A New Ballgame: Negotiating Financial Covenants In An Uncertain Environment

By Inez M. Markovich and Howard Brownstein

Lending in 2022 presents a new host of challenges for financing providers of all types. Inez M. Markovich and Howard Brod Brownstein break down how lenders and borrowers will need to adjust their expectations and requirements.

Escalating inflation, rising interest rates and the war in Ukraine have all contributed to a change in the landscape for secured lenders. After the somewhat overstated economic recovery of 2021, supported by a now-expired Paycheck Protection Program, during the first six months of 2022, the U.S. economy suddenly faced a downward outlook fueled by several ongoing trends.

In an effort to combat persistent inflation, the Federal Reserve has issued four interest rate hikes, including the biggest rate hike of the last four decades in June, which the Fed matched with another increase in July. In such a rising rate environment, the U.S. economy finds itself at a proverbial crossroads. Escalating prices for a broad range of products and crippling supply interruptions, exacerbated by the raging war in Ukraine, assure further uncertainty down the road. These trends have already begun to impact the commercial lending markets, both for new loan originations and refinancing transactions. As interest rates are expected to continue rising, lenders and borrowers will need to adjust their expectations and requirements.

In the face of this reality, lenders have started preparing themselves for a decline in new loan originations, as well as potential covenant defaults on existing loans. Borrowers looking for financing, particularly to finance commercial real estate, need to be prepared for reduced loan amounts and more rigorous covenant testing in addition to higher interest rates. In fact, in the remainder of 2022 and in 2023, negotiation of financial covenants, particularly in conventional loans, will feature front-and-center, both in the negotiations of new loans and in structuring modifications of existing loans.

Debt Service Coverage Ratios

It is common to think of the loan-to-value (LTV) ratio as the key determinant of the amount a lender will be willing to loan on a specific asset. However, in addition to the LTV ratio, lenders use other measurements, especially the debt service coverage ratio (DSCR), which measures a borrower’s earning capacity to cover debt service payments, to determine what they may be willing to lend. Thus, to ensure loan compliance with a lender’s target DSCR ratio, an increase in loan pricing is likely to result in a reduced loan amount.

Compliance with DSCR requirements will present a concern, not just in terms of new loan originations, but also with respect to existing variable rate loans. In recent years, borrowers have tried (and often succeeded) in getting more flexibility in DSCR requirements by negotiating a more inclusive definition of EBIDTA or net operating income (NOI), allowing borrowers to add certain expenses or projected earnings to the calculation of EBIDTA and/or NOI.

In the current environment, lenders are less likely to allow such a flexible approach to the calculation of DSCR. As an alternative accommodation, borrowers may request a provision allowing them to cure a failure to maintain a minimum DSCR by paying down the outstanding balance of the loan in such an amount as may be necessary to bring the covenant into compliance. Specific requirements notwithstanding, negotiations of DSCR will take a prominent place in the negotiations of new loan agreements and modifications of existing loans.

Opportunities for ABL?

Highly leveraged companies whose performances may never have recovered from the first two years of the COVID-19 pandemic may now find themselves struggling to make increased debt service payments. A concern for borrowers’ capacity to cover debt service payments may also drive lenders to impose tighter restrictions on borrowers’ ability to incur other debt, such as subordinated debt nor unsecured debt as suggested earlier in this article, i.e., senior lenders may be stricter due to current conditions.

As some lenders become stricter with borrowers, asset-based lending may present an attractive alternative to traditional cash flow lending. Unlike conventional lenders, ABL lenders do not focus on borrowers’ cash flows in determining borrowing availability, nor do they impose as many financial covenants. Instead, these lenders provide borrowers with much-needed working capital by lending against eligible accounts receivable and inventory. However, in the current financial climate, as collections slow, supply chain disruptions affect production and account debtors become distressed, asset-based lenders can expect to see deterioration of their clients’ borrowing bases. To avoid potential defaults resulting from a decline in the value of borrowing bases, ABL borrowers may focus on negotiating permitted over-advances in new ABL credit agreements, as well as modifications of existing facilities.

Material Adverse Change Provision

Another covenant that is making a serious comeback is the so-called material adverse change (MAC) provision in loan agreements. Lenders are likely to insist on both conditioning their obligation to make a loan and continuing to provide financing under an ABL line upon no MAC having occurred while including some version of a MAC clause in the “laundry list” of events of default. The very definition of material adverse change has now become, and will continue to be, a major point of lenders’ and borrowers’ negotiations.

For instance, borrowers will try to negotiate a broader variety of what they perceive to be force majeure events to be excluded from the definition of a material adverse change. Although typical carveouts have included events such as acts of God, war, or terrorism in the past, future negotiations of MAC clauses are likely to reflect specific industry risks. Looking back at the recent COVID-19 pandemic (which is not over yet!), borrowers may attempt to carve out other risks, such as pandemics, epidemics and government shutdowns. In 2020, while lenders operating in jurisdictions severely affected by government shutdowns were sympathetic to such concerns, in 2022, with the wide availability of COVID-19 vaccines and the general reopening of the economy, these arguments are less likely to succeed.

Also, during 2020 and 2021, regulators were reportedly less demanding upon regulated lenders, possibly permitting more latitude than they are expected to allow going forward. A change in the approach of regulators may impact both regulated and non-regulated lenders, since the latter often utilize “lender finance” from regulated banks.

A New Ballgame

Borrowers and lenders alike should more frequently test and measure compliance with covenants, including the “headroom” available to permit any future degradation without triggering a default. This process should be a moving picture and not a snapshot, with both sides staying alert for signs of declining performance so that intervention can be earlier and potentially more effective.

While the exact impact of tighter monetary
policy, coupled with a rather bleak economic outlook, on commercial lending remains to be seen, some general predictions appear warranted. Facing lower returns, some investors may start losing their appetites for new acquisitions, projects and buyouts. At the same time, traditional lenders are likely to develop a more cautious approach to loan commitments, rate locks and financial covenants, which may offer more opportunities to mezzanine lenders and equity investors. One thing is clear, however: Both lenders and borrowers must be ready to face new challenges because “it’s a new ballgame!”