Financial Covenants

Course Overview

The debt markets fall into two broad categories; Investment grade or I-Grade (firms rated at least BBB) and High Yield (also referred to as Sub-investment grade or “Junk”). The High Yield segment includes two sub-categories, Corporates (listed or private e.g. Virgin Media) and those acquired by Private Equity firms (via LBOs or leveraged deals). Whilst many of the financing tools and techniques used by Corporates and LBOs are almost identical (senior debt, high yield) some instruments are peculiar to one segment only (e.g. mezzanine is rarely used in Sponsor-less deals). In the same vein, the Loan documentation and financial (and other) covenants are similar for both Sponsored and Sponsor-less deals.

This course deals with the various issues which relate to and impact on the financial covenants. First, participants will develop an understanding of the basic instruments used in these types of deals and how they interact with the financial covenants; second, participants will gain insight into how the Lenders approach the issue of debt capacity and risk as this affects which credit ratios which are selected as financial covenants; third, the course will cover the various scenarios developed by the various parties in the deal (Management /MLO case, Agreed/ Bank case, Downside Case) and how they interact with setting the level or headroom for the covenants; forth the course will cover the main financial ratios and the considerations which determine which credit ratios will be used in the loan agreement together with the various considerations that need to be borne in mind by both lender and Borrower; fifth, the programme will cover probably the most topical issue which is the nature of the key constituents which make up the financial covenants, particularly EBITDA and Net Debt both of which are purely defined terms and are not recognised by traditional accounting standards such as IFRS or UK/US GAAP.

This aspect is about to become even more important with the forthcoming revisions to the treatment of leases; last, the programme will look at financial ratios which apply to Inter-creditor issues affecting Senior and Junior debt (standstill etc) the issues affecting Bonds as these have gained traction over last 18 months and many structures now include a mix of loans and bonds following a refinancing.

The programme is aimed primarily professionals involved in Leveraged deals, such as Lawyers, Private Equity professionals, Bankers in Lending (all departments), Corporate financiers, M&A advisors, Debt advisory and Restructuring. Accounting professionals looking to expand their knowledge of this topic will also benefit as many of the issues embrace legal /documentary considerations. The programme adopts a pan-European approach to the topic but the presenter is able to discuss issues relevant in the USA in view of his exposure to those markets.

The programme is highly intensive and will require participants to do some pre-course reading. Case studies will be used during the programme and participants will also use an Excel spreadsheet which will enable them to evaluate how these aspects work in practice as a hands on approach is essential to develop a full understanding of these issue.

To derive full benefit from the programme, it is essential that attendees have a basic understanding of the main / headline elements of a Profit and Loss account (Sales, EBITDA, EBIT etc) and a basic understanding of the differences between P&L /Accrual Accounting on the one hand and Cash accounting on the other. For those attending, a short module will be provided in advance of the course which forms part of the pre-course reading.  It is to be emphasised that participants DO NOT require an understanding of IFRS or GAAP as the programme is designed to enable attendees to have enough basic knowledge to identify the key commercial issues

Course Content

Financing Instruments: summary

• Spectrum of financing instruments in LBOs
• Senior loans
• Mezzanine
• Notes – Senior and Subordinated
• PIK 1
• 2nd Lien 1

 Approach to debt capacity

• Structuring parameters – creating an appropriate financial structure (overview)
  • Percentage senior, junior and equity in debt capital structure
  • Ebitda multiples
  • Target returns for PE & Mezz Funds
• Lender’s approach to the credit decision
  • measuring debt capacity
  • security over assets
  • exit routes
  • Industry – cyclical, defensive or growth
  • Size of deal
• Overview of loan documentation and impact on deal/restructuring
  • LMA precedent
  • Loan as a radar system
  • Typical structure
  • Key parties (Obligors, Borrowers and Guarantors)
• The 4 different scenarios used in the deal – use, application and inter-action
  • Management case / MLO
  • Base / Bank or Agreed case
  • Downside Case &  Lockout test
  • Upside case

