What to expect when expecting a covenant default

When the US first began to react to Covid-19, many insiders assumed the pandemic would cause immediate technical and payment defaults throughout the middle market.  Since wide-spread economic lock-downs did not start until the last two weeks of March 2020, most borrowers were, in fact, able to scrape by their March 31^st covenants, making Q2 June covenants the more likely pinch point.  This theory held up as reported defaults in Q1 were in line with previous quarters.

All eyes are now focused on the expected Q2 June 30^th covenants, most of which will be reported no later than August 15^th.  Most lenders are bracing for significant leverage and fixed charge coverage violations for their borrowers.  This publication will briefly examine the events that got us here, speculate as to how lenders will react to the anticipated wave of defaults, and explore the factors that will drive lender behavior.

How did we get here?  The chart below shows that MM total leverage has consistently topped 4.75x for three years, going back to Q2 2017.  At first glance, 4.75x leverage seemed reasonable, particularly with elevated enterprise values across all sectors.  The issue here is not so much the leverage number, but rather how long the market supported these levels with minimal mandatory principal amortization and repayments.  How these loan portfolios age will determine the degree to which lenders will be accommodating when borrowers default.

One sector that was already feeling this crunch is healthcare.  Healthcare financings totaled $23b in 2019, leading all sectors.  Leverage in healthcare has increased slightly from 4.25x in 2013 to 4.75x in 2019, a modest increase given the elevated enterprise values the sector has enjoyed for the past 24 months.  But with the pandemic, many pockets in healthcare have been hit hard, notably dental, pain management, physical therapy practices, and various sector rollups that involve elective procedures.

Many of these businesses experienced several months with anemic revenue and negative EBTIDA during Q2 2020.  Once the Q2 2020 covenants are reported on August 15^th, the healthcare sector is expected to lead the pack with covenant defaults.

How will lenders react?  Most lenders spent the bulk of Q2 working with their borrowers to understand the magnitude of the pending earnings misses.  Although covenants are not due until August 15^th, most middle-market borrowers report monthly financials, so lenders should be abreast of the financial plight experienced by many through May 2020.  As a result, lenders are just waiting on the formality of the June reporting package.  From what we have gathered, both sponsors and lenders seem to understand and expect underperformance to be temporary for many borrowers.  Livingstone anticipates that in these cases, lenders will grant covenant waivers for the June reporting period and potentially proactively reset covenants through the end of the year.

However, as simple as it may seem to just “waive” a covenant, one must understand that direct lenders have their own constituents to appease.  In addition to having LP’s, most direct lenders also utilize leverage lines to help finance their businesses and enhance their equity yields.  Wells Fargo, JP Morgan, and Natixis are some of the largest lenders providing these leverage lines; and almost always, such lines are structured with asset-based formulas.

These facilities typically allow direct lenders to borrow up to 65% of the term loan facilities extended to borrowers; meaning that if a direct lender extends a $50mm credit facility for a leveraged buy-out (“LBO”), the leverage line of credit provides the direct lender with $32.5mm of capital.  Just as with any other asset-based facility, the leverage line provider has the right to reduce the advance rate if the underlying business/asset is not performing.  Events that could cause a reduction in an advance rate include a loan write-down by the direct lender, a material loan modification, or a payment default or modification of the repayment schedule.  These leverage line facilities behind the scenes can make covenant waivers and loan modifications more complicated for direct lenders. What may seem like a reasonable ask from a borrower may not be such an easy request to grant from the direct lender’s perspective.

By and large, we expect most lenders will waive June 30^th covenant defaults for businesses where the Covid impact appears to be isolated and temporary.  For borrowers where the impact of Covid is expected to be longer-lasting, these conversations are likely much more adversarial and combative.  In these cases, lenders will likely require additional conditions in exchange for covenant waivers, such as asking for updated projections and 13-week cash flow forecasts, and, in some cases, even requiring the borrower to engage a third-party consultant or turnaround advisor.

If the covenant default also comes with a request to fund additional capital for future liquidity needs, we do not anticipate lenders to be accommodative unilaterally. Instead, lenders will look to the equity holders to fund a portion or all of the capital necessary to meet short-term liquidity needs.  In a subsequent article, we will walk through what happens when there is a default, and the borrower and lender are in a standoff over financing the near-term needs of the business.  We will explore how both sides have historically acted and how these dynamics have changed with the prevalence of non-bank lenders leading the majority of middle-market LBOs.

Livingstone’s debt advisory team has experience positioning and marketing companies with unique or complex credit stories, soliciting financing options from a broad range of lenders and investors, and managing competitive financing processes.  Since 2007, we have completed 70 financing transactions for private-equity backed, and family-owned clients and our consistent deal flow ensures that we are abreast of the most recent pricing, terms, and structure available in the market.