It is clear that many businesses, whether private family owned, SME’s or large corporates, will suffer as a result of the global pandemic and will increasingly be impacted by the “lockdown” restrictions introduced by the UK government on 23 March 2020.
For over a month, trading activity has been impacted with the vast majority of “non-essential” businesses closing to the public. It has been announced that the lockdown is set to continue for a further three weeks into May.
The commercial operations of many businesses, predominantly in the travel, hospitality and leisure industries have been affected and property construction or development projects could be impacted and may, in many cases, have grinded to a halt. The repercussions for businesses who have been unable to quickly adapt to this new way of operating (ie keeping supply chains open, such as providing an online service to customers), or who are prevented from doing so entirely due to their business model, may be severe. This in turn affects investors or landlords that have relationships with affected businesses.
What are the key areas of concern for borrowers?
Throughout this unprecedented period, unless otherwise agreed with the lender, borrowers must maintain compliance with their contractual obligations under any debt facilities they may have in place. Each borrower will be affected to varying degrees depending on their debt profile and on the industry that they operate in.
Therefore, for each business, it will be necessary to closely examine on an individual basis how deteriorating economics and changes in customer behaviour could adversely impact the ability of borrowers to comply with their contractual obligations to their lenders.
If debt facilities are documented using Loan Market Association finance documents, it is possible to identify common areas of concern and points to monitor closely in the loan documents as Covid-19 develops over the coming months.
Financial concerns will be clearly at the forefront of every borrower’s mind.
Loans provided to corporates on a look forward basis, such as the projected income of the business, will inevitably be of greater concern due to their link to the performance of the UK’s economy.
The main issues likely to be of concern for both borrowers and lenders are:
- breach of financial and information covenants: one of the key concerns for borrowers will be ensuring compliance with covenants contained in the finance documents.
Any adverse financial impact on the borrower or borrower group due to a reduction in cash flow from trading activity or receipt of rental income may result in a breach of financial covenants such as compliance with cashflow ratios, ie the ratio of cashflow to debt service, or interest cover ratios.
These covenants are usually tested on a quarterly or annual basis with a requirement for the borrower to supply the lender with regular compliance certificates containing certain financial information, such as profit and loss, balance sheets, cashflow projections and (if relevant) property management information.
If it is likely that a breach may occur, early conversations with lenders are advisable and it may be prudent to check the terms of your loan agreement for any ‘cure rights’, such as the provision of an equity cure where a sponsor or shareholder can inject additional capital so the financial covenant is deemed not to have been breached.
Throughout this period, it may become increasingly difficult for borrowers to provide lenders with budgets, as projected cashflow and profit and loss becomes harder to predict and for real estate investors, tenants may not be paying rents in accordance with their lease.
- breach of payment obligations: a borrower’s limited or complete inability to pay amortising principal payments and interest due on interest payment dates will, unless a grace period applies, trigger an event of default. Failure to pay capital or interest payments will be treated more seriously by lenders than other breaches of debt facilities so should be avoided.
Borrowers should be aware of any upcoming payment dates and, if necessary, look to negotiate with lenders to defer scheduled repayments. It may also be possible to discuss with lenders the option to capitalise any outstanding interest to the loan or apply for repayment holidays.
- breach of representations and warranties: the borrower gives to the lender certain representations and warranties in relation to its financial condition both on a drawdown date (particularly relevant for revolving credit facilities) and on each interest payment date under the loan agreement.
The borrower confirms, amongst other things, that there is no default, no litigation (actual or threatened) and there has been no material adverse change (MAC) since the preparation of the last financial statements.
Many loan agreements include an event of default where the lender believes that there has been a 'material adverse change' in the borrower’s assets, business or financial condition, or that a change in circumstances has caused, or is reasonably likely to cause, a 'material adverse effect' on the borrower’s ability to comply with its obligations. This concept may also be framed as a repeating representation so may apply at various points throughout the lifecycle of the loan. The drafting of the provision will be important, as a lender may be able to determine whether a MAC event has occurred in its ‘sole discretion’ or in its ‘reasonable opinion’. Whether a lender is inclined to use a MAC provision in these circumstances remains to be seen and it is likely that lenders will be reluctant to call an event of default on this basis due to the reputational damage they might suffer by doing so, particularly during a global pandemic. Some development finance loans may also have an “Adverse Market Condition” clause which may apply and give some protection to developer borrowers if there is a fall in the sale of units due to circumstances outside of their control.
Again, these statements and confirmations may become increasingly difficult for the borrower to give to the lender in such uncertain times.
- events of default: breaches of covenants, payment obligations, representations and warranties and various insolvency events can all lead to triggering an event of default which could ultimately result in acceleration by the lender or other enforcement steps being taken against the borrower. Considerations include:
- Cessation of business: where the borrower suspends or ceases to carry on (or threatens to suspend or carry on) all or a material part of its business this can trigger an event of default. Due to the pandemic, some businesses have been required to suspend all or part of their operations or close offices, it is therefore possible that this event of default may be triggered.
- Negotiations with creditors: in addition to other insolvency related events, there is often an event of default if a borrower commences negotiations with creditors (other than the lender under the loan agreement) with a view to rescheduling their indebtedness, such as renegotiation of debt payments with other lenders or trade creditors. It is advisable for a borrower to check the existence and scope of any such provisions before approaching creditors for any debt rescheduling.
- Cross default: enforcement steps may lead to cross defaulting other facilities the borrower has with the lender or other financial providers and also mandatory prepayment under the loan agreement.
- Abandonment of development works for more than a set period of time and missing milestones for completion.
It is clear that avoiding triggering events of default is of paramount importance to borrowers, as businesses require the financial support of its lender and other creditors more so now than in a normal economic environment.
Although many lenders will most likely be keen to assist their borrowers in the current economic difficulties, to ensure financing arrangements stay in place, it is recommended that borrowers enter into discussions with their finance provider at the earliest possible time to negotiate some flexibility or headroom for compliance with covenants, rescheduling of payments or to agree temporary extensions of credit lines.
All of these factors may ultimately lead to the requirement for amendments or waivers, refinancing or restructuring of existing deals.
Key takeaways for borrowers:
- raise any issues and discuss concerns as early as possible with your existing lender to agree commercially viable steps to maintain the business
- know your compliance testing dates, your financial reporting obligations and what aspects of your business may be impacted by the change in your operations
- pursue temporary amendments and/or waivers if necessary on the basis that this may be a relatively short term problem in the context of the lifetime of the loan or consider exercising any “cure” rights. Lenders are likely to assess recent financial performance of the business from before the Covid-19 measures were implemented to determine whether to provide additional emergency funding.
- explore the option of finance being provided to your business under the Coronavirus Business Interruption Loan Scheme or the Coronavirus Large Business Interruption Loan Scheme
For more information on how we can help your business, we suggest that you visit our Coronavirus Hub.
We continue to monitor further developments and, in the meantime, the Mills & Reeve banking team is on hand to discuss any concerns you may have during this time. Please do not hesitate to contact us if your business is impacted (or is likely to be impacted) by Covid-19.