October 11, 2024 - On October 10th, the LSTA and the American College of Commercial Financial Lawyers co-sponsored a webinar hosted by the National Association of Women Lawyers. The webinar, Financial Definitions 101: The Borrower and Lender Perspectives on Financial Definitions and Calculations, was presented by Michelle Kilkenney of Kirkland & Ellis and Heather Waters Borthwick and moderated by Kira Mineroff both of DLA Piper.
The panelists first discussed why financial covenants are included in credit agreements. Maintenance covenants, incurrence based covenants and reporting requirements all give lenders a general proxy for the value of a borrower and what they may realize in a downside sale. They allow the lenders to monitor the strength and financial health of a business and evaluate a borrower’s ability to repay its debt. Should things deteriorate, they should also provide early warnings of any potential payment defaults and also give lenders a seat at the table to participate in discussions before any restructuring. This is achieved by setting covenant levels that are determined by reference to a bank model based on a borrower’s past performance and projections. Importantly, a failure by a borrower to abide by financial covenants will typically result in an event of default, lenders accelerating loans, and lenders refusing to fund a revolver.
Leverage ratios were then dissected. The ratio of indebtedness (balance as of a specific date) to adjusted EBITDA (typically trailing four quarters) regulates how much debt a borrower and its subsidiaries can incur relative to EBITDA. It provides another layer of protection for lenders beyond exceptions to negative covenants. Historically the private corporate credit market has offered more flexibility with respect to leverage than the BSL market. The average adjusted leverage for syndicated LBO loans was 5x for first lien/5.2x total in Q3. Notably, only 7% of M&A driven BSL deals in Q3 were leveraged at 6x or higher, and, on the flipside, 29% of M&A driven BSL deals in Q3 were levered at 4x or lower.
Borrowers want leverage ratios to be limited to indebtedness for borrowed money but typically will include other forms of debt, for example, capital leases, purchase money indebtedness and drawn letters of credit. Of course, lenders will take a different perspective and will want to include all indebtedness for any amount that might be payable to the borrower and its subsidiaries. They will typically hold a different view on whether contingent obligations should be included. On the topic of cash netting, lenders may set caps or minimum levels and may only permit cash to be netted if it is deposited in accounts subject to “deposit account control agreements” in favor of the agent, or if it is domestic cash or is cash maintained by the borrower or a guarantor.
The definition of EBITDA and its impact on financial covenants was then examined. EBITDA starts with consolidated net income and certain adjustments are then made. The negotiation between lenders and borrowers will focus on the “addbacks” to reach “Adjusted EBTIDA” which is the cash flow generated by the borrower and its subsidiaries in the ordinary course of business. Lenders will seek to to base financial covenant calculations on actual “clean” EBITDA or realized cost savings and true extraordinary non recurring expenses. There are many different types of addbacks (see slide 18).
They then moved on to discuss the fixed charge coverage ratio which measures a borrower’s ability to pay regular recurring fixed charges in cash on a periodic basis. Borrowers and lenders negotiate what qualifies as fixed charges and as a deduction to EBITDA for determining cashflow.
Although rarely seen now in the BSL market, the financial maintenance covenant was reviewed. Generally, it is tested quarterly, although sometimes lenders may push for monthly testing. The webinar concluded with a discussion of the other uses of financial ratios. Click here for the slides and the link to the NAWL replay will be provided soon.
