If you plan to invest in distressed debt instruments (loans or bonds), you need to know the terms of the debt agreements. Ultimately, the only thing that gives you a claim to an issuer’s cash flows is the contract governing the issuer - lender relationship. These contracts are where you’ll find things such as maturity, rates, covenants and events of default along with the rights you have as a creditor. So it’s vitally important to understand the terms of your debt contract.
These documents (credit agreements in the case of loans, indentures in the case of bonds) are written by lawyers and are not easy reading, but it’s essential that you parse through them to understand the terms of the transaction. Many key terms of the loan / bond are highlighted on Bloomberg, but it is always wise to check the source document.
Let’s start with a loan. The primary document to review is the credit agreement. It contains all of the information you’ll need to understand the features of the loan. If it is a secured loan, you’ll need to review the Security and Collateral Agreement to learn which assets secure your claim. You can find the loan agreement on Bloomberg or, if you don’t have access to Bloomberg, in the company’s SEC filings (it’s normally filed as an exhibit to the 10K or 10Q filed nearest to the closing of the loan). The loan agreement typically has the following sections (though not necessarily in this order – different law firms have different templates for this document). The section you’ll spend the most time with – by far - is the negative covenants section.
1. Title page. Here you’ll find info such as the closing date of the loan, name of the borrower (legal entity), and the agent banks on the loan.
2. Table of contents.
3. Recitals. This section will tell you, again, the date of closing as well as the borrower(s) and guarantor(s) of the facility. The names of the borrowers and guarantors are enormously important because they are the only entities that are required to pay you principal and interest. Sometime, the terms Borrower and Guarantor are listed without naming legal entities. Then, you’ll have to consult the Definitions section of the agreement to see who the Borrower(s) and Guarantor(s) are. Which leads us to….
4. Definitions. You’ll need this section handy as you review the rest of the document. Every capitalized term in the document is usually defined in this section. And get used to working your way through definitions. Want to know the total leverage covenant? Ah, it’s Total Debt to Consolidated EBITDA, per the negative covenants. But, how are those terms defined? Is Total Debt reduced by the amount of Cash and Cash Equivalents? And what counts as Cash and Cash Equivalents? And how about Consolidated EBITDA? It starts with Consolidated Net Income. Is that just the net income figure from the company’s income statement or are their adjustments to make (there are ALWAYS adjustments to be made). You get the idea. But a few important definitions to always review include Applicable Margin (tells you the margin of interest you’ll earn above a base rate, such as LIBOR) and Maturity Dates. If you purchase a Term Loan B, you’ll consult the Term Loan B Maturity Date definition to see when the Term Loan B matures.
5. Amount and terms of the credits. This section includes such items as the amount of the facility as well as the amount of each tranche of the facility (so if a facility has a revolving credit and a term loan, it has 2 tranches). It will also include the amortization schedule of the facility, the amount of letters of credit that are permitted to be issued and a host of other items, many of which you really won’t have to consider. However, two items that you will have to review have to do with prepayments: mandatory and voluntary. What if the company sells an asset for cash, does it have to repay the loan? Or how about if it issues equity? What if an insured plant is destroyed by a fire, do the insurance proceeds repay the loan? Or what if the company, after satisfying all of its obligations (capital expenditures, interest, taxes, etc.) has Excess Cashflow (yes, that’s another defined term)? These questions are all typically addressed in the mandatory prepayments section. Voluntary prepayments are just as you’d guess – the company has excess cash that it would like to use to repay the loan. How can the company do that? Does it have to pay the loan back at par? Or maybe at a premium to par, like 101 in the first year of the agreement? All of this is found in the voluntary prepayments section.
6. Representations and warranties. These are a list of items that the Borrower and Guarantor state are true as of a certain date (items such as there are no material legal or environmental issues not previously disclosed to the lenders, etc.). Typically, you won’t spend a lot of time here.
7. Conditions. These are the conditions that allow the borrower to use the facility. There are usually two sets of conditions – conditions on the initial closing date and then each subsequent borrowing (for example, each revolving credit borrowing would be subject to meeting the conditions). The overriding principle here is that the borrower must be in compliance with the terms of the agreement each time it borrows. Again, not a place you’ll likely spend a ton of time.
8. Affirmative covenants. These are things the borrower must do to remain in compliance with the agreement. These include payment of principal and interest when do, delivery of financial statements within a certain amount of days after a quarter/ year end. You’ll look here to know when you must receive financial information, when the company is required to provide budgets, etc.
9. Negative covenants. This is the section you’ll spend the most time reading. It contains all of the things a Borrower CANNOT do. The big items include prohibitions on debt incurrence, prohibitions on lien incurrence, prohibitions on restricted payments (payments to junior capital providers such as dividends or share repurchases), limitations on investments and limitations on capital expenditures. A typical covenant will state that the borrower cannot incur, for example, any debt other than the debt outstanding at close SUBJECT TO the exceptions that follow. It’s the exceptions you need to know well. Can a borrower increase the amount of secured debt (thus diluting your claim on collateral)? Or can it raise an unlimited amount of unsecured debt? There are many other important issues addressed in this section. You’ll need to read each covenant carefully and have the definitions section handy, as you’ll be referring to it very frequently. I’d say that I spend 80% of the time reviewing a credit agreement on the negative covenants. A thorough discussion of negative covenants would be an entirely separate post.
