While the proliferation of cov-lite loans has garnered significant press, the detailed structure of loan agreements even when a covenant is present is critical to the embedded risk in a given loan.
Imagine you decided to build a waterfront home. One of the first and most important things you will do is hire an architect to draft a detailed blueprint for the engineers and contractors to follow. This blueprint will include everything from your foundation to the electrical layout of the house, which impacts the way you will use your home post-construction. Further, the blueprint will give you peace of mind, ensuring there are clear guidelines on how the home will be developed and that the contractors don’t have free reign.
Think of a credit agreement as a blueprint for leveraged loans. Credit agreements state how a company (the borrower) can act and dictates the term-loan investors’ rights. To protect your investors and advise them well, you must be well-versed in the anatomy of credit agreements and critically examine the elements of their construction. Here’s what you should hold top-of-mind when considering a loan’s structure.
Financial Covenants
In leveraged finance, there are two main credit agreements: cov-lite and non-cov lite, and each is defined by whether or not it is governed by financial promises called covenants. Cov-lite means that the term loan in question does not have a financial covenant and leaves the investor with less decision-making authority when the company faces financial hardships. Non-cov-lite means that the term loan has financial covenants, which give the investors more control over the investment when a company’s financial performance deteriorates.
Common financial covenants include:
Leverage Covenant = Company’s total debt less cash on hand divided by Earnings Before Interest, Tax, Depreciation, and Amortization (“EBITDA”). For example: “a company’s total debt cannot be more than 6x its EBITDA”
Interest Coverage = Company’s EBITDA divided by their interest expense. For example: “A company’s interest coverage cannot be less than 2x its EBITDA”
Defining EBITDA is Critical
The power of each financial covenant hinges on the definition of EBITDA in the agreement. EBITDA is a term that is as frequently used in a credit agreement as latte is used in a Starbucks. Not every latte is the same, just like the definition of EBITDA it is different in each credit agreement. It is crucial that EBITDA is clearly defined in a credit agreement and that a company does not have free rein in creating EBITDA add-backs, which are usually classified as non-recurring one-time expenses, restructuring expenses, management fees, etc. A credit agreement should cap each individual add-back at a dollar amount or a percentage of EBITDA, in addition to capping the total amount of add-back as a percentage of EBITDA. (For example, “total add-backs cannot exceed 25% of EBITDA.”) It’s a misstep to assume general conditions for EBITDA. The definition of EBITDA can make or break your financial covenants, as EBITDA can be easily inflated with egregious add-backs.
The Value of Negative Covenants
n addition to financial covenants, it is also important to look for tight negative covenants. Unlike a financial covenant, which binds the investor, think of a negative covenant as a restrictive measure on what a company can and cannot do. Negative covenants play an extremely important role, as they govern the amount of additional debt a business can incur, subsidiaries they can sell, IP they can transfer, payments they can make, etc. For example, someone that invests in a first lien term loan needs to ensure that another party cannot file a superior lien on the same assets. A credit agreement should cap incremental debt and/or carve-out a dollar amount for said debt and subject it to an acceptable leverage ratio.
Freedom for Unrestricted Subsidiaries
In regards to a company’s freedoms, it is also important to ensure that the credit agreement captures a company’s ability to form and transfer assets to unrestricted subsidiaries. Unrestricted subsidiaries are not included in the credit facility and are not subject to covenants or any other terms of the credit agreement. J.Crew is a great example of a company that found and capitalized on a loophole in its credit agreement. In 2017, J.Crew had notes that were due and needed to raise additional debt. So through multiple inter-company “investments,” the company transferred ~72% interest in its trademarks (worth ~$250MM) to an unrestricted subsidiary. This subsidiary now held the collateral, which was meant for the first lien term loan investors and used it to raise additional debt on the newly created subsidiary.
Summing Up
Like a well-built home, a loan is only as good as its foundational framework. Identifying properly structured loans with reasonable financial and negative covenants, a clear definition of EBITDA, and breathing room for unrestricted subsidiaries, is critical in choosing high quality, low-risk investments. The best way to maximize the use of higher quality loan structures is through employing a capacity-constrained strategy. In today’s market, smart credit investors need to position their funds to pass on the increasing number of poorly structured loans.
At Flat Rock, we focus on traditional covenanted middle market investment opportunities, which include negotiated credit agreements that offer our investors critical protections. As we continue to screen new opportunities, we look out for the aforementioned touch points in our credit agreement analysis and negotiation.
For further information feel free to email info@flatrockglobal.com