Southern Africa Syndicated Loans Documentation Training 31 July 2014, Johannesburg. Financial Covenants Edmund Boyo, Partner Clifford Chance

Transcription

1 Southern Africa Syndicated Loans Documentation Training 31 July 2014, Johannesburg Financial Covenants Edmund Boyo, Partner Clifford Chance

2 Introduction The LMA financial covenants: LMA leveraged facility agreement template was launched without financial covenants financial covenant section introduced in 2007 and Financial Covenant Provisions User s Guide issued in 2007 and most recently updated in 2012 the key features financial definitions financial undertakings (maintenance covenants) calculation, headroom and testing methodology

3 Overview of this session 1) Introduction to basic principles, definitions and testing 2) Financial covenants in a wider transaction context 3) Variation in financial covenants across sectors and industries 4) Current market trends and recent developments

4 Key concepts and definitions EBITDA: Earnings Before Interest Taxation Depreciation Amortisation Key definition for the purpose of leverage/interest cover/cashflow cover financial covenants Calculated on a rolling last twelve months basis

5 Key concepts and definitions Borrowings: Includes: all loans/bonds/debit balances of borrower group; finance leases; and counter-indemnities in respect of guarantees Excludes: intra-group debt and [deeply subordinated debt] Used as the basis of Debt / Net Debt in leverage covenant (and other covenants such as gearing) Flashpoint test calculated as at relevant testing date

6 Key concepts and definitions Cashflow: aim is to adjust EBITDA to include cash items and exclude non-cash items calculated by adjusting EBITDA for the following items (amongst others): changes in working capital position; exceptional/non-recurring items (positive or negative); pension costs; and capital expenditure costs different from cash flow statements included in a company s financial statements

7 Key concepts and definitions Finance Charges: aggregate of all interest, commission, fees and other charges in respect of Borrowings which are paid or payable in cash in the relevant LTM period used for the purpose of Interest Cover covenant Net Debt Service: aggregate of Finance Charges in the relevant LTM period together with repayments of Borrowings made in such LTM period used for the purpose of Cashflow Cover covenant

8 The financial covenants (1/4) Leverage (ratio of Net Debt to EBITDA) Net Debt: borrowings (net of cash/cash equivalents) hedging equity and quasi-equity EBITDA (Adjusted EBITDA): acquired/discontinued operations exceptional items unrealised gains/losses (hedge accounting) acquisition costs EBITDA attributable to non-group members

9 The financial covenants (2/4) Interest Cover (ratio of EBITDA to Finance Charges) EBITDA (as per Leverage calculation) Finance Charges: pension and similar liabilities? which interest? (e.g. cash pay/pik) which debt? (senior/subordinated) hedging adjustments net of interest receivable Usually requirement for Leverage ratio to decrease and Interest Cover ratio to increase over time until agreed flatline ratios have been reached and business is derisked

10 The financial covenants (3/4) Cashflow Cover (ratio of Cashflow to Net Debt Service) Cashflow: non Group companies JV investments/dividends capex/acquisition neutralisers acquisition costs Net Debt Service: Finance Charges scheduled repayments (what debt?) treatment of voluntary/mandatory prepayments Test of ability to meet debt service obligations. Covenant ratio is normally set at 1.00:1.00

11 The financial covenants (4/4) Capital Expenditure Capital Expenditure usually defined to exclude amounts spent on permitted acquisitions and reinvested insurance proceeds per annum limits (set by reference to base case model), subject to: exclusions based on type of funding source carry forward? carry back? increasing limit based on acquisitions?

12 Accounting methodology and frozen GAAP Requirement: for the same accounting practices and policies to be consistently applied; to notify Lenders of any change and corresponding adjustments to allow like with like comparison; and to amend facility agreements where there has been a material alteration to commercial terms. There may be negotiated positions as to dealing with anticipated changes to IFRS during term of agreement: Lease accounting? Joint venture accounting

13 Headroom in the numbers Headroom over agreed base case model: what is the % headroom and how is it calculated? % under anticipated ratio level in the model? % decrease against EBITDA in the model for the testing period? % under anticipated EBITDA in the model for each period after closing cash effect of cumulative underperformance? Adjust covenants levels if market flex is exercised? Flexibility in the definitions may also provide headroom

14 Testing (1/2) When first tested (covenant holiday after closing)? Information used for initial stub period after closing: (pre-closing information, pro forma adjustment, annualisation or not tested on LTM basis?) availability of accounts for initial period after closing? What accounts are delivered and used to test covenants (including at financial year end) Impact of F/X movements over testing period Days for delivery of accounts (30/45 monthlies, 45/60 quarterlies and 120/150 annuals) Testing may be delayed due to an equity cure

15 Testing 2/2 Example of testing/default timeline Profit Underperformance Breach Close Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Covenant Honeymoon [Mulligan] First Test Date Equity Cures Covenants tested again Equity Cures roll off?

