the benefit of this super senior security

without the need to enter into new security documents (or only a

simple security confirmation agreement).

2. General debt basket/local credit facilities basket: this basket is

usually a fixed amount (though it may also include a grower

feature), but it is generally not able to be secured on a super senior

basis on the Common Collateral via the ICA. Rather, it may be

incurred by non-guarantor restricted subsidiaries (“NGRS”) and,

because notes are often issued by holding companies and

guaranteed by a limited group of restricted subsidiaries, this debt

will generally be incurred by operating/asset owning subsidiaries

and thus structurally senior to the holding company issuer (or the

guarantor restricted group).

In order for the general basket debt to be secured, the debt basket

must be read together with the ‘permitted lien’ and the ‘permitted

collateral lien’ definitions in the indenture. The former is the

provision which permits securing certain debt baskets on assets

which do not form part of the Common Collateral and the later will

determine whether it may be secured on the assets that are

subject to the Common Collateral. In particular, there are often

restrictions on the amount of debt that can be incurred by NGRS,

either as an aggregate amount across all debt baskets or under a

specified list of permitted debt baskets. A key consideration in

utilizing NGRS debt incurrence structures is the availability of

enough unencumbered EBITDA/revenue-generating assets (or

shares in subsidiaries of companies that do) at the NGRS level to

provide credit support to such additional borrowings. While this

requires a case-by-case analysis of the issuer’s capital structure, we

have generally observed a gradual decline in guarantor coverage

(expressed as a percentage of group assets, revenue and EBITDA)

over time, and security packages are now commonly limited to

exclude tangible asset security (i.e. only comprising share pledges,

intercompany receivables and bank accounts) which would suggest

that a number of credits will be able to utilize this strategy. We

would expect this type of financing structure to be more time

consuming and expensive for issuers as additional lender due

diligence may be required on the new obligor group (which may be

domiciled in different jurisdictions from the original credit group

thus making diligence more complicated due to the inability to

complete site visits or in-person management sessions in the

current COVID-19 lockdown environment) and the new debt will

not be able to slot into the existing ICA arrangements and will

require new security documentation. A new lender may also require

an intra-group reorganization to generate a single point of

enforcement over the new obligor group, which will usually require

more cost and time (and tax analysis). Care will also need to be

taken to ensure that the incurrence of such structurally senior debt

is not prohibited by one of the most unread covenants in

indentures – the restriction on distributions from restricted

subsidiaries (or “dividend blocker”) covenant or other existing

financings. We would expect a well-drafted indenture to provide

for the ability to utilize the general basket and local credit facilities

baskets for this purpose, but that analysis should be completed

with the issuer’s legal advisors. We also note that sponsors and

issuers have added a number of permitted baskets which

effectively operate like general baskets (e.g. additional working

capital baskets) that can be utilized on the same basis as the

general basket or local credit facilities basket outlined above and

may similarly be tapped by NGRS.

3. Ratio debt: the ratio debt test is not subject to a dollar or euro cap

but permits an unlimited amount of debt to be incurred subject to

pro forma compliance with a specified ratio(s). For senior secured

notes this usually takes the form of a fixed charge coverage ratio

(“FCCR”) test and an additional consolidated senior secured

leverage ratio (“CSLR”) test for the incurrence of secured debt.

Senior secured debt incurred under the CSLR ratio is generally

supported by a “permitted collateral lien” enabling the holders of

such secured debt to accede to the ICA and providing for such debt

to rank pari passu with the existing senior secured notes. However,

as with the general basket and local credit facilities baskets

discussion above, all or a portion of such ratio debt may be

incurred (and consequently secured) by NGRS and may, therefore,

be structurally senior to the existing senior secured notes and RCF.

A review of the particular indenture is critical but issuers could also

combine ratio debt capacity with certain permitted lien capacity

(predominately in the form of the general permitted lien basket) to

In the Know | March 2020

provide effective super senior security in the form of assets that

do not currently secure the existing senior secured notes and RCF.

