A full eight months into the global pandemic, we see continued stress for many businesses in the middle-market. Of course, certain sectors are enjoying record-breaking years thanks to shifting professional and personal routines leading to new spending habits; see Amazon, or for that matter, second home vacation properties.
For the businesses affected by COVID-19, we are finally seeing the covenant breaches we had all expected. Although the pandemic hit the U.S. in mid-March, some credit managers experienced upticks in covenant defaults as early as the March 31st reporting period, and this trend continued into Q2.
Additionally, Business Development Corporation (BDC) managers have stepped up the number of loans placed on Non-Accrual, following a similar path as covenant defaults. To an outsider, this makes sense as large commercial banks also increased their loss reserves at the time. However, for BDC’s which were already under immense pressure due to stock valuations trading under their net book value, adding to the Non-Accrual list was not as easy for them as it was detrimental to their short term earnings.
When Q3 covenants are reported on November 15, 2020, we expect both defaults and Non-Accruals will continue their upward trajectory as the COVID-19 impact continues.
How lenders are reacting to the increase in defaults
Lenders have been understanding and supportive; commercial banks and non-bank lenders have shown patience as covenant defaults roll in. Breaking a leverage covenant or fixed charge covenant is not catastrophic, and is something most lenders view as temporary. However, even supportive lenders usually cannot just simply “Waive” a covenant default.
As covered in the last edition of Tom’s Two Cents, many non-bank lenders have both their own equity holders to look out for, as well as their own liquidity line lenders to appease. Therefore, the multiple constituencies lead to a more complicated decision as to what to do about a violated financial covenant.
Rather than just waive covenant defaults, we see lenders reset covenant levels based on the projected EBITDA degradation. While, lenders have proven less accommodating to borrowers’ requests for major loan modifications such as principal and interest holidays. For non-bank lenders that use a liquidity line to support their loan portfolio, a major loan modification could cause them to lose availability on their liquidity line, which takes down their return. Even a request to move interest from cash pay to PIK might meet resistance, particularly if such a request is made to a BDC. BDCs are required to pay out 90% of their net income to their shareholders. PIK interest is treated as income; but, it is non-cash income, therefore having too much income come from PIK interest can be problematic.
This is not to say lenders are not doing their best to accommodate their borrowers. Many lenders make modifications to both principal and interest obligations, but the complexity of their own capital structure results in lenders usually agreeing to less than what the borrower wants/needs.
For more challenged credits, we are seeing lenders taking a tougher stance. In the past, lenders might be more patient, whereas now lenders are more actively managing their work-out credits. In addition to requiring restructuring advisors and rolling 13-week cash flow statements, both bank and non-bank lenders are shortening forbearance periods.
Shorter forbearance periods give the borrower less time and flexibility to turn around their businesses. In the past, six months to even a year was considered a standard forbearance period, where-as 90-120 day forbearance agreements have quickly become the current standard. The thought is that in this environment, lenders want to keep a very close eye on their troubled credits and more proactively manage/mitigate loan losses.
Fred Fisher, a partner at Mayer Brown with twenty years’ experience documenting middle-market loans for both lenders and borrowers, has noticed the shift in lenders’ attitude in managing troubled credits, “More and more, we are encountering shorter forbearance periods. These shorter periods ensure borrowers come back to the table to update how they are navigating the downturn. Overall, lenders try to accommodate requests as long as they are within reason. But asking a lender to fund a loss while the equity holder does nothing is not a strategy lenders are embracing.”
Get out the Vote
Most middle-market professionals agree that lenders are trying to work with their borrowers; however, what happens when the negotiation between borrower and lender takes a turn for the worse? We frequently get this question, and usually, it is hypothetical; however, we have seen a handful of instances where the lender has exercised their right to “vote the shares” and remove management/ownership from the business.
Voting the Shares is a common provision in most loan agreements where the stock of the business has been pledged. Rarely used, it gives the lender the right to replace the board of directors, thus taking control over the business. It has long been considered the last remedy a lender would use to protect their investment.
Fred Fisher noted, “Voting the shares is certainly extreme and is usually used as leverage moreso than in actual practice. That being said, in certain circumstances it is necessary and lenders are well aware of their rights. In most cases, the threat or use of this remedy will push the parties to agree on a consensual restructuring or lead to a bankruptcy filing.”
To be clear, this measure is rare and usually invoked only when a severe breakdown occurs between borrower and lender. To protect themselves against this scenario, many borrowers negotiate to require a “Notice Period” in the loan agreement. This “Notice Period” is a time range from one to three days where the lender has to give notice before exercising their right to vote the shares. The notice period gives the borrower time to file for bankruptcy protection ahead of the lender voting the shares. Some lenders accommodate a notice period in their loan document, while others push back on it.
As scary as it may seem, Voting the Shares is the last remedy a lender uses to protect their investment. Instead of taking drastic measures most lenders will continue to kick the can down the road and hope the negative impact of COVID will soon burn off and the defaults will correct themselves.
During this period of uncertainty, Livingstone has closed over 20+ healthy and distressed deals, including the sale of Right/Pointe to Crafco and the sale of Schumacher Electric Corporation to Lincolnshire Management. We continue to build our global team, adding bandwidth to our Special Situations team, while delivering terrific results for our clients.