 Key financial ratios used by Lenders / covenants for Loans

• Leverage ratios (Balance sheet and P&L ratios)
  • Total Debt / EBITDA
  • Senior Debt/ EBITDA
• Interest coverage
  • EBITDA / Total interest
  • EBITDA / Senior Interest
  • EBITDA / Cash interest
  • [EBITDA – Maintenance Capex] / Cash Interest
  • [EBITDA – Capex] / Cash Interest
  • Fixed Charge cover ratio

Selecting the appropriate ratio for the deal

• Cash flow ratios (ADSCR)
• CADS / Total Debt Service
• CADS / Senior Debt service
• Capex ratios
• Capex Baskets
• Net Asset Value
• Ratios used in (Infrastructure) cross-over credits
  • ADSCR
  • Loan Life cover
  • Project Life cover
• A quick look at key differences in the US market
• The Guarantor coverage test
  • What percentages shall apply to Guarantors
  • Which “guarantors” are included
  • What items should be included in the test – gross assets, net assets, sales

 Key considerations re the Covenants

• Which ratios should be used as covenants & why – pros and cons of each as a covenant
• How many covenants are needed
• Which companies should be included
• Definition of “Group” – what is included
  • Effect of Subsidiaries and/or Material Subsidiaries
  • What is “Material” cover (Sales, profits, assets?)
  • What percentage is appropriate
  • Impact of dormant Subsidiaries
  • What happens when Subsidiaries become “material” or cease to be “dormant”
• How should the ratios be tested
  • Historic TTM/LTM, forecast, both (quarterly, monthly)
  • Annualising in first year and traps for the unwary
• Consequences of a breach – is it an Event of Default or can it be cured
  • Equity cures – What are they, good or bad
  • What should be cured (EBITDA or Debt)
  • Treatment of “overcures”
  • Is the cure EBITDA? And if yes what effect will this have
  • How should the cash be used? (Why repayment of debt is not appropriate)
  • What level of “Headroom” is appropriate
• Impact of Clean-ups
• Typical periods in P2Ps and private deals
• Approach for small bilateral deals vs clubs or syndicated transactions

 A closer look at the key constituents of the ratios2

• EBITDA (note: is a defined term in the Loan Agreement, it is not a GAAP or IFRS term)
  • Simplistic calculation of EBITDA
  • Consistency of application (dealing with Accounting changes under IFRS, GAAP etc)
  • What should be included
  • What should be excluded
• Hot issues
  • Impact of Leasing on EBITDA (Operating vs Finance Leases)
  • Forthcoming changes in IFRS & impact on covenants
  • Capitalising costs
  • Forex gains/losses on Intra-group transactions
  • Debt buy-back gains & impact on EBITDA
  • Restructuring costs
  • Exceptional, extraordinary items & other “one-off”, non-recurring items
  • Related party income
  • Differences between US & UK GAAP definition of extraordinary items
• Net Debt
• Simplistic calculation of Net Debt
• Example of net debt items
• Treatment of PE “Debt” and Vendor Loans
• Treatment of cash and cash equivalents
• Esoteric instruments used in Luxcos3 (TPECs & CPECs)
• Impact of Leasing on Net Debt (Operating vs Finance Leases)

 Key financial covenants for Bonds

• Fixed charge cover ratio (Incurrence ratio)
• Typical level
• Key constituents of the ratio
• Permitted debt
• Definition of Group and Restricted subsidiaries

 Inter-creditor issues

• Financial covenants for mezzanine and second lien and interaction with senior debt
• Covenant Levels for mezzanine and 2nd Lien
• Standstills and enforcement
• Other issues
• Cross default and interaction of convents laminated structures (Loans, Bonds and junior debt)

“Very detailed and professional explanations. Good case studies.”

Delivering this course in-house for you to a number of participants could be very cost effective. Please call us on 020 7387 4484 to discuss this further.

If you have any questions about this seminar please write to us at post@redcliffetraining.co.uk.