COVID-19 Considerations in Private Credit Transactions
The COVID-19 coronavirus has caused significant disruption across the globe and injected considerable uncertainty into financial markets. Governmental authorities and market participants continue to assess the long-term effects of the coronavirus outbreak as the short-term effects begin to be felt. Of particular concern for many of our clients is COVID-19’s impact on lenders’ commitments under existing credit facilities and on borrowers’ financial performance metrics.
Analysis
Lenders must first recognize that the impact of COVID-19 will vary for each company based on a number of factors, including the company’s industry, geographic footprint and scope of operations. The treatment of related issues under each credit facility will similarly vary based on the language of the applicable credit documentation. As such, the issues highlighted below should be viewed in light of the applicable borrower’s specific circumstances and the actual provisions of the applicable credit facility.
- Considerations Regarding Existing Commitments. As many borrowers seek additional liquidity by drawing on their existing credit facilities amid the current economic uncertainty, lenders receiving borrowing requests should confirm that all required conditions to draw funds have been satisfied. One such condition is a requirement that the borrower “bring down” the representations and warranties made on the closing date. The following typical representations deserve extra attention in light of the pandemic outbreak:
- Solvency—Most credit agreements include a representation that the credit parties, either individually or on a consolidated basis, are solvent before and after giving effect to the requested loan. Lenders should determine not only who is covered by this representation but also the precise meaning of solvency under the credit facility.
- Material Adverse Effect—While almost all credit agreements include a representation as to the absence of any material adverse effect (“MAE”), the operation of this provision can vary based on the precise language of the contract. Some agreements may limit this provision to a borrower’s financial condition; others may include a borrower’s business, property or operations as well; others still may include impacts on a borrower’s future business prospects. The fact-intensive and contract-specific nature of this analysis creates considerable uncertainty in determining whether an MAE has occurred, and any such determination is subject to judicial review by the courts, which have noted the “heavy burden”[1] imposed on lenders seeking to rely on this clause.[2]
Another common condition to borrow funds is the absence of any defaults under the credit facility. The scope of this provision will ultimately depend on the protections negotiated in the applicable credit documentation, but lenders should confirm that the credit parties have complied with any provisions related to (1) cross-defaults with other agreements; (2) limitations on the use of proceeds; and (3) periodic financial reporting and information requirements. Some credit facilities, particularly those in favor of borrowers in highly regulated industries, may include additional defaults for the occurrence of certain specified events, such as work stoppages or the inability to deliver its goods or services. Lastly, lenders should verify that all applicable post-closing obligations have been met, particularly those with respect to control agreements and other security matters. Lenders wishing to minimize their risks of funding should confirm that the account into which an advance is deposited is subject to a control agreement and consider including so-called “anti-cash hoarding” provisions in their new credit facilities.
Going beyond the four corners of the credit documentation, we recommend that lenders take a holistic view of their portfolio when deliberating over any decision to decline funding a borrowing request to ensure a consistent position in relation to other similarly situated borrowers. Declining to fund a requested loan may result in litigation, and lenders may benefit from the perspective of litigators familiar with the relevant legal considerations in advance of making such a decision.
- Considerations Regarding Financial Performance Metrics. COVID-19 will have a substantial impact on many companies’ top and bottom lines. Some borrowers may seek to minimize these impacts by utilizing provisions in credit agreements that permit excluding certain costs, expenses and losses related to COVID-19 from consolidated net income or adding back such amounts to EBITDA (or, “earnings before interest, taxes, depreciation and amortization”) as an extraordinary, unusual or non-recurring item. The market appears to be accepting the notion that the impact of COVID-19 could very well be an extraordinary, unusual or non-recurring event. Credit agreements can vary significantly with respect to permitted exclusions from consolidated net income and add-backs to EBITDA and lenders should pay careful attention to whether the requested adjustments relate to extraordinary, unusual or non-recurring costs, expenses or losses, as each of these categories may be subject to different criteria and caps.
Borrowers may also seek to limit the impact of COVID-19 by adding back to EBITDA the proceeds or expected proceeds of business interruption insurance triggered by the COVID-19 outbreak. The terms of these insurance policies will vary, as will scope of the applicable EBITDA add-back, so lenders are well-advised to understand when an insurer is required to pay under the applicable policy and when (and to what extent) these proceeds may be included in the calculation of EBITDA.
The impact of these adjustments may be substantial, particularly given that amount of such adjustments may not be capped, and may extend beyond the current fiscal period. Further, the impact of these adjustments may reach beyond the financial covenants, as the financial covenants are often used to restrict a borrower’s ability to incur additional debt, make certain restricted payments, prepay other subordinated debt or take other actions. When negotiating the terms of new credit facilities, lenders should consider whether it is appropriate to minimize these impacts by capping the aggregate amount of these EBITDA adjustments for COVID-19.
Future Expectations
The long-term impact of the COVID-19 outbreak on credit markets remains to be seen, but the short-term effect on private credit transactions is already starting to appear. We expect for many borrowers to request waivers, forbearances and extensions with respect to their reporting obligations as the applicable year-end financial statements become due. We understand that some lending clients are discussing proposed extensions for the delivery of audit reports with respect to 2019 fiscal year-end; we anticipate similar requests for the delivery of quarterly financial statements related to the first quarter of 2020. To the extent lenders are willing to accommodate these requests, they should make clear the specific requirements at issue and narrowly tailor the scope of these accommodations to preserve their rights going forward, especially given the uncertainty inherent in forecasting future performance under current conditions. These lenders should further consider whether there are any other changes to the credit facility that should be addressed when documenting the requested accommodation.
We also expect borrowers to request other express accommodations for COVID-19. These might include, for example, EBITDA add-backs for COVID-19 (or pandemics generally) as discussed above, carve-outs to the representation regarding the absence of an MAE or other changes to the financial or operating covenants to provide additional flexibility on a short- or longer-term basis. We encourage lenders to consider any such requests in light of issues facing the particular borrower and the broader economic context. Confronting the challenges that lie ahead, for lenders and borrowers alike, will require creative thinking, clear lines of communication and a firm understanding of the issues companies are facing and the implications of any proposed accommodations.
Conclusion
COVID-19 is likely to have a profound effect on the global economy and credit markets. Lenders should carefully consider the issues raised as a result of this global pandemic when determining their obligations on existing credit facilities and negotiating the terms of new credit facilities.
For additional perspectives regarding COVID-19’s impact on leveraged lending transactions, please see Mayer Brown’s Coronavirus COVID-19 page. Our team of experienced lending lawyers is continuing to monitor ongoing developments with respect to COVID-19 and expects to provide additional updates as they arise.
[1] See Hexion Specialty Chemicals, Inc. v. Huntsman Corp., 965 A.2d 715, 738-39 (Del. Ch. 2008).
[2] For additional information regarding the intersection of COVID-19 and material adverse change clauses, please see “COVID-19: Material Adverse Changes Clauses in US Contracts.”
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