16 Financial covenants in a wider transaction context Selected issues with financial covenant impact: disposals acquisitions the treatment of surplus cash/excess Cashflow Related areas cash sweep, margin ratchet, dividend and prepayment trigger levels

17 Disposals Extent of covenanted restrictions on disposals (ordinary course of business or trade permissions) Prepayment provisions with de minimis (per disposal and per annum) exclusions. Proceeds can typically be retained if reinvested in the business within [12/18] months Disposal proceeds are generally added to Cashflow (and deducted from Excess Cashflow) but any related prepayment may not be included in Net Debt Service Pro forma adjustment of financial covenants (in respect of disposals)?

18 Acquisitions Extent of covenanted restriction on acquisitions may depend on the source of funding for acquisitions Cost of acquisitions reduces Cashflow (unless acquisition is funded by surplus cash, new equity or [borrowings]) Consequently, the cash sweep is calculated after the cost of acquisitions Acquisitions increase Net Debt, so acquiring companies with negative EBITDA is generally restricted Acquisitions may be permitted subject to complying with look-forward or look-back financial covenant tests Financial covenants may be tested pro forma for acquisitions, including effect of projected synergies over next [12/18] months?

19 The treatment of surplus cash basket of surplus cash (i.e. cash not arising from trading activities within a given period) built up from: initial cash overfunding (if any) retained disposal and insurance proceeds cash retained after a cash sweep from a previous period What surplus cash can potentially be used for: acquisitions/capex (over and beyond limits) as a credit to Cashflow when used, subject to restrictions (overfunding available in first year only or cash retained after a cash sweep only in the next year) paying dividends in the case of cash retained after a cash sweep (subject to reinvestment obligations if disposal or insurance proceeds) paying other obligations

20 Prepayment of Excess Cashflow (the cash sweep ) Excess Cashflow is based on Cashflow after Net Debt Service Cash sweep will typically: exclude a previous period s surplus cash exclude new equity/subordinated debt exclude an amount required to pay for any carry forward capex or contractually committed capex by virtue of the definition of Cashflow be calculated less amounts spent on acquisitions, permitted JVs, etc. be after deduction of a de minimis or buffer amount require a % proportion (calculated using a leverage grid) of Excess Cashflow for the previous LTM period to be applied in prepayment

21 What is Net Debt in the leverage covenant? Net Debt means all borrowings net of cash (and so does not encourage deleveraging), but cash: would include surplus cash until such cash is used would include new equity/subordinated debt even if not used for prepayment of senior debt (unless expressly excluded) would include cash equivalents may not exclude trapped cash

22 Variation in financial covenants across sectors/industries Real estate financings: Interest Cover (LMA real estate finance template) ratio of net rental income to Finance Charges (may be tested on a projected or historic basis) Loan to Value (LMA real estate finance template) Pre-export financings/project financings: minimum Tangible Net Worth (LMA PXF template) share capital less goodwill, deferred tax, bad debts Loan Life Cover (LMA PXF template) ratio of [Sales Value] to debt service obligations over remaining term of the facilities

23 Variation in financial covenants across sectors/industries Financings for retailers: Rent adjusted leverage and/or interest cover: (using Consolidated EBITDAR and adding rental expenditure to Net Debt and/or Finance Charges) Asset-heavy corporates: minimum Tangible Net Worth: share capital less goodwill, deferred tax, bad debts gearing ratio: ratio of debt to net worth

24 Consequences of syndication Crossover credit borrowers may benefit from established relationships with their lenders in certain regions in terms of negotiating financial covenants and dealing with any breaches LBO borrowers may encounter different approaches to any subsequent covenant breaches from various types of lenders in widely syndicated deals (relationship banks, brokers, static CLOs, distressed debt investors): Looking for consent fees? Willing to consider forbearance? Pursuing loan to own strategies?

25 Current market trends and outlook Equity cure rights Cov-loose transactions Incurrence or maintenance financial covenants in high yield bond/super senior RCF deals

26 Equity cures Current status: no EBITDA cure (except in cov-lite deals?) stops multiplier effect Net Debt cure 50% prepayment may be required? Interest cover deemed reduction in borrowings for LTM period Right to over-cure generally not restricted Limitation on number of cures remains more restrictive?

27 Covenant-loose LBO financings No Cashflow Cover or Capex covenants Leverage and Interest Cover covenants tested quarterly Headroom of up to 30-35% Covenants may be set at a flatline level (rather than requiring deleveraging) Flexibility to incur incremental debt and/or make acquisitions subject to compliance with an incurrence covenant

28 Incurrence/maintenance covenants in high yield/rcf deals High yield bond indentures contain incurrence -type financial covenants only Where a borrower has a super senior RCF alongside the bond, what covenants should be included in the RCF? incurrence covenants which follow the bond? maintenance leverage covenant (in respect of drawn RCF only)? minimum EBITDA/cash balance covenants? deemed cure of covenant breaches?

29 Speaker contact details Edmund Boyo Partner