1. Overview
'Boy, that escalated quickly, I mean it really got out of hand fast'
- Ron Burgundy
2020 presented a number of challenges for the Australasia leveraged loan markets. Among other impacts, the Coronavirus (COVID-19) resulted in several aborted deals, detailed examination of MAC/MAE clauses in acquisition and debt documents, actual or anticipated covenant and liquidity pressures, emergency debt/equity raising and many consent processes.
In the face of these headwinds, 2020 still saw new money deals being executed. KWM has been pleased to support our Sponsor and lender clients on the financing of some the year's landmark deals including GenesisCare's acquisition of 21st Century Oncology, Ventia's acquisition of Broadspectrum, EQT's public-to-private bid for MetLife, BGH's public-to-private bids for Abano and Village, and acquisition of Healius Medical Centres, Madison Dearborn Partner's acquisition of APM and PEP's acquisition of Citadel.
2. Material Adverse Change?
For many of us, the first interplay between COVID-19 and the loan markets involved determining whether COVID-19 was an event having a material adverse effect or triggering a material adverse change event of default .
While there were many high profile examples of a COVID-19 triggered MAC being invoked in M&A transactions[1], lenders were thankfully less trigger happy to call a MAC event of default under loan agreements. The prevailing sentiment from lenders was a pragmatic "we are all in this together", influenced by the lack of any upside to lenders in calling a MAC, or enforcing in the uncertain environment (not to mention the associated material reputational and lender liability risk in getting it wrong) coupled with heavy government pressure on financial institutions to provide relief to borrowers. Nevertheless in situations where consent processes were commenced with lenders (eg for covenant relief), many borrowers also took the opportunity to clarify the position in their loan agreements that COVID-19 of itself, should not trigger a MAC event of default.
3. EBITDAC
The markets spent (and in some cases are still spending!) a considerable amount of time considering the extent to which Borrowers can adjust EBITDA to take into account the impact of COVID-19 (the so-called EBITDA before Coronavirus or EBITDAC adjustment).
If a borrower's EBITDA definition in their loan agreement is sufficiently wide to allow adjustments for "extraordinary", "significant", "one-off", "unusual", "non-recurring" and/or "exceptional" "items" and/or "gains and losses", it is possible in our view for them to make an EBITDAC adjustment. An objective observer could pose the question: if a one-in-a-century pandemic is insufficient to justify an adjustment – what is? That said, it is, of course, necessary to analyse closely the relevant formulation in its entirety (including any lead in words) as each formulation is different and its application is fact specific.
A point that often is forgotten as that these are not terms having any meaning under accounting standards so the words simply have a plain English meaning.
EBITDAC adjustments can take several forms:
- for incremental costs (eg increased cleaning costs / PPE for staff) – these are usually not so controversial
- loss of revenue due to the government enforced shutdowns/lockdowns – the most affected being travel / hospitality / leisure / gyms / retail businesses to other not as obvious ones such as private hospitals who faced restrictions on many categories of elective surgery as part of the national effort to ensure there was sufficient healthcare facilities to cater for the pandemic.
The loss of revenue adjustment is, not surprisingly, the more controversial EBITDAC adjustment, with varying methodologies being applied. The other question is how long one can make EBITDAC adjustments for and whether results can be attributable to COVID-19 or a more permanent change to the trading landscape such as the increased volumes of e-retail.
Where a borrower's EBITDA definition has been sufficiently wide and the borrower has not needed anything else from its lenders (eg more liquidity lines or covenant relief), we have observed borrowers making such adjustments. With Australia switching to a 'back-to-normal' mode with its successful COVID-19 suppression measures, the increasing likelihood of successful vaccine rollouts and the 'bounceback' already being experienced in the economy and across many industries hopefully will make the EBITDAC discussion less relevant as we move into 2021.
4. Consents
KWM assisted many borrower and lender clients navigate COVID-19 consent processes during 2020.
Our general impression has been that lenders and borrowers have worked collaboratively on these processes. We have not observed any marked difference between the approach taken by commercial banks and debt funds in their consent processes.
