When companies begin to announce their second-quarter 2020 earnings, the full effect of the Covid-19 crisis will become clearer. In advance of those announcements, it’s reasonable to expect U.S. companies of all sizes, in nearly every industry sector, to experience reductions in revenues and earnings. These reductions will make analyst and investor conversations more challenging. The uncertainty about where things are headed will make forecasts murky (at best). And both sets of challenges may also strain organizations’ ability to meet their loan covenants.
Two weeks ago, Treasury & Risk sat down with Reuben Daniels, founder and CEO of loan arranger EA Markets, to discuss the tsunami of requests for waivers and amendments to loan contracts that he anticipates within the next 90 days. He explained the risk that borrowers and lenders will become overwhelmed, as more businesses than ever before need modifications all at once. If his vision comes to pass, borrowers wanting a waiver or amendment will need to very carefully prepare their proposals to their lenders.
Today, we delve into how borrowers can determine which types of modifications they should ask for and what concessions they should offer their lenders to increase a proposal’s chances of success.
Meg Waters: Last time, we talked about how companies have made decisions in the past two months around whether to draw down their credit revolvers. You think the next debt-related decision a lot of these businesses will face is whether to ask their lender to modify their loans, right?
Reuben Daniels: Right. In April, after companies drew down their bank facilities, they had a sudden realization that if their numbers end up being a lot worse than current forecasts, they’re going to need to get loan modifications. These amendments and waivers haven’t hit yet because companies had January and February in the bag already; for many organizations—certainly, most larger companies—the numbers haven’t yet been impacted.
But it’s clear that many businesses are facing a very difficult quarter, and many have loan requirements or covenant tests to address within the next 90 days. This means they are going to be facing challenges with their bank loans, so they are going to be looking to modify their loans—whether as a waiver or an amendment or an amend-and-extend.
MW: Tell me about the different forms of loan modifications that companies will be considering.
RD: Generally speaking, waivers tend to be simple, short-term modifications, such as ‘For the next two quarters, we will raise the leverage covenant by half a turn.’ Depending on the documentation and the term that you’re changing, you might need to get a certain percentage of the banks in your lender group to agree to a waiver, or you might need to get all the banks to agree.
I think we will see a lot of waivers in the next quarter, but we will also see amendments and amend-and-extends. Amendments are longer-term and more comprehensive changes to the facility than waivers—increasing this, decreasing that, moving pricing, changing the allocation. An amendment typically starts with the loan documents and makes a whole series of changes to the debt. And then, an amend-and-extend is like an amendment, but it changes a term that requires 100 percent participation among the lender group, such as pricing or an extension in maturity.
MW: You mentioned last time that some companies might be requesting deferral of principal and interest, or relief on the leverage-test covenant. What other loan modifications do you expect U.S. businesses to be asking for in the coming months?
RD: Another example might be a waiver of a reporting or audit covenant. The lenders might agree to waive the covenant for the next six months or year, as long as the borrower stays in compliance with other tests.
I also expect to see definitional changes in loan agreements, and I think those are going to be far more interesting and impactful. There are a number of areas where companies have already been pushing hard on definitions in their bank revolvers. Some have gained flexibility around excluding restructuring charges or acquisition charges in their financial measures, or adding a full year of earnings for an acquisition that closes near the end of the year. Such definitional changes can increase EBITDA [earnings before interest, tax, depreciation, and amortization] and reduce the company’s measured leverage level substantially.
Significant adjustments to EBITDA have become far more common over the past several years, and even as I expect companies to be asking for these types of changes to survive the Covid-19 crisis, I also expect banks to start pushing back on it in the long term. There’s a joke circulating among lenders right now that borrowers are looking for EBITDAC—EBITDA with Covid expenses added back. Borrowers would certainly prefer to be judged using an EBITDAC ratio, but the lack of forward-looking visibility on Covid-related expenses will prevent all but the very narrowest of definitional changes from passing muster with lenders.
Nevertheless, I think we will see some definitional changes in the immediate term. A recently announced loan modification for Live Nation Entertainment allows the company to substitute certain 2019, pre-Covid EBITDA periods to replace its 2020, post-Covid EBITDA periods, for purposes of covenant calculations—effectively erasing the existence of the current crisis in terms of the loan covenants. Why would banks agree to such a borrower-friendly loan modification? Perhaps they agreed because using the actual EBITDA could have worse consequences for the lenders than just handing the company a pass.
MW: Are there any other types of modifications that you expect companies to request?
RD: Some borrowers will take a more nuanced approach to modifications, with the understanding that their banks will expect concessions in exchange for providing relief. A company can take a linear approach, saying to its bank, basically, ‘I’m at risk of breaking my leverage covenant. I need you to give me a waiver on my leverage covenant so that I won’t break it.’ That approach doesn’t give the bank a lot of flexibility, and it doesn’t give the bank’s credit committee much incentive to agree to the requested changes.
A more nuanced path toward the same goal would include some concessions that the company could offer that would provide the lender protection on their loan. The lender may also be more responsive if the borrower includes financial projections, with analysis, that address a variety of recovery scenarios.