Again, timing is critical for issuers that wish to utilize the ratio test

as the test date for the EBITDA numerator (in the case of the FCCR

ratio) and denominator (in the case of the CSLR) are typically set

off the availability of the most recent financial statements. Issuers

will want to access this liquidity before any deterioration of EBITDA

is reflected in their next quarterly accounts. Ratio debt can also be

used to refresh permitted debt basket capacity or preserve current

ratio debt capacity by the use of “designated commitments” or

“elected amounts” provisions (see below under “How to maximize

(or preserve) debt capacity: Adjusted EBITDA calculations,

reclassification and “designated commitments” or “elected

amounts” provisions”). The ratio test allows for quick execution

with respect to secured indebtedness ranking pari passu with the

existing senior secured notes, but similar time and cost

considerations discussed above with respect to the general and

local credit facilities baskets apply to the utilization of the ratio

debt test by NGRS or the securing of ratio debt over non-collateral

by using permitted lien capacity.

4. Available RP capacity amount: while this technology is not

prevalent throughout the market, top-tier sponsor deals have

increasingly been providing for the ability to convert restricted

payment (“RP”) capacity into debt capacity, commonly referred to

as an “Available RP Capacity Amount” debt basket. The original

thinking behind the inclusion of this basket was that sponsors and

issuers were already permitted to carry out a transaction with the

same end result by (1) making a dividend to an entity outside of

the restricted group using RP capacity, (2) contributing such

amounts back into the restricted group as a shareholder loan or

equity funding, and (3) using their contribution debt baskets to

incur third party indebtedness on 100% (or in some cases 200%) of

such contributed amounts. Importantly, while contribution debt

baskets are commonly included in high yield bond indentures, the

issuer requires cash on balance sheet to make the original dividend.

Accordingly, where included, the Available RP Capacity Amount

debt basket provides sponsors with additional flexibility as they

can complete the RP/debt conversion to increase debt capacity

without having cash on hand. The baskets that build the Available

RP Capacity Amount vary from deal to deal but it is common to

include restricted payment capacity under the “CNI builder basket”.

The CNI builder basket typically provides the issuer with the ability

to make RPs in an aggregate amount equal to 50% of consolidated

net income of the issuer from the issue date (provided that if the

issuer has posted a loss during this period, then 100% of the loss is

deducted in calculating the builder basket). While certain top-tier

sponsor deals have removed the requirement to deduct 100% of

losses, if CNI builder basket capacity is expected to decline upon

availability of Q1 2020 accounts, then issuers should consider

whether they would benefit from converting this RP capacity into

debt incurrence capacity prior to these accounts becoming

available. Finally, issuers will need to consider what security can be

provided to secure debt incurred under the Available RP Capacity

Amount debt basket and whether such debt may be incurred by

NGRS, as this may allow the Available RP Capacity Amount to be

incurred as structurally senior debt.

5. Receivables financing baskets: most high yield bonds provide for

the ability to complete a “Qualified Receivables Financing”. These

structures are generally required to be incurred at a receivables

subsidiary (akin to an unrestricted subsidiary) and can take

considerable time and analysis to implement. However, high yield

bonds increasingly include more flexibility with respect to recourse

receivables and factoring transactions under specified dollar or

euro baskets which may provide sponsors with an additional

structurally senior liquidity source provided that the receivables in

question remain a viable investment for factoring and receivables

financing platforms in the current COVID-19 environment.

In the Know | March 2020

How to maximize (or preserve)

debt capacity: Adjusted EBITDA

calculations, reclassification and

“designated commitments” or

“elected amounts” provisions

As noted above, timing is a key

consideration in maximising debt capacity as

issuers look to draw down on additional

liquidity before ratios and grower baskets

start to be impacted by a decline in revenues

due to COVID-19, but there are some

additional options that issuers can pursue to

maximise the debt capacity under the above

baskets.

