Testing times

These are testing times. Many companies acquired by private equity houses back when leverage was readily available are now breaching their covenants either on a technical basis or more seriously. While previously breaches were few and far between, turnaround specialist Nicolas de Germay, chairman of Alandia Capital, estimates that up to 70% of French companies breached their covenants in some way at the last test. Things are equally alarming abroad, where Alchemy's Jon Moulton estimated that there were 200 covenant breaches in the UK in Q4 and Standard & Poor's expects EUR25bn of debt default this year. Hard negotiations between company owners and their creditors are likely to be the future order of the day in contrast to the easy resolutions of the past.

Options for companies and owners who find themselves faced with a covenant breach "usually involve debt rescheduling, debt write off and/or, debt-for-equity sway" says Nicolas Laurent, partner at law firm Bredin Prat. "As a result, the more minor breaches can result in waivers that could be granted in order to deal with the mass influx," adds de Germay. Another option is the "Loi de Sauvegarde" recently put to use in TowerBrook's acquisition of Autodistribution, which had sought protection from creditors last year (see page 56). Worryingly, the amount of covenant breaches we are seeing today may just be the tip of the iceberg. French private equity as well as creditors will have to demonstrate flexibility in order to keep portfolio companies afloat.

In recent years, covenants in France, as elsewhere, had become more relaxed. Though at the moment cov-lite companies are less likely to be in difficulty compared to companies with more complex covenants, they may experience difficulties later on if markets continue to deteriorate. If the portfolio companies do break their cov-lite agreement, it may well be too late for any turnaround operations. Many GPs have therefore been combing over their portfolios to assess which companies are likely to have issues in the future and are reviewing their options.

Traditionally, the renegotiation of debt in France has followed a standard set of tried and tested methods over the last 30 years. Due to the financial crisis these procedures can now no longer be taken for granted. French banks have "traditionally rarely accepted debt-for-equity swaps as a solution to a breach of covenant on the grounds that the holding of equity was a different business from that of holding debt," says Laurent. De Germay adds that "the sheer amount of covenant breaches means that banks cannot allocate enough resources to each individual case." Many highly leveraged portfolio companies currently find themselves between a rock and a hard place, with banks keen to sort out their battered balance sheets. Long term relationships with banks which once procured flexibility may today be worthless. Methods and understandings between creditors, companies and their owners are set to change.

Loi de Sauvegarde

The Loi de Sauvegarde is a law aimed at protecting troubled companies if an accord between the firm and their creditors is not achievable. Like Chapter 11 in the US, companies are now allowed to utilise the "sauvegarde" procedure if they can demonstrate that the debt will eventually become unmanageable even before covenants are breached. This is particularly useful as a pre-emptive option for companies which are particularly cov-lite.

Before being allowed to go to court with the Loi de Savegarde, the management must have at least proposed an offer to all its creditors. The management must get a 100% approval from all its creditors in order to implement any debt restructuring. Herein lies the issue: buyouts would have been financed by clubs of banks due to their size. In deals which were underwritten by a single bank, it would have later syndicated the loans off into buoyant CDO markets. This means that creditors, including other banks, hedge funds, etc can add up to hundreds and this is without mezzanine creditors. "An outside-court global restructuring requires the unanimous (or quasi-unanimous) consent of the debt holders, which is impossible to obtain when there is a large number of lenders, such as in major LBOs. The refusal of one or a few lenders results in the borrower having no other option but to go to court and to have a bankruptcy-related procedure (such as safeguard) opened to 'cram down' the hold-outs," states Laurent.

Having failed out-of-court arrangements and proved the debt is totally unmanageable, the management can seek protection from the Loi de Sauvegarde and present a restructuring plan to the courts and investors. "In safeguard, the management prepares a 'safeguard plan' and submits it to its lenders. A majority of the lenders representing two-thirds of the debt may impose such plan on the remaining one-third, thus resulting in cramming down the debt in accordance with the plan" explains Laurent.

The advantage for the smaller credit holder is that they all have to be consulted under Sauvegarde and treated in the same way as the large banks, no matter which way they decide to vote. The fact that all creditors are treated in the same way makes it less likely that France will see a "back-to-back" deal where a private equity owner collaborates with the senior lender to put a business into pre-pack administration in order to re-acquire it, as has been the contentious case in the US. If no agreement is reached in court, the maximum the court can do is impose debt repayment over a period of 10 years. Laurent believes that "failing the ability to find a majority, the firm would fall into recovery or liquidation, which generally means everyone loses out."

In the current economic climate and with changes in the law, banks are being forced to adapt and have been revising their options. Banks now do consider taking equity stakes in companies, since it might be the only thing which has value in the long run. The method is well tested abroad, where in some cases banks actively hope that a "good" company breaches its covenant, since it is only at that point that the bank has any power on its debt. In certain cases they actively seek to take a valuable equity stake in the company or even impose large waiver fees. De Germay warns that in France, while this has become an option, the fact that banks might have to take up equity as a last resort doesn't mean they are accostomed to it. On occasion in the past, banks that had taken equity in companies as debt repayment have not been able to manage them and the companies have folded. In the UK Barclays Bank has shifted a few assets into Barclays Ventures, its private equity arm. French regulations make that route difficult to follow for French bankers. Additionally, restructuring and turnaround are a specialised skill, but specialised people are thin on the ground and not easy to hire.

While there is some criticism of the sauvegarde law, it does save companies and jobs, whereas the traditional, more rigid administration of other European countries more often than not propels the company into liquidation.

Traditionally, covenant breaches in France and indeed the rest of Europe have been dealt with in a specific manner. However there is nothing in the traditional rule book on how to cope with the sheer number of covenant breaches currently occurring. With the downturn still very much a reality, portfolio troubles and covenant breaches are set to increase this year. France's decision to give more protection to companies, creditors and investors has resulted in the formation of more complex agreements in an attempt to save as many companies and jobs as possible.

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