Covenants are provisions in credit agreements and indentures intended to protect against the deterioration of the borrower/issuer's credit quality. They govern specific actions that may or may not be taken during the term of the debt obligation. Failure to comply with a covenant may trigger an event of default, which allows investors to accelerate the maturity of their debt unless amended or waived. There are three primary classifications of covenants: affirmative, negative, and financial.
While many of the covenants in credit agreements and indentures are similar in nature, a key difference is that traditional bank debt features financial maintenance covenants while high yield bonds have less restrictive incurrence covenants. As detailed in Exhibit 4.22, financial maintenance covenants require the borrower to "maintain" a certain credit profile at all times through compliance with certain financial ratios or tests on a quarterly basis. Financial maintenance covenants are also designed to limit the borrower's ability to take certain actions that may be adverse to lenders (e.g., making capital expenditures beyond a set amount), which allows the lender group to influence the financial risks taken by the borrower. They are also designed to provide lenders with an early indication of financial distress.
Bank Debt Covenants Exhibit 4.22 displays typical covenants found in a credit agreement. With respect to financial maintenance covenants, the typical credit agreement contains two to three of these covenants.58 The required maintenance leverage ratios typically decrease ("step down") throughout the term of the loan. Similarly, the coverage ratios typically increase over time. This requires the borrower to improve its credit profile by repaying debt and/or growing cash flow in accordance with the financial projections it presents to lenders during syndication.
EXHIBIT 4.22 Bank Debt Covenants
Affirmative Require the borrower and its subsidiaries to perform certain actions. Covenants Examples of standard affirmative covenants include:
■ maintaining corporate existence and books and records
■ regular financial reporting (e.g., supplying financial statements on a quarterly basis)
■ maintaining assets, collateral, or other security
■ maintaining insurance
■ complying with laws
■ continuing in the same line of business
58 "Covenant-lite" loans, a feature in the leveraged loan market that experienced a surge during the credit boom of the mid-2000s, represents an exception to the aforementioned norms. Covenant-lite packages were typically similar to that of high yield bonds, featuring incurrence covenants as opposed to financial maintenance covenants. Covenant-lite term loans in LBO financing structures were more typical when structured alongside an ABL facility because commercial banks would not agree to covenant-lite cash flow revolvers unless the revolver benefited from a super-priority security interest in the collateral.
EXHIBIT 4.22 (Continued)
Negative Limit the borrower's and its subsidiaries' ability to take certain actions
Covenants (often subject to certain exceptions or "baskets").(a) Examples of negative covenants include:
■ limitations on debt - limits the amount of debt that may be outstanding at any time
■ limitations on dividends and stock redemptions - prevents cash from being distributed by the borrower to, or for the benefit of, equity holders
■ limitations on liens - prevents pledge of assets as collateral
■ limitations on dispositions of assets (including sale/leaseback transactions) - prevents the sale or transfer of assets in excess of an aggregate threshold
■ limitations on investments - restricts the making of loans, acquisitions, and other investments (including joint ventures)
■ limitations on mergers and consolidations - prohibits a merger or consolidation
■ limitations on prepayments of, and amendments to, certain other debt - prohibits the prepayment of certain other debt or any amendments thereto in a manner that would be adverse to lenders
■ limitations on transactions with affiliates - restricts the borrower and its subsidiaries from undertaking transactions with affiliated companies that may benefit the affiliate to the detriment of the borrower and its creditors(b)
Financial Require the borrower to maintain a certain credit profile through
Maintenance compliance with specified financial ratios or tests on a quarterly basis.
