Structuring Covenants in Leveraged Loans

and High Yield Bonds for Borrowers and Lenders Analyzing Financial and Performance Covenants,

Equity Cures, Builder Baskets, Events of Default and More

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THURSDAY, APRIL 3, 2014

Presenting a live 90-minute webinar with interactive Q&A

Maura E. O'Sullivan, Partner, Shearman & Sterling, New York

Benjamin M. Cheng, Counsel, Shearman & Sterling, New York

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April 3, 2014 Maura O’Sullivan– Partner – New York mosullivan@shearman.com Benjamin Cheng – Counsel – New York bcheng@shearman.com

Structuring Covenants in Leveraged Loans and High Yield Bonds for Borrowers and Lenders Strafford Webinar Program

6

Table of Contents

Loans vs. Bonds 7

Financial Maintenance Covenants 8

Financial Maintenance Covenants (continued) 9

Benefits for Lenders of Financial Maintenance Covenants 10

Borrower’s Response to Financial Maintenance Covenants 11

Borrower’s Response to Financial Maintenance Covenants (cont’d) 12

Covenant-lite Loans: Why now 13

Debt Incurrence 14

Acquisitions 15

Repayment of Junior Debt 16

Builder Baskets 17

Restricted Subsidiaries 18

Restricted Subsidiaries (cont’d) 19

Events of Default 20

Opportunities and Risks 21

NYDOCS02/1023813

7

Loans Vs. Bonds

Historically, syndicated bank loans had tighter covenants than high yield

bonds

One of the main differences was the inclusion of financial maintenance covenants

in syndicated loan agreements

Maximum leverage ratio

Minimum interest coverage ratio

Minimum fixed charge coverage ratio

Other significant differences:

Bonds have incurrence style negative covenants while loans historically have had fixed

dollar baskets as exceptions to the negative covenants

Floating vs. Fixed interest rates

5/6 year maturity for term loans vs. 8/10 year maturity for bonds

8

Financial Maintenance Covenants

Require borrower to meet certain financial performance levels on a periodic

basis

Performance levels generally tied to model provided to lenders prior to

commitment

Covenants can be applied on a quarterly basis or at any time basis

Failure to comply results in an event of default (typically no grace period)

Maintenance Covenants are applicable whether or not a borrower intends to

engage in a transaction that may be limited by the negative covenants

Maximum leverage ratio → the borrower cannot exceed a specific ratio of

debt to a cash flow measure (typically EBITDA)

Total debt

Secured debt

First lien debt

9

Financial Maintenance Covenants (continued)

Minimum Interest Coverage Ratio → the borrower must have at least a

specified ratio of cash flow (EBITDA) to interest expense

Total interest

Cash interest

Minimum Fixed Charge Coverage Ratio → the borrower must have at least

a specified ratio of cash flow (EBITDA) to fixed charges

Interest expense

Capital expenditures

Scheduled amortization payments

Rent expenses

Dividends

10

Benefits for Lenders of Financial Maintenance Covenants:

Maintenance covenants provide early warnings of financial difficulty

Payment default

Bankruptcy default

Early warnings allow lenders to be pro-active in devising solutions

Early seat at negotiating table with borrower

Maintenance Covenants can deter borrower from pursuing transactions that

have negative impact on cash flow

11

Borrower’s Response to Financial Maintenance Covenants

Equity cures

Cash injection within 10 business days after delivery of financials

Standstill

5 for life of loan and 2 for every 4 quarters

Not any larger amount than is necessary for the cure

Disregarded for other purposes

Cash injection increases the cash flow companent of the ratio and may also be negotiated

to decrease the debt companent

Net leverage tests

Maximum cash

Unrestricted cash

Cash of foreign entities

12

Borrower’s Response to Financial Maintenance Covenants (cont’d)

Springing Covenants

Triggered if outstandings under revolver exceed a certain percentage of

commitments

Letters of credit often exclude in calculation

Cushion to base case model

Covenants-lite term loans

13

Covenant-lite Loans: Why now

Key factors that today are affecting market dynamics:

