Covenant amendment and maturity extension: the new refinancing?

Lenders and advisers have been busy with a swathe of requests from borrowers to amend their loan agreements. Possible or forecast financial covenant breaches, a looming scheduled maturity date, or substantial amortisation obligation have provided the impetus for borrowers, their shareholders and advisers to consider the alternatives. Unfortunately, there are not many.

Traditionally, there are a few different approaches when a serious (non-technical) default looms. A borrower can seek to sell some of its assets or divisions to generate some cash.

This is an unpalatable choice at the moment, with few buyers willing to contemplate much more than fire-sale prices and the process typically being lengthy, uncertain and likely to receive publicity.

Refinancing is of course predicated on lenders being prepared to lend. If there has been a deterioration of the borrower's credit quality or business trading, it usually means that refinancing will depend on tapping a variety of different lenders that are prepared to take an informed risk in return for greater reward, in the form of higher margins and fees, and possibly an equity upside in the form of warrants. The closure of the high yield bond market has also restricted the refinancing options for borrowers, although there have recently been some new issuances.

The difficulty in achieving a good price if selling is also a deterrent for lenders when deciding whether to lend anew - as it affects their assessment of the worst-case downside scenario and likely recoveries.

Even when a default is only a possibility, and as far off as three or four quarters, borrowers are considering - and being advised to seek - a financial covenant holiday, a permanent covenant reset or to extend the maturity dates for their loans as much in advance as possible. The process has become much more like a traditional stressed or even distressed debt refinancing.

Borrowers are:

appointing external restructuring advisers;

preparing elaborate data packs and timetables for the waiver request;

taking soundings from representative lenders;

considering whether to employ equity cures in conjunction with covenant holidays or permanent resets; and

paying considerable amounts in fees and increased margin to achieve the desired amendments.

What will it cost me?

The amount of fees and margin increase will vary considerably, depending on the circumstances of the borrower, and what the debt documents originally provided. It is not uncommon for borrowers to pay up to 100 basis points - and occasionally even more - in amendment fees to lenders. Margin increases are often in the region of 200 basis points, but this is dependant on likely leverage ratios.

Where chunky amendment fees are paid, the rationale is often that the margin increase is less than it would otherwise be, which has a lower cost to the borrower in the long term, while also providing an immediate up-front incentive to lenders to agree the amendment.

Non-monetary amendments to the loan documents may also be required. If a loan document previously did not include the full extent of financial covenants, additional covenants may be imposed.

One example would be the inclusion of a capital expenditure covenant, restricting the amount of capital expenditure that can be made by the borrower.

It is fairly common for stricter dividend payment restrictions to be applied - for example, dividend payments only being possible when (senior) leverage is less than 3x EBITDA.

There are also amendments dictating that matters which previously required only a majority lender vote are amended so that all lender consent is required. One example of this is in relation to acquisitions.

If any equity cure or similar boost to the capital structure of the borrower is provided by shareholders, the price of the waiver, in terms of fees and margin, tends to go down. Borrowers are commonly using all or a portion of any equity cure provided to buy back debt, as this can greatly enhance a balance sheet if the debt is trading at a substantial discount to par.

In return, lenders are agreeing to provide a covenant holiday for a period to allow the borrower to trade out of difficult conditions, or a permanent reset in certain circumstances (typically where additional equity is provided).

For a covenant holiday, the period will depend on the budget and forecasts of the borrower and likely date for improvement of trading conditions and cost reductions.

Of course, when the margin increases, if there is an interest cover ratio, cashflow cover ratio or fixed charge cover ratio, these will need to be reset on a long term basis. Typically, the headroom over the revised business case will be fairly tight - about 15% seems common. This is in contrast to the 25- 30% headroom that was frequently provided at the top of the market (based on what would now look like a very optimistic base case).

Provided there is enough time and financial incentive for lenders, lenders are tending to approve well thought through waiver requests.

The benefits are that the lenders realise some additional fees and margin immediately, avoid having to put a loan in workout territory (with the consequent impairment of value, or risks of recovery through an insolvency-related process) or selling on the secondary market at a loss.

From a borrower's point of view, it is often the only viable option, unless the borrower is prepared to wait and see whether the trading environment improves, lending markets open up and/or prices for selling assets increase.

However, the consequences include a substantial cash outlay in fees and ongoing margin and a likely inability to do much with the business apart from cut costs.

Where a business simply has the wrong capital structure going forward, a covenant reset or extension of loan maturity date will not fix the problem.

We may find that the short-term solution of a covenant reset or maturity extension leads to a spate of stressed sales and refinancings in a year or so in any event.

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