The impact of COVID-19 is developing fast across the globe and across industries. We outline a selection of the issues which we are currently busy discussing with lenders, sponsors and portfolio businesses in various jurisdictions.
Can the impact of COVID-19 constitute a MAC event?
Just how long and severe the impact of the global spread of coronavirus will be is currently unknown. Things are changing daily. The longer term impact on a particular business is also very difficult to predict as is the extent to which steps being taken around the globe by central banks, governments and regulators to ease the impact for many businesses will help.
Understandably parties are reviewing ‘material adverse change’ (MAC) provisions in their finance documents.
The occurrence of a MAC:
- is often an event of default in its own right, which if breached allows the lender to accelerate the loan and enforce security; and
- also acts as a draw-stop for a new loan and sometimes for the rollover of an RCF advance, as it will usually be a condition for utilisation that the borrower confirms that no Default is continuing or would result from the proposed drawing. (Whilst the LMA standard form also provides for a drawstop in the case of an RCF rollover loan if an Event of Default is continuing, in practice most often in negotiation this is changed so that Rollover loans are typically only stopped from rolling over on declared default.)
Yet the MAC clause is rarely invoked as the sole reason for refusing to allow a drawdown or for accelerating the loan.
The reasons for this are many, but include:
- the requirement for a detailed dissection of the MAC definition in each transaction against the factual matrix of what is then known;
- that in the majority of cases, the decision as to whether a MAC has occurred will involve an objective decision based on the facts and circumstances;
- whether the MAC has to impact "the business, operations, property” of the borrower or whether it is wider and also includes a material change in the financial condition and/or prospects of the borrower;
- whether one is to look only at the borrower itself or has to show that there is such an impact on “the Group taken as a whole" (which is often harder to demonstrate); and
- the need to assess whether the circumstances have caused a temporary or more permanent adverse change in a borrower's business.
Lenders will also be very conscious of a potential impact on their reputation for relying on a MAC default (either to accelerate or to draw stop) in the situation where another default cannot be cited alongside it, as well as the risk of having to compensate a borrower should it successfully argue in court that the lender wrongly relied upon the MAC clause.
Financial covenants, EBITDA add-backs and Equity Cure
To mitigate the effect of falling revenues and/or increased costs resulting from coronavirus fears and the requirement for social distancing and self-isolation, borrowers are examining closely the financial covenant definitions and equity cure provisions in facilities agreements.
In particular the following questions are being carefully analysed:
- Have all available mitigants, such as add-backs, permitted synergies and cost saving initiatives been included in the calculation of the relevant financial ratios, as well as their pro forma effect? If so, are they capped?
- Does the definition of EBITDA permit add-backs for any exceptional, one off, non-recurring or extraordinary items or any material items of an unusual or non-recurring nature which represent losses which could be applied in relation to losses linked to this pandemic?
- Can losses that are covered or expected to be covered by business interruption insurance be added back to EBITDA? If so, do the insurance proceeds actually have to be received in order to effect the addback? And do you exclude any excess recovery (if relevant)?
- Are equity cures permitted? How many and how will they be applied in the calculation of the financial covenants (increase of EBITDA versus decrease of net debt / is cash permitted to be retained in the company versus mandatory prepayment)?
- Are overcures permitted?
- Is it going to be preferable, given the constraints of the particular equity cure provision, for the sponsor to inject additional equity outside of the equity cure regime?
- Does the document include the deemed cure concept and if so, what is the interplay (if any) between that provision and the equity cure provision?
The EBITDA add-back regime is also of vital importance with a view to any applicable net leverage ratio based step-ups and step-downs in margin ratchets and pricing and grower basket concepts to ease covenant restrictions to the borrower’s business.
Reliance on availability of RCF
As usually happens in times of financial distress, we are seeing borrowers asking to draw down in full their RCF and other working capital lines to be able to meet their ongoing payment obligations towards their employees, landlords, insurers and business partners. The impact of this should it trigger a springing RCF covenant will need to be considered.
Market participants seem increasingly sensitised to borrowers struggling to meet clean down obligations. In addition to waiver requests, we are expecting sponsors to consider injecting equity with a view to enabling the company to facilitate clean downs or meet repayment obligations.
Events of Default
Besides MAC, and obviously the spectre of a non-payment default should it come to that, consideration should be given as to whether the borrower may be in breach of any other events of default which would (amongst other things) entitle the lenders to draw stop any undrawn portion of the facilities and/or to accelerate repayment of outstanding amounts:
Given that insolvency / insolvency proceedings events of default may be triggered should a member of the obligor group enter into discussions with its creditors to re-schedule any of its debt or to agree on suspension of payments, the borrower should proceed with caution should it need to enter into any such discussions.
Since the impacts of COVID-19 and business interruptions may inevitably result in breaches of contractual obligations vis-à-vis customers, suppliers and other creditors, cross defaults and litigation and creditors’ process events of default may be triggered.
With government shutdowns of shops, restaurants, gyms and other places where people gather, many businesses may trigger the cessation of business event of default.
Where a business has been forced to close due to government intervention as part of its pandemic control provisions, such a breach has to be read in that light and also against any state measures designed to protect business from the ramifications of that action. For instance, in Germany, as an addition to the government aid package already resolved by the Federal Government, the German legislator is currently preparing a statutory suspension of the obligation of companies to file for insolvency with effect until 30 September 2020. This applies where the grounds for that insolvency are based on the effects of COVID-19 and where there are reasonable prospects of a successful restructuring. The suspension is designed to give companies the opportunity to obtain the promised government funds as the usual legal obligation for a German company to file for insolvency within three weeks is considered too short to enable the business to clear the necessary bureaucratic hurdles to access that funding and to agree a restructuring.
Transfer restrictions may fall away
Many facilities agreements provide for restrictions on lenders making transfers without borrower consent to fall away whilst an Event of Default is continuing. Some agreements limit this to certain named key Events of Default (such as non-payment, financial covenant breach and breach of negative pledge) and some prohibit transfers to ‘competitors’ and/or to ‘hedge funds’ or ’loan to own investors’(or the like) notwithstanding the occurrence of any event of default. These transfer restrictions (and related definitions) should be analysed very carefully if a lender decides to trade out of the credit. If an outright transfer is not permitted is it possible to sub-participate instead or do the same restrictions apply (which often they will if voting rights are also to be transferred)?
In a ‘back to the future’ moment, debt buy-backs (last seen in the aftermath of the 2008 financial crisis) may become attractive if lenders are willing to sell sub-par. The terms of the documentation will govern the extent to which this is possible and the terms on which it has to be done.
Giving life support to business
These are unprecedented times. Many sponsors will be very glad of the protections they built into the terms of their financings. They still may not be enough to prevent a default but there is a strong will from governments and central banks to protect the global economy and, in our experience, a general desire on the part of lenders to do their bit.
The Hogan Lovells global leveraged and acquisition finance practice is engaged in monitoring and responding to the market developments arising from Covid-19 in multiple jurisdictions.