Cutting through covenant complications resulting from COVID-19-linked borrowing
The shock to the UK economy caused by the COVID-19 crisis has resulted in record numbers of companies seeking financial assistance. Lenders have supported UK businesses with over 1.3 million loans totaling over £100 billion via the various coronavirus stimulus initiatives.1 Where companies typically borrowed to support working capital, fund capital investment or finance M&A activity, the implications of COVID-19 have forced many corporates to take on debt to survive. Lockdown challenges, government restrictions and social distancing resulted in swathes of businesses being either temporarily downsized or mothballed, with UK corporates now facing further headwinds that will extend the road to recovery.
Despite the recent extension of some government support measures, businesses are seeing the gradual retrenchment of state support, with the Job Retention Scheme closing in October 2020 (to be replaced with the smaller scale Job Support Scheme) and the Coronavirus Business Interruption Loan Scheme (CBILS) and its variants ending in November 2020. A second national lockdown has just been announced and for many, 2021 may present a perfect storm of unprofitable trading, new debt service obligations and deferred liabilities falling due for payment.
This unfavorable combination presents a myriad of challenges when setting covenants. Ordinarily, to get to an offer of funding, a business presents financial forecasts showing positive EBITDA and cash generation. Historically, when setting covenants, particularly those relating to debt service cover, the required levels of headroom form the basis for negotiation. Typically, management teams seek lighter covenants that provide meaningful capacity for underperformance, whereas lenders prefer covenants that provide earlier warning signs.
However, as a consequence of the disruption caused by COVID-19, many businesses are now forecasting negative EBITDA and high cash burn rates, at least in the initial recovery period and in some cases for much longer. The common debt service covenants, such as EBITDA hurdles or cash flow available for debt service (CFADS) ratios, can no longer be applied.
In these instances, finding covenants that are fit for purpose requires a more creative approach. Common conventions regarding testing frequency, look-back periods and minimum acceptable ratios often have to be set aside and replaced with unfamiliar considerations such as acknowledging opening headroom in debt service covenants, measuring covenants cumulatively and utilizing minimum headroom covenants as liquidity safeguards. In addition, when a business defers liabilities, it faces very lumpy future cash flows. CFADS covenants that are tested on a relatively short-term rolling basis become highly susceptible to future breaches, if large deferred liabilities are to be settled in short periods.
Case Study One
On one recent assignment we worked with a business borrowing under the CBILS scheme to fund the repayment of accumulated deferred liabilities, including trade creditors and HMRC. The business had retained liquidity by deferring these liabilities but faced a funding requirement to finance their unwind. Our covenant solution included a CFADS covenant set at a ratio to debt service costs of just one times, measured cumulatively for a two-year period and with the CBILS loan capital being an allowable income in the CFADS calculation. All three of these parts of the covenant would have been highly unusual prior to COVID-19, however, the covenant factored in the high opening headroom by being set at a ratio of one times; it acknowledged that the purpose of the loan was to fund legacy arrears by allowing the loan capital advance to be included in the CFADS working; and it counteracted the lumpy nature of the cash flow by being measured cumulatively rather than on a short-term rolling basis. An interlocking minimum headroom covenant was also added to provide the lender with extra protection.
Case Study Two
We have also seen situations where covenants can act as a barrier to a business pursuing its wider strategic objectives. One of our clients in the food manufacturing sector planned a sizeable capital investment in plant and machinery to facilitate growth and drive production efficiencies. The investment was to be funded via a combination of opening cash reserves, equity capital investment and trading profits in the period ahead of the investment. If the existing three-month rolling CFADS covenants had remained in place, this investment would have triggered a covenant breach. We restructured the covenants to be measured on a cumulative basis rather than on a three-month rolling basis and we adjusted the covenant definitions so the equity capital injection was allowable income in the CFADS calculation. These two adjustments prevented the company from being penalized for funding the investment from trading profits and support from the shareholders.
The old adage that ‘cash is king’ has never been more relevant. Businesses that have sufficient liquid resources to absorb a period of loss-making trading have the best prospects of survival. Where debt has been secured to fund these losses, the priority for covenants should be tracking cash flow performance to forecast. We have found that a more flexible approach to covenants allows businesses to navigate the ongoing challenges presented by COVID-19, while still providing adequate protection to lenders. In addition, we have found lenders to be pragmatic when it comes to setting creative covenants and there has been acceptance that where losses and cash absorption dominate, the normal covenants playbook may need to be left on the shelf.
Global Restructuring Advisory
Advising companies, financial sponsors and other stakeholders involved in challenging situations and distressed transactions.