April 8, 2020
Michael Levy View bio
David Zafft
As we move into the second quarter of 2020, companies are faced with assessing the negative impacts of the COVID-19 virus on their financial and operational performance. Most companies are seeing a significant decline in revenue and are having to react quickly to adjust their cost and expense structure to the current economic situation.
If you are a company with leverage, you have probably already been in touch with your lender to discuss any immediate needs for liquidity and negative impacts on your business. Now comes the bigger question of what amendments are necessary to your loan agreement in order to allow you to move ahead and manage your business through the COVID-19 crisis.
Lenders have a vested interest in your operational and financial success. Our sense over the past few weeks is that lenders have the attitude that “We are all in this together.” As such, it is imperative that you establish and maintain trust with your lender. The more open, honest and frank you are with your lender, the better chance you have in maintaining the lender’s support of your business through the downturn.
The first step in establishing and maintaining this trust is to know your situation and know what terms and conditions are in your loan agreement. From a business and operational perspective, do you have a strong enough balance sheet to survive the next quarter with any anticipated (or unanticipated) decline in your quarterly revenue run rate? Do you know the length of your cash conversion cycle? Do you have a budget process? Do you perform scenario planning to understand the most sensitive assumptions in your budget? Do you have a system in place to monitor your key performance indicators and performance in real time? Have you read and do you understand the requirements of your loan agreement? Once you have, you can establish where you are and what amendments or waivers you should ask for with respect to your loan agreement.
All loan agreements are different, and you will need to review the provisions carefully as definitions, covenants and defaults vary significantly from deal to deal. However, we have identified the following four general areas of your loan agreement that will be most impacted by the financial stresses resulting from COVID-19: Upcoming Payments and Amortization; Financial Covenants and Definitions; Reporting Requirements and Notices; and Events of Default. Additionally, if you have a revolving credit facility, you will also need to review the conditions to future borrowing under your loan agreement in order to ensure you meet all of the specified conditions required to receive a future advance, which we have described in the section titled "Conditions to Borrowings in Revolving Loans” below.[1]
While most loan agreements provide for monthly payments of interest, there may be additional payments due under the loan agreement, particularly if your facility has a term loan component. Two of the most common are principal amortization payments and excess cash flow sweeps. Loan agreements may also require mandatory prepayments although this is less common.
What do I have?
Review your loan agreement carefully to determine if there are any payments due under your loan agreement during the next two quarters. Some examples of common payments are:
What do I ask for?
We have seen lenders regularly waive principal amortization payments at least through the second quarter of 2020 and excess cash flow payments during 2020.
Waivers of mandatory prepayments will need to be evaluated on a case-by-case basis. However, so long as the circumstances giving rise to the mandatory prepayments do not negatively impact the ongoing earning power of the business, lenders seem to be willing to waive these prepayments. Specifically, lenders should be willing to waive any mandatory prepayment required as a result of the receipt of proceeds of an equity issuance, business interruption insurance and any government relief loan (including under the CARES Act or PPP Program)[2].
Additionally, if there is an issue with payments of monthly interest, we have seen some lenders be willing to allow a portion of the interest to be “paid-in-kind” by adding such interest to the balance of the loan for a short period of time.
While a loan agreement may have any number of financial covenants, the two of the more common covenants are the leverage ratio and the fixed charge coverage ratio. Both of these covenants are centered on EBITDA. EBITDA is generally intended to approximate the normalized free cash flow of a business that is not distorted by irregular gains, losses, or other items.
What do I have?
At its most basic form, EBITDA will be calculated as consolidated net income (earnings) plus the sum of interest, taxes, depreciation and amortization. However, there may be additional one-time non-recurring items which are often referred to as “add-backs”. Common add-backs that could be applicable to COVID-19 disruptions include the following:
What do I ask for?
Once you have evaluated your current add-backs and your projections of covenant compliance, you should consider asking your lender for additional add-backs or other amendments to financial covenants related to COVID-19 disruptions.
In some instances, we have seen lenders agree to a broad add-back not only for costs and expenses associated with COVID-19, but also lost earnings associated with COVID-19.[3]
In other instances, we have seen lenders amend the financial covenant levels without modifying the definition of EBITDA. Since financial covenants are most often measured on a trailing 12-month basis, it is important to keep in mind that the impacts of COVID-19 will affect covenant calculations until at least the second quarter of 2021, and the covenant levels should be adjusted accordingly.
