May 18, 2017 - The question “How will President Trump change lending?” has been on our minds lately – and this week was no different, as we (along with Sidley Austin partners) discussed “The (Loan) World According to Trump”. What was different this week was that, in addition to our usual political analysis, we also dissected several devils in several details. First, as discussed below, we analyzed the interplay between Leveraged Lending Guidance and actual leveraged lending practices. Second, in a nearby article, we examine the misery that is flood insurance (and suggest there may be a solution).
First, as folks know, U.S. Leveraged Lending Guidance has been a governor in the loan market since 2013. (See related story on what might come from European Leveraged Lending Guidance.) As slides 20 and 21 of The (Loan) World indicate, leveraged lending guidance has expanded the role of non-bank and direct lenders and also has created a putative debt/EBITDA cap somewhere in the 7x context. But that cap is not as firm as one might think. Not to be tautological, but a company can (often legitimately) change its debt/EBITDA ratio by changing either its debt or its EBITDA.
As slides 21 and 23 demonstrate, EBITDA adjustments are everyday occurrences in credit agreements. But what’s really going on with these adjustments? Slide 22 reveals all. First off, there are frequent EBITDA adjustments that account for projected cost savings and synergies from i) acquisitions and dispositions, ii) integration /consolidation/ discontinuation of operations, headcount reductions or facilities closures and/or iii) any action or operational change. That said, these adjustments don’t occur in a vacuum; parties negotiate vigorously around cost savings and synergies, including whether there can be a cap on amount of adjustments (most often styled as a percentage – like 10-25% – of unadjusted EBITDA) and the time horizon during which the anticipated cost savings and synergies are projected to be realized. Moreover, cost savings often must be reasonably identifiable and factually supportable.
Then there is the “debt” side of the debt/EBITDA ratio. Notwithstanding disapproval from the Guidance, companies also can reduce their leverage by netting cash on the balance sheet against indebtedness in leverage ratio calculations. But why does this matter? The resulting leverage ratio cascades through a number of provisions in the credit agreement. Obviously, it affects maintenance covenants (when there are maintenance covenants) and pricing (when there is leverage-based pricing), but the leverage ratio also can open doors to certain borrower conduct, including through ratio-based incurrence tests, as well as step-downs for mandatory prepayments such as excess cash flow sweeps and asset sales sweeps.