Covenants Examples of financial maintenance covenants include:
■ maximum senior secured leverage ratio - prohibits the ratio of senior secured debt -to-EBITDA for the trailing four quarters from exceeding a level set forth in a defined quarterly schedule
■ maximum total leverage ratio - prohibits the ratio of total debt-to-EBITDA for the trailing four quarters from exceeding a level set in a defined quarterly schedule
■ minimum interest coverage ratio - prohibits the ratio of EBITDA-to-interest expense for the trailing four quarters from falling below a set level as defined in a quarterly schedule
■ minimum fixed charge coverage ratio(c) - prohibits the ratio of a measure of cash flow-to-fixed charges from falling below a set level (which may be fixed for the term of the bank debt or adjusted quarterly)
■ maximum annual capital expenditures - prohibits the borrower and its subsidiaries from exceeding a set dollar amount of capital expenditures in any given year
■ minimum EBITDA - requires the borrower to maintain a minimum dollar amount of EBITDA for the trailing four quarters as set forth in a defined quarterly schedule
(a)Baskets ("carve-outs") provide exceptions to covenants that permit the borrower/issuer to take specific actions (e.g., incur specific types and amounts of debt, make certain restricted payments, and sell assets up to a specified amount).
(b)Affiliate transactions must be conducted on an "arms-length" basis (i.e., terms no less favorable than if the counterparty was unrelated).
(c)A fixed charge coverage ratio measures a borrower/issuer's ability to cover its fixed obligations, including debt interest and lease obligations. Although the definition may vary by credit agreement or indenture, fixed charges typically include interest expense, preferred stock dividends, and lease expenses (such as rent). The definition may be structured to include or exclude non-cash and capitalized interest.
High Yield Bond Covenants Many of the covenants found in a high yield bond indenture are similar to those found in a bank debt credit agreement (see Exhibit 4.23). A key difference, however, is that indentures contain incurrence covenants as opposed to maintenance covenants. Incurrence covenants only prevent the issuer from taking specific actions (e.g., incurring additional debt, making certain investments, paying dividends) in the event it is not in pro forma compliance with a "Ratio Test," or does not have certain "baskets" available to it at the time such action is taken. The Ratio Test is often a coverage test (e.g., a fixed charge coverage ratio), although it may also be structured as a leverage test (e.g., total debt-to-EBITDA) as is common for telecommunications/media companies.
EXHIBIT 4.23 High Yield Bond Covenants
High Yield Principal covenants found in high yield bond indentures include: Covenants
■ limitations on additional debt - ensures that the issuer cannot incur additional debt unless it is in pro forma compliance with the Ratio Test or otherwise permitted by a defined "basket"
■ limitations on restricted payments - prohibits the issuer from making certain payments such as dividends, investments, and prepayments of junior debt except for a defined "basket" (subject to certain exceptions)'3'
■ limitations on liens (generally senior subordinated notes allow unlimited liens on senior debt otherwise permitted to be incurred) - for senior notes, prohibits the issuer from granting liens on pari passu or junior debt without providing an equal and ratable lien in favor of the senior notes, subject to certain exceptions and/or compliance with a specified "senior secured leverage ratio"
■ limitations on asset sales - prevents the issuer from selling assets without using net proceeds to reinvest in the business or reduce indebtedness (subject to certain exceptions)
■ limitations on transactions with affiliates - see credit agreement definition
■ limitations on mergers, consolidations, or sale of substantially all assets - prohibits a merger, consolidation, or sale of substantially all assets unless the surviving entity assumes the debt of the issuer and can incur $1.00 of additional debt under the Ratio Test
■ limitation on layering (specific to indentures for senior subordinated notes) - prevents the issuer from issuing additional subordinated debt ("layering") which is senior to the existing issue
■ change of control put (specific to indentures) - provides bondholders with the right to require the issuer to repurchase the notes at a premium of 101% of par in the event of a change in majority ownership of the company or sale of substantially all of the assets of the borrower and its subsidiaries
(a)The restricted payments basket is typically calculated as a small set dollar amount ("starting basket") plus 50% of cumulative consolidated net income of the issuer since issuance of the bonds, plus the amount of new equity issuances by the issuer since issuance of the bonds, plus cash from the sale of unrestricted subsidiaries (i.e., those that do not guarantee the debt).
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