Presenting a live 90-minute webinar with interactive Q&A Structuring Covenants in Leveraged Loans and High Yield Bonds for Borrowers and Lenders Analyzing Financial and Performance Covenants, Equity Cures, Builder Baskets, Events of Default and More THURSDAY, APRIL 3, 2014 1pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Maura E. O'Sullivan, Partner, Shearman & Sterling, New York Benjamin M. Cheng, Counsel, Shearman & Sterling, New York The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.
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Structuring Covenants in Leveraged Loans and High Yield Bonds for Borrowers and Lenders Strafford Webinar Program April 3, 2014 Maura O Sullivan Partner New York mosullivan@shearman.com Benjamin Cheng Counsel New York bcheng@shearman.com 5
Table of Contents Loans vs. Bonds 7 Financial Maintenance Covenants 8 Financial Maintenance Covenants (continued) 9 Benefits for Lenders of Financial Maintenance Covenants 10 Borrower s Response to Financial Maintenance Covenants 11 Borrower s Response to Financial Maintenance Covenants (cont d) 12 Covenant-lite Loans: Why now 13 Debt Incurrence 14 Acquisitions 15 Repayment of Junior Debt 16 Builder Baskets 17 Restricted Subsidiaries 18 Restricted Subsidiaries (cont d) 19 Events of Default 20 Opportunities and Risks 21 NYDOCS02/1023813 6
Loans Vs. Bonds Historically, syndicated bank loans had tighter covenants than high yield bonds One of the main differences was the inclusion of financial maintenance covenants in syndicated loan agreements Maximum leverage ratio Minimum interest coverage ratio Minimum fixed charge coverage ratio Other significant differences: Bonds have incurrence style negative covenants while loans historically have had fixed dollar baskets as exceptions to the negative covenants Floating vs. Fixed interest rates 5/6 year maturity for term loans vs. 8/10 year maturity for bonds 7
Financial Maintenance Covenants Require borrower to meet certain financial performance levels on a periodic basis Performance levels generally tied to model provided to lenders prior to commitment Covenants can be applied on a quarterly basis or at any time basis Failure to comply results in an event of default (typically no grace period) Maintenance Covenants are applicable whether or not a borrower intends to engage in a transaction that may be limited by the negative covenants Maximum leverage ratio the borrower cannot exceed a specific ratio of debt to a cash flow measure (typically EBITDA) Total debt Secured debt First lien debt 8
Financial Maintenance Covenants (continued) Minimum Interest Coverage Ratio the borrower must have at least a specified ratio of cash flow (EBITDA) to interest expense Total interest Cash interest Minimum Fixed Charge Coverage Ratio the borrower must have at least a specified ratio of cash flow (EBITDA) to fixed charges Interest expense Capital expenditures Scheduled amortization payments Rent expenses Dividends 9
Benefits for Lenders of Financial Maintenance Covenants: Maintenance covenants provide early warnings of financial difficulty Payment default Bankruptcy default Early warnings allow lenders to be pro-active in devising solutions Early seat at negotiating table with borrower Maintenance Covenants can deter borrower from pursuing transactions that have negative impact on cash flow 10
Borrower s Response to Financial Maintenance Covenants Equity cures Cash injection within 10 business days after delivery of financials Standstill 5 for life of loan and 2 for every 4 quarters Not any larger amount than is necessary for the cure Disregarded for other purposes Cash injection increases the cash flow companent of the ratio and may also be negotiated to decrease the debt companent Net leverage tests Maximum cash Unrestricted cash Cash of foreign entities 11
Borrower s Response to Financial Maintenance Covenants (cont d) Springing Covenants Triggered if outstandings under revolver exceed a certain percentage of commitments Letters of credit often exclude in calculation Cushion to base case model Covenants-lite term loans 12
Covenant-lite Loans: Why now Key factors that today are affecting market dynamics: Interest rates are low so more debt investors are looking to the leveraged market for higher yields Belief that interest rates will increase so floating rate debt (loans) is preferable to fixed rate debt (bonds) Leveraged acquisition activity has not increased enough to keep up with demand As a result, certain borrowers have more negotiating leverage to obtain more favorable terms Private equity sponsors Higher rated leveraged borrowers 13
Debt Incurrence Fixed dollar baskets Ratio basket Cash interest coverage ratio, fixed charge coverage ratio, leverage ratio if, on the date of such incurrence and after giving effect thereto on a pro forma basis (including giving pro forma effect to the use of the proceeds thereof) no Default or Event of Default has occurred or is continuing, the Issuer and the Restricted Subsidiaries may incur Indebtedness if the Issuer s Consolidated Fixed Charge Coverage Ratio for the most recent four full fiscal quarters for which financial statements are available immediately preceding the incurrence of such Indebtedness taken as one period is at least equal to or greater than 2.00 to 1.00 Grower components so that baskets can grow as business expands The greater of $ and % of total assets Ability to secure new issuance of debt with collateral on either pari passu basis or junior basis Test if typically a maximum total secured leverage ratio, or a first lien leverage ratio 14
Acquisitions Traditional loans would limit acquisitions to a fixed amount per year or over the life of the loan (sometimes with a per acquisition limit) Covenant lite loans allow unlimited acquisitions subject to pro forma compliance with an incurrence test (leverage ratio or interest coverage) If the covenant lite term loan is paired with a revolver then the test might be pro forma compliance with the financial covenant for the revolver regardless of whether it is then applicable Generally will include a limit on acquisitions of non-credit parties 15
Repayment of Junior Debt Junior Debt can be junior lien debt, unsecured or subordinated debt Traditional loans would have a small fixed dollar basket with which the borrower could prepay the junior debt Junior debt is typically more expensive than first lien senior secured debt and therefor it is beneficial for borrower to pay down the junior debt However, this would mean that the senior lenders would have lost the cushion of junior debt in a work-out scenario (through the depletion of the borrower s cash) Covenant-lite loans may allow the borrower to prepay junior debt subject to compliance with an incurrence test (typically a leverage ratio) 16
Builder Baskets In covenant-lite loans, for acquisitions, investments and repayments of junior debt, one would normally see builder baskets Starter basket (fixed dollar) + retained excess cash flow or 50% consolidated net income Plus: Equity injections or issuances Returns on investments Asset sales proceeds Leverage test for use of builder basket for dividends 17
Restricted Subsidiaries Traditional loans would typically cover all subsidiaries of the Borrower in the representations, covenants and events of defaults Covenant-lite loans typically permit the concept of unrestricted subsidiaries and therefore only restricted subsidiaries of the Borrower are subject to the representations, covenants and events of defaults Restricted Subsidiaries vs. guarantor subsidiaries Traditional loans would have restrictions on money/assets flowing from creditor group to non-creditor group Bonds typically have restrictions on money/assets flowing from restricted group to unrestricted group 18
Restricted Subsidiaries (cont d) Bonds do not typically have restrictions on money/assets from credit group to non-creditor group Covenant lite loans typically continue to have restrictions on money/assets flowing to non-credit group 19
Events of Default Default in interest payment Covenant default Default in other material debt Bonds Senior Bank Loans 30 days grace period 3-5 business days grace period 60 days grace period other than mergers, asset sales and failure to repurchase upon a change of control Cross acceleration None for negative covenants and certain affirmative covenants; 30 days for others Cross default 20
Opportunities and Risks Opportunities for sponsors/issuers: better financial terms Opportunities for investors: risk arbitrage Risks: Investors beware Systemic risk and regulatory tightening 21