10. Financial covenants. This is a section in the negative covenants, but it’s so important I’m discussing it separately. Historically, you could expect to find, at a minimum, a leverage covenant and an interest coverage covenant in most loan agreements. As the credit markets peaked in 2006 and early 2007, a good number of agreements were struck without maintenance covenants. Instead, they had incurrence covenants (for example, an issuer could issue debt provided they were in compliance with a 2.0x interest coverage ratio pro forma for the issuance). Complicating matters further, some agreements had maintenance covenants that applied only to the revolving credit facility and not the term loan. If that wasn’t bad enough, the revolver covenants only were operative if the company borrowed under the facility. So read the covenant carefully, including the preamble to the covenant. Don’t simply go straight to the table listing the relevant ratios. And, again, you’ll need the definitions section handy to accurately calculate the components of each ratio. A further note – another feature you’ll find in a number of 2006 and 2007 agreements is something called an Equity Cure. This is a provision that allows a financial sponsor to inject an amount of equity into the company to “cure” a financial ratio default. For example, if the company needed an extra $5 million of EBITDA to be in compliance with its leverage ratio, a sponsor would have the right (but not the obligation) to inject $5 million of equity and have that count as EBITDA for that quarter as well as the subsequent 3 quarters. Why is equity counted the same as cash flow from the company’s business? Good question. But things did get pretty silly in the loan market for quite some time.
11. Events of Default. Ok, here are the things that cause the company to be in default under the agreement. Non-compliance with negative or affirmative covenants, for example, or failure to pay interest or principal. Pay close attention to the cure periods. For example, a failure to pay principal when due is an immediate event of default, but there may be a period of days where the company can make an interest payment after it was due and still be in compliance (this would be the cure period).
12. The rest of the sections are fairly boilerplate and you’ll likely not spend much time reviewing them. They include a description of the role of the agent banks (as well as circumstances where a bank might be in default under the agreement) and other notices / miscellaneous items. These are not normally relevant to distressed situations.
Of course, this is intended to be a high level guide to reviewing a loan agreement. If you are going to invest in a distressed situation, it’s advisable to have a lawyer review the document as well. But this should give you a high-level roadmap to reading a credit agreement.
There are two things I would add:
ReplyDelete1. Many of these Agreements provide for a Revolver, a Term Loan, and Letters of Credit. There is typically a formula for determining how much the borrower can draw down on the revolver at any point in time (often based on percentages of inventory and accounts receivable). In many cases (although, not typically the cov lite period) there is also a commitment fee for the undrawn portion of the revolver.
2. There may also be a schedule for amortization of the principal of the loans (rather than simply a lump sum at the end of the term). These principal amortizations can also lead to a default or other credit event.
Hunter, do you agree?
Good basic overview. Most major lawfirms produce guides to reading/documenting the credit agreement. If you have a relationship with any lawyer, ask him for a copy.
ReplyDeleteIs anyone familiar with LSTA Xtract Bank Debt Review? They prepare summaries of credit agreements and comment on the strength or weakness of the covenants. I understand its a team of attorneys and they make it much easier to go through. Not sure of cost. Xtract does high yield covenant work as well and has a big following on the convert side.
ReplyDeleteLawrence - I think it should be mentioned that Revolvers (RC) you are talking about that are governed by a borrowing base are ABL RCs. They have very specific collateral (either AR or inventory...see HCA for an example). This effectively gives any Term Loan (TL) holders a second lien or the residual value of the AR or inventory. By the way, these are not incredibly common. However, this is changing (see Solo Cup) as this is a cheap form of financing for asset rich companies.
ReplyDeleteAlso check your credit agreements and indentures to make you there’s no carve out greenshoe language. If the credit agreement or indenture allows for a greenshoe or carve out language you should also check for Most Favored Nation (MFN) language. Also called Yield Protection / Maintenance. See Jarden (JAH) for a very good example.
Inter-creditor agreements: If the credit has second lien debt (bonds in drag…guess you could say that about most first lien too though) there will be an inter-creditor agreement. Mainly look for what the Standstill language says. Look for the number of days the Standstill lasts and what rights you as a current or potential holder of second lien have in regards to terminating the Standstill agreement. From my experience long Standstill periods cause very disorganized Steering Committees and cause the debt to trade erratically => creates opportunity but is a living hell when trying to mark your books.
If you're part of the original syndicated bank deal or have a relationship with the agent bank you should ask for a Term Sheet. While this is not a legal document in the same way as a credit agreement, it will have much of the basic information that everyone has already mentioned in 5 pages.
Assignment and participation also form a vital part of any credit agreement.The section is usually named as "Assignment and Participation" This section basically outlines the right of the lender to sub part his position to a third party. In most cases the borrower won't even know to whom the participation has been sold. Assignment can be by way of novation as well by assignment, the terms are usually specified in the credit agreement. The borrower consent is usually required for assignmen.
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