Sponsors and issuers are reviewing their

financial definitions to ensure that they are

not missing any add-backs to consolidated

net income or EBITDA to maximise their debt

capacity, including considering whether some

of the general “one-time” events which

permit add-backs could be used to increase

EBITDA and other metrics for COVID-19

related losses. While we are seeing issuers

focus on extraordinary events and business

interruption insurance proceeds add-backs,

our insurance industry experts generally

expect that business interruption insurance

will not cover losses sustained as a result of

the current COVID-19 government-instigated

shut down given that most business

interruption insurance policies require

property damage for coverage to apply.

Another tried and true method to maximise

permitted basket capacity is to reclassify

previously incurred basket debt under the

ratio test to free up additional capacity

under permitted debt baskets discussed

above. Issuers should review their

reclassification provisions with their legal

advisors, as it is common to prohibit the

reclassification of debt incurred under the

credit facility basket but this may only apply

to issue date drawings.

A more novel method to provide additional

flexibility has been provided in the form of

“designated commitments” or “elected

amounts” provisions. These provisions

typically provide the issuer with the ability

to select when it utilizes its ratio or basket

capacity (and related liens) even though the

debt has not been drawn down under the

applicable facility. Once it has been

designated, such amount is counted under

subsequent ratio tests but it effectively

becomes a fixed dollar or eurao amount

under the ratio which is available for drawing

without need for a subsequent ratio test.

This could be beneficial for issuers looking to

preserve current ratio capacity in anticipation

of an expected worsening in incurrence ratio

levels upon availability of Q1 2020 accounts.

Again, issuers should review these provisions

with their legal advisors to confirm what

conditions are applicable to the utilization of

this provision, including in particular whether

they are required to obtain formal

commitments from third party financers and/

or whether these provisions are limited to

RCFs or can also be utilized for term loans.

Even though I can, should I prime

my existing lenders?

Issuers should discuss with their advisors

whether it makes sense for them to incur

additional priority debt ahead of existing

debt held by their existing lender group.

While this will depend on the state of the

business and urgency for funding, sponsors

and issuers would be prudent to first discuss

their liquidity needs with their existing

lenders and relationship banks to see if

additional liquidity can be provided by the

existing syndicate. In particular, issuers

should consider asking their existing lender

group whether they are willing to increase

existing facilities on a pari passu basis via an

amend and extend with some pricing

sweetener or de-risking for the banks in the

form of some junior or equity financing. We

are generally seeing banks take a

constructive approach to their clients’

liquidity needs in the current environment

and governments (and, in the UK, the Bank

of England) have indicated that they expect

banks to act appropriately.

Home team assist: sponsor/

sponsor affiliates providing

additional liquidity

The above summary focuses on obtaining

third party external financing but sponsors

will be considering whether to inject further

funding into their portfolio companies. This

could be for a covenant cure under their

existing credit facilities (with the proceeds

being contributed as equity or subordinated

shareholder funding under the senior secured

notes covenants). But sponsors and their

affiliates could also provide new senior

secured or super senior funding directly to

their portfolio companies using the debt

baskets outlined above. Care should be taken

when providing such funding in reviewing

any restrictions or conditions under the

affiliate transactions covenant in the

indenture, and such transactions may require

consent under existing credit facilities.

The direct funding approach is advantageous

from the sponsor’s perspective as it allows

the sponsor to hedge its equity exposure by

lending directly to the portfolio company

and, while lenders would prefer an equity

injection by the sponsor, they would

generally be more supportive of any new

money that sits pari passu alongside their

facilities rather than at a super senior or

structurally senior level. Sponsors could use

this flexibility when negotiating credit

extensions with their existing lender group,

but when providing any senior or super

senior lending to their portfolio companies

they should be cognisant of

disenfranchisement (as the sponsor/sponsor

affiliate will typically not be able to vote

under the ICA or the existing facility if

provided as an additional facility) and the

possibility of equitable subordination issues

depending on the jurisdictions involved.

