Advanced Negotiation Issues in Financial Covenants

Course Overview:

This programme covers financial covenants in Loan Agreements and includes specific reference and analysis of the terms and definitions as used in the LMA Senior Facilities Agreement for Leveraged transactions but consideration will also be given to current developments in the market particularly the larger syndicated deals.

The loan market in Europe is bifurcating into two groups; smaller club and bilateral deals which tend to follow the lender friendly LMA approach and larger syndicated TLB-style deals which, increasingly, are being influenced by the high yield bond market and are cov-loose or cov-lite which have culminated in the recent Ceva Sante Animale deal which had no financial covenants.

Financial covenants are arguably one of the most heavily negotiated aspects of the Loan Agreement. Too often some parties fail to understand the key issues that really matter, for example, they view the financial covenants in isolation rather than appreciating they must be seen in the context of each particular capital structure. A second pitfall is to spend too much time on which covenants apply rather than focusing on the key constituents of the key terms in the financial covenant.

This course provides a detailed look at commercial aspects of financial covenants and looks under the bonnet at the critical issues that arise in practice. This course provides an in-depth look at the covenants as set out in the Loan Market Association precedent together with other covenants that might be used in practice. Reference is made to the Debtxplained loan Database which tracks key terms in the larger syndicated deals.

Participants will gain an in-depth view of which covenants should be used and why together with a detailed analysis of the constituents of the covenants and the sponsor friendly add-backs and other sponsor friendly techniques used by borrowers to manipulate the covenants.

The programme is aimed primarily professionals involved in Leveraged deals, such as Lawyers, Private Equity professionals, Bankers in Lending (all departments), Corporate financiers, M&A advisors, Debt advisory and Restructuring. Accounting professionals looking to expand their knowledge of this topic will also benefit as many of the issues embrace legal /documentary considerations. The programme adopts a pan-European approach to the topic but the presenter is able to discuss issues relevant in the USA in view of his exposure to those markets.

To derive full benefit from the programme, it is essential that attendees have a basic understanding of the main / headline elements of a Profit and Loss account (Sales, EBITDA, EBIT etc) and a basic understanding of the differences between P&L /Accrual Accounting on the one hand and Cash accounting on the other.

For those attending, a short module will be provided in advance of the course which forms part of the pre-course reading. It is to be emphasised that participants DO NOT require an understanding of IFRS or GAAP as the programme is designed to enable attendees to have enough basic knowledge to identify the key commercial issues.

Course Content:

Interaction of capital structure & financial covenants

• Types of instruments & impact on the financial covenants
• Structuring parameters – creating an appropriate financial structure (overview)
  • Percentage senior, junior and equity in debt capital structure
  • EBITDA multiples
  • Target returns for PE & Mezz Funds
• Impact of Capital Structure on Financial Covenants
• Bullet loans
• Impact of PIK

Key financial ratios used by Lenders / covenants for Loans (per LMA)

• Leverage ratios (Balance sheet and P&L ratios)
  • Total Debt / EBITDA
  • Senior Debt/ EBITDA
• Interest coverage ratios
  • EBITDA / Total interest
  • EBITDA / Senior Interest
  • EBITDA / Cash interest
  • [EBITDA – Maintenance Capex] / Cash Interest
  • [EBITDA – Capex] / Cash Interest
• Cash flow cover (DSCR)
  • CADS / Total Debt Service
  • CADS / Senior Debt service
• Capex covenant
  • Baskets – LMA vs Market approach
  • Carry forward / carry back amounts – LMA vs Market approach
  • Add-backs – LMA vs Market
• Other ratios
  • Net Asset Value
  • Fixed Charge cover ratio

A closer look at the key constituents of the ratios

• EBITDA (note: is a defined term in the Loan Agreement, it is not a GAAP or IFRS term)
  • Simplistic calculation of EBITDA
  • Consistency of application (dealing with Accounting changes under IFRS, GAAP etc)
  • Exceptional items – LMA approach, UK GAAP vs IFRS
  • Sponsor friendly add-backs
  • Discontinued Operations – LMA, different approaches of UK GAAP vs IFRS
  • Derivative & Financial Instruments – UK GAAP vs IFRS
  • Pension Items – UK GAAP vs IFRS
• Total [Net] Debt and Senior Total [Net] Debt
  • “Borrowings” per the LMA
  • Simplistic calculation of Net Debt
  • Example of net debt items
  • Treatment of PE “Debt” and Vendor Loans
  • Impact of Debt Buybacks and impact on “Debt”
  • Treatment of “Trapped” cash on Debt
• Finance charges & Net Finance Charges
  • Tricky issues
• Financial Indebtedness & impact on the covenants
• Topical matters affecting the covenants
  • Impact of Leasing on EBITDA (Operating vs Finance Leases)
  • Forthcoming changes in IFRS & impact on covenants
  • Capitalising costs
  • Forex gains/losses on Intra-group transactions
  • Debt buy-back gains & impact on EBITDA
  • Restructuring costs
  • Exceptional, extraordinary items & other “one-off”, non-recurring items
  • Related party income

Pros & cons of the Financial Covenants & typical application

• Cashflow cover – pros, cons and application
• Interest cover – pros, cons and application
• Leverage ratios – pros, cons and application
• Capex ratios -– pros, cons and application

Other considerations

• How many covenants are needed
• Which companies should be included
  • Definition of “Group”
  • Adjusted EBITDA (effect of acquisitions & disposals)
• Dealing with “Short” periods (i.e. Less than 12 months post the deal)
  • Periods shorter than 12 months
  • Typical pitfalls to avoid
• Frequency of application: When should the ratios be tested
  • Historic TTM/LTM, forecast, both (quarterly, monthly)
  • 2 options per LMA
  • What level of “Headroom” is appropriate
  • Impact of Clean-ups
• Additional role of the financial covenants on the Deal
  • Margin ratchets
  • Guarantor Coverage Test
• The Compliance Certificate
  • Requirements per LMA Sch 9
  • Current commercial requirements
  • When does the breach occur
  • Ramifications of the breach for Lender (traps to avoid)
• Equity cures
  • Equity cures – What are they, good or bad
  • What should be cured (EBITDA, Cashflow, Debt)
  • Treatment of “overcures”
  • Is the cure EBITDA? And if yes what effect will this have
  • How should the cash be used? (Why repayment of debt is not appropriate)
  • Review of recent topical case law lessons from Ideal Standard
• The Guarantor coverage test
  • What percentages shall apply to Guarantors
  • Which “guarantors” are included
  • What items should be included in the test – gross assets, net assets, sales

Current trends & developments

• Cov-lite deals (developments in the market – large syndicated deals vs clubs and bilateral)
• Covenant suspension – current trends, market approach (not in LMA)
• Springing Maintenance covenants (not in LMA)
  • Use and application

Inter-creditor issues

• Financial covenants for mezzanine and second lien and interaction with senior debt
• Cross default and interaction of convents laminated structures (Loans, Bonds and junior debt)

What Redcliffe’s clients are saying about the course

“An excellent use of case studies & indication of recent trends”

“A good mixture of the sponsor, lender, legal & accountancy perspectives”

“The trainer is clearly very experienced with good market insight which was used to make links to the materials & content”

“Up to date market information with enthusiastic and knowledgeable trainer.
Clear and useful explanation as to how various components
involved in financial covenants relate to each other”