COVID-19 Coronavirus: Action Items for Private Equity Sponsors under Their Portfolio Companies’ Credit Facilities

As the COVID-19 health crisis deepens and increasingly rankles the financial markets, private equity sponsors should take the time to review their portfolio companies’ credit facilities and determine what flexibility they may have if their performance is adversely affected. In some cases, it may be advisable to draw down undrawn facilities now, in case it becomes difficult or impossible to do so at a later stage. According to Bloomberg News, the Blackstone Group is asking its portfolio companies to draw down credit lines to avoid liquidity crises, particularly in sectors impacted by the spread of coronavirus, like hospitality and energy, the latter of which is getting hit by drops in oil prices.

Two examples of areas for review in the credit facilities are the financial covenants, in order to estimate the likelihood of breach, and any reporting obligations that may be occasioned by the anticipated consequences of the pandemic.

Looking briefly at the financial-covenants issue, to the extent that non compliance is reasonably likely, the sponsor and management should carefully review the definition of “EBITDA” in the credit facility to ascertain whether any add-backs are available with respect not only to lost earnings attributable to the health crisis, but to the attendant costs and expenses that may be incurred in connection therewith, and whether the full benefit of those add-backs has been included in the sponsor’s calculation. If it can be said that the effects of the crisis are “extraordinary, unusual or non-recurring” (in the typical US parlance) or “exceptional, one-off, non-recurring or extraordinary” (the common test in European credit facilities), then an add-back to EBITDA may well be available for the associated expenses, charges and/or losses (or “items,” the arguably more generous term used in European credit facilities).

Also, as part of the EBITDA add-back review, sponsors should check to see if the borrower has business-interruption insurance in place. The proceeds of such insurance coverage, if paid, will often be permitted to be added back to EBITDA for purposes of covenant compliance. However, whether or not proceeds are payable for a business downturn short of a direct impact by the viral outbreak on the portfolio company itself is a fact-specific inquiry that depends on the language of the particular policy.

If a breach appears inevitable, sponsors might consider exercising an “equity cure” right to either cure the breach or even prevent a technical breach from occurring in the first instance. However, the right to an equity cure is usually limited, is not invariably available to cure EBITDA and, in any event, is not suitable to address a long-term problem, because it will at most have a 12-month effect in the EBITDA calculation (it will have a longer-term effect on the net debt calculation, but the impact is much smaller than its impact on the EBITDA calculation). A longer-term and more fruitful solution might be to negotiate a waiver or reset of the covenants with the lenders.

With respect to the financial-reporting review, portfolio companies’ credit facilities should be checked to see if they obligate the borrower to provide the lenders with periodic financial projections.

In some credit facilities, an event of default may be defined to include a material adverse change (MAC) in the borrower’s performance (as is invariably the case in European facilities). In most of these cases, it is unlikely that a MAC will be triggered as a result of a short-term downturn, but the language should be checked carefully to see if it is triggered by the expectation of a breach of financial covenants. In addition, sponsors of smaller borrowers should be aware that their credit facilities may have numerical thresholds built into their definition of MAC, which may make them more sensitive to a short-term downturn than otherwise.