The Covid-19 pandemic has had a negative financial impact on businesses across all but a small number of sectors: from customers and staff having to make adjustments to their usual purchasing and working patterns respectively, to supply chain interruptions, market volatility and business failures on a level not seen in over a decade. This has brought financial covenant provisions and definitions in loan documentation into sharp focus – and none more so than the definition of earnings before interest and tax, depreciation and amortisation (EBITDA).
Lenders and borrowers have, in the main, had limited cause to focus on EBITDA in the context of look-back financial covenants. We anticipate this will change during the autumn and into 2021 as the number of months during the past year testing period affected by Covid-19 will start to exceed the number of more healthy pre-pandemic months included in calculations.
Most of the focus on the definition we have encountered has been in the context of drawstops and debt incurrence more generally. The documents we have had cause to examine did not contain any provisions that could justify (with a straight face) positive add-backs to EBITDA for profits that would have been generated but for the pandemic. However, a number did expressly provide for any proceeds of business interruption insurance to be included. Further, to the extent any costs arise in connection with the pandemic – such as redundancies, reorganisations, additional health and safety compliance costs and mothballing – a reasonable case could be made to include those costs under 'group initiative' add-backs and/or 'exceptional costs' exclusions (see further below).
In the case of business interruption insurance, attention should be paid to the timing for when such proceeds can be included - whether upon claim or on receipt. This is particularly relevant given well-publicised issues with making successful claims. It is also important to look at mandatory prepayment provisions in respect of claim proceeds. In the main, sponsor-backed deals contain far stronger borrower rights in these regards, relative to corporate transactions tracking closer to more lender-friendly Loan Market Association (LMA) terms.
The comparatively few new deals with which we have been involved over the summer and early autumn have not required any express treatment for Covid-19 to be made in EBITDA. This is primarily because these credits have been taken to market on the back of being Covid-resilient.
However, at least one larger deal has been reported in the market where a sponsor-backed issuer aggressively construed and presented "EBITDAC" for debt-incurrence purposes. This resulted in guidance being directed towards issuers from the European Leveraged Finance Association Ltd, the European Securities and Markets Authority and the Financial Reporting Council in May 2020. For instance, FRC guidance on exceptional items seeks to ensure even treatment of 'exceptional' revenues as well as costs, and discourages against describing amounts as 'non-recurring' or 'one-off' if they are also expected to arise in future periods. Borrowers (and their lenders) will need to determine the extent to which this guidance has an impact on reporting EBITDA in their documents.
Nonetheless, we expect that as markets start to tackle new deals for Covid-impacted businesses and more fulsome amendment/restructuring exercises take shape, sponsors and borrowers will search for ways to counteract revenue declines in their financials for the upcoming quarters, in order to provide headroom against covenant breaches and tightened restrictions under loan agreements. Lenders should expect to confront proposals for express EBITDA adjustments over the coming quarters, in the same way as we have already been negotiating Covid-related impact elsewhere in new and amended finance documents. Lenders will be mindful of limiting the latitude for borrowers to exercise subjective judgment in covenant determination and will, we anticipate, look to tight drafting, caps (noting 'exceptional items' are frequently uncapped in sponsor-backed deals) and time limits to mitigate the risk that 'EBITDAC' materially detracts from the usefulness of covenants at a time of stress.
Minimum cash covenants (which we have seen replace temporarily waived EBITDA-based covenants in some cases) may provide an additional level of comfort to lenders where there is concern that EBITDA adjustments inappropriately mask underperformance. But we suspect their inclusion will be forcefully resisted by borrowers outside of a stressed-financing, or potentially corporate lending, context.
The interpretation of EBITDA in financial covenants will take on greater importance over the next two quarters, and will potentially do so against the backdrop of a second wave of the Covid-19 pandemic. Businesses will also for some time be looking to rely upon permissions in the documents that are conditioned on EBITDA, or another metric calculated by reference to EBITDA, such as leverage. Leverage will often be a key metric for determining the operation of a margin ratchet too, going to the heart of debt service expense.
Whether in the context of existing deals or new deals, we suspect that lenders will be mindful not to allow any temporary Covid-based adjustments that give borrowers additional breathing space over the coming periods to impact margin ratchets or to bring forward flexibility to incur debt, make investments or even distributions. For borrowers requiring covenant resets that take into account the impact of Covid-19, it may be that minimum liquidity tests remain an important interim feature.
Of course, supply and demand will continue to dictate new deal terms. That is to say that well-backed sponsors and resilient businesses will likely be able to achieve financing on terms that apportion a larger degree of future Covid risk to lenders. In the main, though, the businesses falling into that category will be ones for whom the risk of Covid-related underperformance is likely to be lower.
Nevertheless, we foresee a lot more negotiation around agreeing appropriate definitions, business cases and covenant headroom in that much larger part of the market that will require financing over the coming short-to-medium term. It appears that liquidity will be available for that purpose, notably from debt funds in the shorter term, but we anticipate a much more even allocation of risk on this front, and indeed more generally, until the spectre of Covid-19 has been borne out to a greater degree of certainty.