MW: So, what types of concessions should companies consider offering their lenders to incentivize them to grant requested waivers or amendments?
RD: There are a lot of concessions a company can offer to make its proposal attractive to the lender. As a borrower, consider what changes to the loan’s terms and conditions would reduce the lender’s direct exposure to the challenges your business will likely face over the next 18 months.
Borrowers may be able to loosen covenants in one area, in exchange for tightening other covenants. One company that I know of was in danger of violating its total leverage test. It proposed to the lender that it should be allowed to exceed the leverage test on a total basis, in exchange for a concession to tighten up an asset borrowing test that accrued to the benefit of the bank by limiting the bank’s credit exposure.
There are also coupon step-ups, increased fees, reduced baskets for permitted liens and priority debt, increased requirements around cash management or maintenance, and limitations on use of proceeds. We have even started to see some troublesome high-yield–style loan covenants—such as restricted payments, mandatory prepayments, and LIBOR floors—make their way into investment-grade company credit facilities.
Another approach that might be persuasive with the lenders could involve finding alternative sources of capital to refinance part of the existing loan, with the objective of reducing the bank’s capital requirements in the loan. The borrower might go to the second-lien market, the mezzanine market, or the securitization market to finance specific assets off the balance sheet. Injecting equity capital could similarly reduce the size of the loan, thus reducing risk for the lender. A midsize company looking for a modification might need to have its private equity sponsor inject some equity, in exchange for covenant relief.
MW: So, basically, offer some kind of burden sharing?
RD: Exactly. These loan modifications are going to be a burden on the banks. Everyone is going to need to carry a little bit of that burden. In the large-cap space, banks are willing to provide additional loan capital, but they want to see that the company is willing to borrow from other markets, like the bond market, as well—even at higher rates. If I can borrow from the bank at 3 percent and I can borrow in a bond at 4 percent, my willingness to issue that bond, even if it’s not the easiest or least-expensive source of capital, is going to resonate with lenders.
The idea of burden sharing is going to be a big theme throughout this process.
MW: What are some other ideas for concessions?
RD: Each situation is unique, and there are many different ways to get to a successful outcome. What about increasing the level of liquidity the borrower will maintain or introducing excess cash flow sweeps? Or eliminating dividend distributions for the next 12 months? From the lender’s perspective, loan modifications like these can be valuable concessions. For a borrower that wasn’t planning to make any distributions anyway, this concession might be relatively painless—and well worth the relief on a leverage test or some other covenant that it is forecasting to be a challenge.
Some loans may already include these types of restrictions, but companies can offer to tighten them as well. For example, a loan might cap international assets at $100 million. The company might offer to lower that limit to $50 million, which would reduce the risk to the lender that the company will go out and spend money recklessly overseas.
MW: What about bringing additional business to the lender? Could that help motivate banks to provide covenant relief?
RD: Yes, offering ancillary business is definitely something to consider. If a borrower can offer something like ‘If you make this loan modification, I’ll be able to buy a competitor that I’ve always wanted to buy, and I’m going to hire you to do the M&A [merger and acquisition] work,’ that modification may become much more appealing to the lender. Offering this type of business opportunity is a lot more important than many companies realize.
The loan represents the foundation of a relationship that supports many other objectives of the lender. When a bank makes a decision around modifying a loan, it’s going to incorporate an enormous amount of other information about that relationship into that decision. Corporate executives often believe getting a loan is a science, purely a function of plugging in the numbers on corporate financial statements—but it’s really an art.
As an example, most waivers have no direct, quantifiable value for either the borrower or the lender. If I compare a bank facility at three turns of leverage and the same facility with a 12-month waiver at three and a half turns, can the difference in the value of the loan be reliably calculated? That increase in flexibility is really not quantifiable. For the most part, once lenders make a quantitative decision about whether to allow an amendment, they find themselves making a qualitative judgment about the benefit of agreeing to that modification.
MW: In the last article in this series, we’ll explore in detail the process that companies should undertake to put together a loan-modification proposal for their lenders. But as borrowers consider modifications they might request and concessions they might offer, what key factors should they weigh?
RD: The enormous challenge we are facing in the coming months is that the tsunami of loan-modification requests will mean neither lenders nor borrowers will have the same resources they would normally want to put into evaluating these requests.
We expect that there will be many different forms of loan modifications, but the initial volumes will probably skew toward short-term waivers that get companies past the next 12 months with a minimum of lender approvals required. I think that’s the rational outcome, as opposed to reopening bank facilities and trying to document certainty in an environment where nobody has any certainty. Companies may be projecting their earnings for the rest of the year, but really nobody knows what the specific impacts of the economic shutdown are going to be.
Successful loan modification outcomes will likely be based on a mutually beneficial give-and-take in which the borrower and lender understand each other’s motivations and limitations. For most non-distressed loan modifications, I would expect that a hyper-aggressive approach by either party is more likely to fail in this environment.