More specific add-backs may be appropriate, either as an alternative to or in addition to a broader COVID-19 addback. Some examples of other specific add-backs include the following:
It goes without saying that any add-backs to financial covenants should be factual and supportable and your lender will want to verify that the add-backs are truly related to the extraordinary disruptions arising out of COVID-19 and are not being used to mask larger problems.
Reporting Requirements and Notices
Loan agreements contain many provisions relating to notices and reporting that is required to be delivered to the lender from time to time. As we mentioned above, during this time of disruption, your lender is your partner and so there should be a regular flow of information. However, there are certain reporting requirements and notices that you should be particularly concerned about.
What do I have?
You should review the reporting requirements to determine the following:
One frequently asked question is when the failure to meet financial covenants becomes a “default” or an “event of default” under the loan agreement triggering the requirement to report a default or event of default. For example, borrowers frequently ask whether the reporting requirement is triggered when it knows it cannot meet its financial covenants, on the last day of the quarter end, or when it delivers the required financial statements and compliance certificate to the lender.
Generally, the reporting requirement is triggered when the borrower becomes aware of the default or event of default. There is very little case law on this subject, but in the context of a certification by a borrower that no default or event of default has occurred, the borrower must have a good faith basis to make such certification. If the borrower knows it cannot meet the financial covenants, it becomes questionable whether the borrower can make the “no default” certification in good faith, even if the borrower makes the certification prior to the end of a financial quarter measurement. Thus, it is best practice to notify your lender as soon as possible if there is no good faith basis to believe you will meet the requirements of your financial covenants.
The ambiguity surrounding certain covenants and reporting requirements in loan agreements emphasizes the need for open and honest communication with your lender and being proactive in seeking amendments or waivers under your loan agreement.
What do I ask for?
In order to avoid defaulting under your loan agreement, we suggest asking your lender to amend the following provisions:
Events of default under loan agreements may include cross defaults to other indebtedness, particularly defaults under material contracts or litigation or a general material adverse effect default.
What do I have?
You should identify particular events of default that have been or may be triggered.
What do I ask for?
Depending on the specific event of default, your lender may be willing to waive the event of default altogether or amend the applicable provision in the loan agreement so that you are no longer in default.
For example, if the default is an “early warning” where a breach of a material contract or agreement relating to other indebtedness has occurred, the lender may be willing to amend the event of default so that it is triggered only upon an actual termination of a material contract or acceleration of other indebtedness. Additionally, in this case, you should also ensure your loan agreement is amended to provide that any cure or waiver of the underlying default under the material contract or agreement relating to other indebtedness also cures the default under your loan agreement.
If your loan agreement has a material adverse effect default, we also recommend amending the definition to exclude the effects of COVID-19, as discussed above.
With respect to loan agreements relating to revolving credit facilities, a borrower generally must “bring down” the representations and warranties made at the initial closing, certify that no default or event of default exists and certify that no material adverse effect has occurred.
What do I have?
Review the conditions precedent to borrowing under the revolver carefully to determine what conditions and certifications are required.
What do I ask for?
See the discussions regarding the representations and warranties, certifications as to no default or event of default and modifications to the material adverse effect definition discussed under “Reporting and Notices” above.
About Aprio
Aprio is a premier full-service, CPA-led business advisory firm based in Atlanta, Georgia, that advises clients and associates on how to achieve what’s next. Aprio’s associates work as integrated teams across advisory, assurance, tax, outsourced accounting solutions and private client services, bringing the best thinking and personal commitment to each client. Across practices, Aprio brings together proven expertise, deep understanding and strategic foresight for industries including Manufacturing and Distribution; Non-Profit and Education; Professional Services; Real Estate and Construction; Retail, Franchise and Hospitality; and Technology and Biosciences. To serve clients wherever life or business may take them, Aprio’s teams speak more than 30 languages and work with clients in over 40 countries. In addition to its Atlanta headquarters, Aprio also operates in Birmingham, Ala. and Sarasota, Fla. and across the Carolinas. For more, visit www.aprio.com.
