What are some of the key terms of a credit agreement that are important to commercial bankers, corporate bankers, credit investors and restructuring investment bankers?
Here are some of the main parts of the credit agreement that are often referenced.
Anatomy of a Credit Agreement
- Terms of Commitments and Loans
- Conditions to Lending
- Representations and Warranties
- Affirmative or Positive Covenants
- Negative Covenants
- Financial Covenants
- Events of Default
Credit Agreement Walkthrough
Recitals (Credit Agreement)
Recitals describe the transaction and what the purpose of the transaction is.
Definitions (Credit Agreement)
Definitions are at the beginning of the credit agreement and define the terms used throughout the contract. This is important as borrowers will negotiate what the definition of EBITDA or indebtedness are, which will have ramifications on credit.
Terms of Commitments and Loans
Loan details and characteristics are outlined here. These include the size, maturity, extension options, loan pricing / applicable interest rates and margins / interest rate benchmarks, commitment fees, utilization / drawn fees, administrative fees, borrowing mechanics and prepayment options.
Representations and Warranties
In banker speak and legalese usually shortened to reps and warranties, these are claims made by the borrower regarding its operating and financial position.
If there is a fundamental breach of any of the reps and warranties there is no basis for the credit agreement and the loan can be pulled.
Affirmative or Positive Covenants in a Credit Agreement
Covenants are credit positive legally enforceable promises made by the borrower to protect the lenders.
Positive or affirmative covenants bind the borrower where they must be in compliance with certain actions of a positive nature.
Examples of positive covenants include maintaining proper insurance coverage adequate for the business (such as insuring against pipeline spills), keeping the main business (for example, a real estate company cannot shift their operations to mining bitcoin or selling the core business), and compliance with governing laws and regulations.
Companies must furnish financial statements and maintain books and records that can be inspected. For public and sometimes private companies, their quarterly results must be published 45 days after each fiscal quarter and audited annual results must be published 60 days after each fiscal year. Quarterly statements may also require compliance certificates for financial covenants where the covenant ratios are calculated and signed off on by the CFO or other executive.
Other positive covenants include what a rational investor would consider to be expected – paying taxes and continuing to exist as a corporation.
Negative Covenants in a Credit Agreement
Negative covenants prohibit borrowers from engaging in a certain action. Negative covenants stop the borrower from taking on credit negative activities.
Examples of negative covenants include limitations on indebtedness, limitations on liens, limitations on investments, limitations on mergers, limitations on asset sales, and limitations on restricted payments (prepayment of subordinated debt, dividends and share repurchases, related party transactions).
Financial maintenance covenants such as Debt / EBITDA governors or Debt / Capitalization or Interest Coverage ratios are also negative covenants as the borrower is not allowed to exceed certain thresholds at any time (although temporary breaches will have cure periods). Financial incurrence covenants are only evaluated upon certain trigger events – for example new indebtedness when Debt / EBITDA is above 2.0x.
Examples of Financial Maintenance Covenants
- Leverage Ratio (Debt / EBITDA) including variants such as Senior Debt / EBITDA, Total Debt / EBITDA, Net Debt / EBITDA
- Fixed Charge Ratio (Cash flow / Fixed Charges) – may include rent, leases
- Interest Coverage Ratio (EBITDA / Interest)
- Minimum EBITDA
- Maximum Capex
- Minimum Liquidity (Cash + Available Revolving Credit Facility)
These ratios may have different thresholds over time with the expectation that the financial position improves as cash flows grow and debt is paid down. As such, ratios will usually get tighter over the course of the loan.
Covenants may also be springing covenants which come into effect once leverage goes above a certain level or a revolver is drawn to a stipulated percentage.
For private equity clients, there may also be an equity cure provision where the financial sponsor can contribute common equity or preferred equity new money to count as EBITDA for the purposes of the covenant calculation – however this is only available a limited number of times.
Financial covenants will often be set based on the company / borrower’s financial forecast or projections (which are MNPI). Banks will look at their forecasts and apply a cushion to reasonably ensure that debt can be serviced.
Negative covenants may have carve-out provisions or baskets. What this means is that the borrower can otherwise not breach covenants such as limitations on indebtedness given the parameters defined except for a quantum that is allowed. So as an example, a credit agreement may say the borrower will not permit to exist any indebtedness except for specific cases in the normal course of business and other indebtedness in aggregate principal not to exceed $25 million.
The dollar figure is an arbitrary figure which is only meaningful versus the total quantum of debt. These covenant baskets are heavily negotiated with lenders.
Events of Default (Credit Agreement)
Default occurs when a borrower breaches the terms of the credit agreement. However, there are differences in the severity of a default – colloquially known in the industry as Big D and little d defaults.
Technical defaults are when the borrower breaches one of the terms of the credit agreement (which includes breaching covenants). Other common trigger points include cross-default or not furnishing a compliance certificate or providing financial statements on time. Any breach of these items and the borrower is in default.
When the situation is truly temporary, creditors may waive financial covenants for the quarter’s requirements and in other technical default cases there are cure periods or grace periods where the borrower can remedy the default. However, if the technical default is allowed to persist beyond the cure period, a Big D default may be in effect.
When a borrower fails to meet an interest or principal payment, this constitutes a Big D (Event of Default) default and creditors can immediately seek remedies including the acceleration of the loan (calling it). In some cases, missed interest payments or fee payments may have grace periods as well – these concessions are negotiated.
Fundamental breaches such as corporate existence, fraud and voluntary bankruptcy may also constitute Events of Default.