The key topics dealt with as part of the processes have been:
4.1 Covenant suspension
Unless a Borrower was able to EBITDAC (see above) their way through the COVID crisis or had a covenant-lite TLB funding solution, they tended to need some form of financial covenant relief. Lenders were typically willing to grant some form of relief and the negotiation focussed on:
- length of covenant suspension period – in most cases the agreed covenant suspension period fell somewhat short of the original borrower ask absent an earlier than expected full recovery, we expect that some credits may need additional waivers in 2021;
- replacement covenants – a typical quid pro quo for waiving financial covenants was the testing, during the covenant suspension period, of a new minimum liquidity covenant, less common was the inclusion of a minimum EBITDA covenant;
- resetting the covenant profile at the end of the covenant suspension period – for sponsors used to covenants being set 20%-30% off the base case the headroom in a post-covid, post-suspension world looks very narrow and many are seeking to reset the covenant profile now or set out mechanics for an agreement before the end of the covenant suspension period
4.2 Liquidity
In the early days of COVID some credits were forecasting a liquidity shortfall that would have needed to be plugged by new funding. The most common initial reaction was the drawing of undrawn liquidity / working capital lines by borrowers to put cash on balance sheet "just in case".
In the Australian market at least, government intervention with relatively generous wage subsidies in the form of JobKeeper and JobSeeker payments meant that the majority of our clients have managed to trade through lockdown periods. Notwithstanding this, a number of borrowers still sought additional liquidity solutions from their financiers – many out of abundance of caution given the lack of visibility in the early days of COVID-19 as to how long the shutdowns would last (see discussion below). Many of the early 'draws' have now been repaid as the situation stabilises and the negative carry from having low-interest earning cash starts to bite.
4.3 Quid pro quo
In return for the flexibility sought by Borrowers lenders have typically sought some or all of the following:
- increased reporting;
- tightening of permissions for various discretionary activities (ie dividends); and
- pricing step ups to the top of the margin grid.
While lenders have asked for equity injections on a number of deals our impression is that the majority of deals were not conditioned on this. As set out above some of the existing covenant suspensions may be seen as a bridge to a further discussion in 2021 where, if the business has not improved, lenders push harder for an equity solution.
By and large we have not seen many deals where lenders have charged consent or work fees for consents. To a certain extent this may be attributable to nature of the pandemic and the industries most affected by it. It may be that, together with the increased focus on equity referred to above, this is one of the areas that is revisited in 2021.
5. Liquidity
As our restricting & insolvency colleagues continue to remind us – cash is king when facing financial distress. Over the course of 2020 borrowers approached the potential lack of liquidity caused by government shutdowns as follows
5.1 Drawing undrawn lines
For those with memories of the global financial crisis, one of the earliest considerations of borrowers when COVID-19 first struck was they should draw all available liquidity lines. In the early days of COVID-19, a number of companies did just that. Unlike the global financial crisis (where financial institutions were in distress), with COVID-19 (where the real economy was disrupted), borrowers were less concerned that lenders would default on their funding obligation, but were driven by other more valid concerns.
Utilisation of a facility will require the borrower to confirm that the representations are true and that no default or event of default is subsisting. At the beginning of the crisis borrowers were modelling multiple different scenarios, some of which pointed to increased financial distress if the pandemic were to persist for long periods. For these borrowers, drawing their undrawn commitments early while they were still confident of their ability to make the representations/confirm no event of default made sense.
Notwithstanding the emergency insolvency legislative relief (including the insolvent trading relief), it was important (and remains important!) for borrowers to be confident that they are solvent at the time they make a drawing. Otherwise they will not be able to meet the "no default" condition precedent to drawing.
For those interested, a 'live' consideration of these very legal issues around borrowers drawing down undrawn lines at a point where solvency may have been questionable is the subject of the ongoing Arrium litigation.
5.2 Repurposing undrawn lines
Of course drawing your undrawn lines was only helpful when you had undrawn lines to draw.