Interest rates are low so more debt investors are looking to the leveraged market

for higher yields

Belief that interest rates will increase so floating rate debt (loans) is preferable to

fixed rate debt (bonds)

Leveraged acquisition activity has not increased enough to keep up with demand

As a result, certain borrowers have more negotiating leverage to obtain

more favorable terms

Private equity sponsors

Higher rated leveraged borrowers

14

Debt Incurrence

Fixed dollar baskets

Ratio basket

Cash interest coverage ratio, fixed charge coverage ratio, leverage ratio

“if, on the date of such incurrence and after giving effect thereto on a pro forma

basis (including giving pro forma effect to the use of the proceeds thereof) no

Default or Event of Default has occurred or is continuing, the Issuer and the

Restricted Subsidiaries may incur Indebtedness if the Issuer’s Consolidated Fixed

Charge Coverage Ratio for the most recent four full fiscal quarters for which

financial statements are available immediately preceding the incurrence of such

Indebtedness taken as one period is at least equal to or greater than 2.00 to 1.00”

Grower components so that baskets can grow as business expands

The greater of $__ and __% of total assets

Ability to secure new issuance of debt with collateral on either pari passu basis or

junior basis

Test if typically a maximum total secured leverage ratio, or a first lien leverage ratio

15

Acquisitions

Traditional loans would limit acquisitions to a fixed amount per year or over

the life of the loan (sometimes with a per acquisition limit)

Covenant lite loans allow unlimited acquisitions subject to pro forma

compliance with an incurrence test (leverage ratio or interest coverage)

If the covenant lite term loan is paired with a revolver then the test might be

pro forma compliance with the financial covenant for the revolver regardless

of whether it is then applicable

Generally will include a limit on acquisitions of non-credit parties

16

Repayment of Junior Debt

Junior Debt can be junior lien debt, unsecured or subordinated debt

Traditional loans would have a small fixed dollar basket with which the

borrower could prepay the junior debt

Junior debt is typically more expensive than first lien senior secured debt and

therefor it is beneficial for borrower to pay down the junior debt

However, this would mean that the senior lenders would have lost the cushion of

junior debt in a work-out scenario (through the depletion of the borrower’s cash)

Covenant-lite loans may allow the borrower to prepay junior debt subject to

compliance with an incurrence test (typically a leverage ratio)

17

Builder Baskets

In covenant-lite loans, for acquisitions, investments and repayments of

junior debt, one would normally see builder baskets

Starter basket (fixed dollar) + retained excess cash flow or 50%

consolidated net income

Plus:

Equity injections or issuances

Returns on investments

Asset sales proceeds

Leverage test for use of builder basket for dividends

18

Restricted Subsidiaries

Traditional loans would typically cover all subsidiaries of the Borrower in

the representations, covenants and events of defaults

Covenant-lite loans typically permit the concept of unrestricted

subsidiaries and therefore only restricted subsidiaries of the Borrower

are subject to the representations, covenants and events of defaults

Restricted Subsidiaries vs. guarantor subsidiaries

Traditional loans would have restrictions on money/assets flowing from

creditor group to non-creditor group

Bonds typically have restrictions on money/assets flowing from

restricted group to unrestricted group

19

Restricted Subsidiaries (cont’d)

Bonds do not typically have restrictions on money/assets from credit

group to non-creditor group

Covenant lite loans typically continue to have restrictions on

money/assets flowing to non-credit group

20

Events of Default

Bonds Senior Bank Loans

Default in interest

payment

30 days grace period 3-5 business days

grace period

Covenant default 60 days grace period

other than mergers,

asset sales and

failure to repurchase

upon a change of

control

None for negative

covenants and certain

affirmative covenants;

30 days for others

Default in other

material debt

Cross acceleration Cross default

21

Opportunities and Risks

Opportunities for sponsors/issuers: better financial terms

Opportunities for investors: risk arbitrage

Risks:

Investors beware

Systemic risk and regulatory tightening