Financial Covenants: Communicating With Your Lenders Early Is More Important Than Ever

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With the onslaught of news that changes almost hourly describing the extent and impact of the Covid‑19, there can be no doubt that this outbreak is a global event that will impact most businesses and industries. This means that now is the time to (a) take a candid look at your business to try and determine the short, medium, and long-term effects of Covid-19, (b) thoroughly review your loan agreement to see if financial covenant relief is needed, and (c) develop a plan to speak with your lenders.

Besides getting ahead of the issues that might arise in the future as a result of Covid-19, now is a good time to open up a dialogue with your lenders because they have specifically been encouraged by government regulators to work with borrowers who are or may be unable to meet their obligations under their loan agreements as a result of the pandemic.

Financial Covenants

One of the first things to understand is whether the financial covenants, if any, in your loan agreement are regular maintenance covenants or covenants that spring into application because of the occurrence of one or more specified events.

If they are springing covenants, have the specified circumstances such as EBITDA and debt level triggers occurred or are they likely to occur? It may well be the case that a drop in operating performance will create a decline in EBITDA levels, putting pressure on leverage and, potentially, liquidity. A thorough analysis of the permitted add-backs to EBITDA, the definition of consolidated net income and other related definitions will be necessary to fully understand the impact of operating performance on the financial covenants, keep in mind that most financial covenants are calculated on a trailing 12‑month or four‑quarter basis, so the impact sustained in 2020 will continue to be felt for at least some portion of 2021.

Potential loan modifications designed to ease the impact of Covid-19 include:

Liquidity

  • Deferral of interest payments or insertion of payment in kind

  • Change frequency of interest payments from monthly to quarterly

  • Deferral of amortization payments of principal for some limited period of time or to the end of maturity (perhaps with a cap or balloon)

  • Mandatory prepayment relief

    • No excess cash flow payment

    • No prepayment from proceeds of extraordinary receipts or insurance proceeds (e.g., business interruption insurance)

    • No prepayment with proceeds from an equity issuance

    • For ABL facilities, temporary changes to advance rates or eligibility criteria and/or no prepayment required if a reserve causes the borrowing base to be out of compliance

Financial Covenants

  • Potential add-backs to EBITDA:

    • Lost revenue related to pandemic

    • Goodwill impairment

    • Expenses related to certain business optimization activities

    • Costs and expenses related to establishing a new supply source, finding replacement goods or hard costs specifically incurred in connection with Covid-19

  • Other EBITDA suggestions:

    • Allow add-backs specifically related to the impact of Covid-19, whether or not deducted from the calculation of consolidated net income (increased hygiene and cleaning costs, temporary shut-down costs, costs associated with retaining people not utilized, other non-recurring, unusual costs)

  • Provide for a holiday from compliance with financial covenants for some period of time (e.g., two or more quarters, with discretion of agent to extend)

  • Implement or expand equity cures

  • Other miscellaneous suggestions

    • Allow borrower to buy back debt and/or sponsor to purchase debt perhaps with limited voting rights

    • Permit temporary equity infusion (no mandatory prepayment) that can be taken back out when the business stabilizes

    • To the extent the borrower takes advantage of any government’s relief plans, the proceeds should not have to be used for mandatory prepayments, and if in the form of debt, the relief should be permitted, and the debt should not count for purposes of financial covenant calculations

    • At least for borrowing purposes, eliminate the impact of a MAE representation and/or event of default caused by Covid-19 events

Conclusion

The prevailing message currently across the country is that “we are all in this together,” so now is the time to contact your lenders and work collaboratively to develop a plan to get through the pandemic. Conduct a thorough and realistic assessment of your current business operations and prospects, carefully review your loan agreement and then develop a reasonable set of “asks” for your lenders that will best ensure your company’s ability to withstand these volatile times.

Our team has extensive experience assisting clients with financing matters, let us know if you have any questions at info@bhlegal.ca.