April 2020
In Part I of this blog post series, we provided an overview of financial covenants in cash flow loans with a particular focus on the leverage ratio covenant and fixed charge ratio covenant. In this blog post, we will take a closer look at the maximum leverage ratio covenant and how it is negotiated in practice.
Maximum Leverage Ratio Priority Considerations
As previously discussed in Part I https://martinllp.net/its-all-about-the-leverage-increasing-rollover-participants-equity-share/, the maximum leverage ratio covenant is one of the most commonly used financial covenants in middle market credit agreements and is often highly negotiated. The borrower has a vested interest in establishing a maximum leverage ratio covenant level that affords the business adequate flexibility and cushion. The lender, on the other hand, has a vested interest in setting the maximum leverage ratio covenant at a level that provides an early warning system for financial distress. Ultimately, however, both parties are better off when the borrower has the financial and operational flexibility to make appropriate investments and operate the business for profitable growth. For this reason, getting the maximum leverage ratio covenant thresholds set at appropriate levels is a key determinant in the long-term success of the borrower-lender relationship.
Maximum Leverage Ratio Covenant Negotiation
The leverage ratio describes total debt relative to earnings available to service such debt. In most cases, earnings before interest, taxes, depreciation and amortization (EBITDA) is used as the denominator in this formula. Ultimately, maximum leverage ratio parameters are set via the definitions of Indebtedness and EBITDA.
The negotiation often begins with a determination of which entities should be included as loan parties and/or guarantors under the credit facility. Lenders usually require all material subsidiaries to be included as loan parties and subject to financial covenant restrictions. By including all material subsidiaries as loan parties, the lender mitigates the risk of loan proceeds or company assets slipping outside the scope of the collateral package.
The definition of Indebtedness as used in the maximum leverage covenant typically includes all forms of borrowing whether by loans or the issuance or sale of debt securities. In some cases, additional items are included to capture financial liabilities akin to borrowed money including (1) deferred purchase price of property or services, (2) capitalized lease obligations, (3) payment obligations for mandatory redeemable preferred stock, (4) third party obligations secured by assets of the borrower, and (5) borrower guarantees. Lastly, the definition of Indebtedness for purposes of calculating the maximum leverage ratio can be further narrowed to include only secured first-lien debt, total secured debt or total debt. The Indebtedness definition is largely a factor of the size of the transaction and the risk appetite of the lender with the largest, most stable borrowers receiving outsized financial covenant flexibility.
The definition of EBITDA for purposes of the maximum leverage ratio covenant is used as a proxy for the borrower’s available ordinary course operating cash flow to service debt obligations. As such, the EBITDA definition is heavily negotiated as a key input for multiple financial covenants. The definition of EBITDA is typically adjusted to account for non-recurring, non-cash and extraordinary items. Lenders typically seek to include percentage or hard dollar caps to EBITDA add-back items in order to mitigate the borrower’s ability to manipulate the overall EBITDA calculation. Similar to the Indebtedness definition negotiations, the largest, most stable borrowers enjoy stable operating cash flows to service debt obligations and hence are able to negotiate increased financial covenant flexibility.
In Part III …
In our next blog post, we will take a deeper dive into the minimum fixed charge coverage ratio and related definitions. Stay tuned …