Equitable subordination is a bankruptcy law

principle that subordinates claims, including

secured claims, of shareholders/connected

parties to those of non-shareholders/

connected parties. The consequences of

equitable subordination can therefore be

severe. However, equitable subordination is

In the Know | March 2020

jurisdictionally specific and the rules and

consequences vary according to the

jurisdiction. Finally, in the event that direct

funding is not available due to restrictions

under the financing documentation, sponsors

could use their contribution debt baskets to

make an equity or shareholder funding

contribution to the issuer and raise external

financing on 100% (or in some cases 200%) of

the amount of such shareholder funding.

While this provision was historically only

available to the issuer and the guarantors

(and not NGRS) the market has moved to a

position whereby contribution debt can be

incurred by NGRS or secured on collateral as a

permitted collateral lien (with or without

CSLR test compliance).

Other options to find liquidity and

manage your capital structure?

The above summary is not exhaustive and

focuses on short- to medium- term liquidity

solutions available to issuers under a

“typical” debt covenant. Other options for

issuers may include: (1) the sale of non-core

assets to generate cash, (2) the use of asset

drop down financing structures (where the

issuer places certain unencumbered assets

into an unrestricted subsidiary using

investment capacity under the RP covenant

and raises new money debt at such

unrestricted subsidiary), (3) extending

interest periods under their bank debt and/or

seeking waivers or forbearance on upcoming

iinterest payments, (4) if their debt is trading

at a significant discount, completing debt

repurchases to reduce financing costs, (5)

receivables discounts, and (6) if appropriate,

derivatives-based strategies. The above

summary also does not consider more holistic

funding solutions that may be required for

certain issuers in the form of holdco or junior

financings to address near-term maturities

(or to refinance a portion of their RCFs) in

order to facilitate a “market” financing to

obtain additional revolving or delayed draw

debt capacity.

Issuers should also continue to follow

government announcements with respect to

government loan schemes and consider

whether they are eligible to participate in

these schemes. Focusing on the UK, as at

date of this newsletter, it seems that the UK

government’s COVID Corporate Financing

Facility and Coronavirus Business Interruption

Loan Scheme will not be available to typical

high yield issuers. However, this is a rapidly

developing situation which Baker McKenzie is

monitoring and further up-to-date analyses

and resources relating to COVID-19 can be

found at our Coronavirus Resource Centre ,

including regularly updated materials on key

government intervention measures being put

in place in the UK and across Europe here.

A final word about consents

While we have focused on senior secured

notes indentures, sponsors and issuers should

review their existing shareholders’

agreements, RCFs, ICAs and other facilities to

confirm whether there are any prohibitions

under those documents that might restrict

the additional financings noted above,

particularly where the issuer is looking to

incur more super senior debt. There may also

be issuers that are in a position to obtain

additional super senior debt from either their

existing banking syndicate or new potential

lenders but are (notwithstanding the above

optionality) currently constrained from doing

so under their indenture(s). We would expect

that, under a typical indenture, issuers

should be able to upsize their super senior

RCF basket (and related lien) with 50.1%

consent of noteholders, but care should be

taken when reviewing the amendment

provisions of the indenture as holders may

seek to challenge such an amendment if

there is a 90% (or 100%) consent threshold to

amend or modify provisions of the indenture

that affect the ranking of the notes.

Conclusion

Sponsors and issuers should, in consultation

with their advisors, consider the various

options available to them under their

indenture covenants and other financing

documentation and the related issues

canvassed in this update when discussing

additional funding options with their

existing bank syndicate and potential

lenders. Careful consideration of their

covenant packages is required to ensure that

sponsors and issuers apprise themselves of

all the flexibility available to them to get

through any anticipated liquidity crunch.

Geoff O'Dea

Partner | London

Geoff.ODea@bakermckenzie.com

TRANSACTIONAL

POWERHOUSE

Samantha Greer

Associate | London

Samantha.Greer@bakermckenzie.com

Priyanka Usmani

Senior Associate | London

Priyanka.Usmani@bakermckenzie.com

     

,   

Haden Henderson

Partner | London

Haden.Henderson@bakermckenzie.com