About Aprio's Authors
Michael Levy is the partner responsible for Aprio's Transaction Advisory Services practice. Michael has assisted both financial and strategic clients in domestic and international merger, acquisition and divestiture transactions. In his capacity as the leader of Transaction Advisory Services, Michael’s primary responsibilities include assisting clients with developing structures, performing accounting and tax buy-side and sell-side due diligence, closing assistance and post-transaction integration assistance.
To reach Michael, call 770.353.7168.
David Zafft is a director in Aprio’s Transaction Advisory Services practice. David has approximately 20 years of audit and merger and acquisition due diligence and valuation experience. David’s primary responsibilities include assisting clients with performing buy-side and sell-side due diligence, transaction closing assistance and post-close integration assistance, including valuation, synergy realization and capital structure alignment. Further, David provides valuation and financial modeling services for financial reporting, M&A, restructuring and tax documentation purposes.
To reach David, call 770.353.5075.
[1] Asset-based lending and revolving credit facilities where availability is based off of a borrowing base are generally outside the scope of this note given the factual specificity required in balancing the inclusion of items in the borrowing base and over-advances with the cash needs of the borrowing.
[2] You will also need to review your loan agreement to determine whether there is any indebtedness covenant that would be violated if you were to receive a Cares Act or PPP Loan. If so, the lender should willingly consent to a waiver or amendment to this provision. The following is a sample consent:
(a) If any Credit Party files an application to any Governmental Authority for the provision of monetary aid or other relief, in the form of a loan, grant or otherwise, from such Governmental Authority (such monetary aid or other relief, “Relief Funds”) due to the adverse impact of COVID-19, the Credit Parties shall deliver a true and complete copy of such application together with all supporting materials to the Agent. In the event that any such application is approved by the applicable Governmental Authority and Relief Funds are disbursed to the applying Credit Party, then the applying Credit Party shall not apply, disburse or distribute any such Relief Funds other than for the purposes set forth in the Laws under which such Relief Funds have been authorized and implemented by such Governmental Authority and to the extent permitted under the terms of the Credit Agreement, without the prior written consent of the Agent (acting at the direction of the Required Lenders).
(b) Additionally, if Relief Funds received by any Credit Party are structured as a loan or other debt obligation (in any such case, a “Relief Fund Loan”), the Agent and the Lenders additionally acknowledge and agree that the incurrence and existence of such Relief Fund Loans shall not violate Section [Indebtedness covenant] of the Loan Agreement (and, for the avoidance of doubt, will not give rise to any prepayment obligation under Section [Prepayment provision relating to incurrence of additional debt] of the Loan Agreement) so long as the Relief Fund Loan shall be (x) unsecured and (y) not senior in payment right to the [Obligations] (by law or otherwise)).
[3] The following is a sample provisions:
“non-recurring cash expenses or charges directly related to the impact of the COVID-19 pandemic on the Borrower and its Subsidiaries during the first, second and third fiscal quarters of the 2020 Fiscal Year of the Borrower in an aggregate amount to be determined by the Borrower and agreed upon by the Agent in its reasonable discretion; plus (l) the amount of lost earnings as a result of the impact of the COVID-19 pandemic on the Borrower and its Subsidiaries for the first and second fiscal quarters of the 2020 Fiscal Year of the Borrower as determined by the Borrower in good faith based on (i) the financial statements provided pursuant to Section [___] for the corresponding period of the previous Fiscal Year of the Borrower and (ii) the annual budget provided pursuant to Section [___] for the 2020 Fiscal Year of the Borrower; provided that (x) the Borrower shall certify to the Administrative Agent that such lost earnings were reasonably anticipated to be realized during such period based on the applicable financial statements, budgets and projections of the Borrower and are factually supportable as determined in good faith by the Borrower and (y) such amount shall be agreed upon by the Agent in its sole discretion.
[4] In addition, amounts received under a PPP loan should be excluded from the amount of indebtedness used to calculate the leverage ratio, at least to the extent, and so long as, the PPP loan may be forgiven.
[5] Definitions in loan agreements almost always include prongs for both a material adverse effect on the financial condition of the business and also the ability of the borrower to perform its obligations under the loan documents. Judicial interpretations of the meaning of “material adverse effect” vary, but have generally held that the item needs to be both significant and not temporary.
These materials have been prepared for informational purposes only and are not legal advice. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. Internet subscribers and online readers should not act upon this information without seeking professional counsel.