A number of leveraged bank deals and a smaller proportion of leveraged unitranche deals had committed facilities which had as its sole purpose the funding of growth capital expenditure and permitted acquisitions.
Many borrowers approached lenders to repurpose these facilities to permit them to be used to fund working capital and liquidity during the period. These requests have generally been accepted by lenders albeit some imposed a sunset date on the repurposing.
5.3 New liquidity facilities / alternatives to preserving liquidity
A number of borrowers managed to raise additional liquidity lines from financiers in the challenging circumstances. Still others managed to get some interest payment relief (deferral or converting into PIK), and/or waiving or deferral of principal amortisation payments. These have been relatively more difficult to obtain from larger bank syndicates due to varying degrees of regulatory capital relief from prudential regulators across different countries for payment deferrals. This is an area where private debt funds had more flexibility to give such relief compared to regulated banks..
6. Look forward
6.1 Return to form
The second half of the year has seen a return to form for the loan markets.
While new money acquisition financings have been limited, sponsors have been reviewing their existing portfolios leading to:
- sponsors seeking financing packages for potential dividend recapitalisations as an alternative to a competing exit process; and
- dual track exit process (the most notable in the back half of 2020 probably being the IPO of Nuix which had attracted considerable sponsor interest prior to the shareholders' decision to head to the ASX boards).
We would expect that this trend will continue in 2021. It feels to us like there is a lot of pent-up demand for deal-doing that will be unlocked to "catch up" on the delay to a number of sponsors' exit plans caused by COVID-19's dampening impact on activity levels in 2020.
For new money deals COVID-19 required some bespoke structuring to take into account the impact on target businesses we have seen and expect to continue to see:
- one-off adjustments to LTM EBITDA to smooth COVID affected months;
- setting negative undertaking 'baskets' based off a back-to-normal situation rather than the current COVID-19 affected position;
- acquisition structures that had built in purchase price adjustments based on target performance rather than MAC conditionality; and
- some debate on the EBITDA definition and MAC event of default and scope for EBITDAC adjustments / MAC carveouts at least for known impacts.
In terms of debt financing products, the early new money deals saw a preference for bank debt as opposed to unitranches and TLBs, with sponsors being less aggressive on headline leverage levels and bank debt having a reasonable pricing advantage. However we are already seeing unitranche and other forms of institutional debt financing being inked recently. So chances are we will end up with the same landscape of the different competing products being considered for every deal in 2021 (absent a second wave).
6.2 Back to the table
As mentioned above, a number of COVID-19 affected deals only managed to obtain a relatively short term financial covenant suspension. Despite the potential V shaped recovery for some, a number of those deals will need to return to lenders in 2021 for new consents. With more data available to lenders and borrowers, we expect that this new round of consent may involve greater discussion with borrower about the appropriate leverage level for these credits (especially those with upcoming maturities) and whether there should be an equity solution to bring leverage down to the covenant levels agreed at the start of the deal.
6.3 Insolvency and reform
As set out in previous updates during the crisis (see, for example, here and here) the Australian government introduced temporary reforms of the Australian debt enforcement and directors' duties laws aimed at encouraging businesses to continue to trade outside of insolvency procedures. Consequently, there has been a very significant decline in the number of companies entering the administration and liquidation processes during the COVID period. The restrictions on the rights of unsecured creditors to enforce unpaid debts have led to a build up of bad debts in the economy.
The temporary reforms have been extended to 31 December 2020 and, at the time of writing, will lapse in a few weeks. In 2021, we expect to see a significant increase in unsecured debt enforcements and in the appointment of administrators and liquidators to companies.
From a permanent reform perspective, the Australian government has focused on introducing a new small business restructuring procedure. However, it is aimed at companies with less than $1 million in creditors. At the time of writing, there is no expected reforms impacting the restructuring or insolvency procedures available to larger companies.
The main impacts of insolvency law reforms on leveraged credits are expected to be the roll-off of the temporary reforms impacting the supply chains of larger businesses.
[1] e.g. BGH's initial bid for Abano, EQT's bid for MetLife, Affinity Equity Partner-backed Scottish Pacific's bid for CML.
