Despite a downturn in its business, AMN Healthcare Services, a $1.2 billion staffing company, is in no danger of flat-lining. Its revenue rose 3% in the December quarter, its net income was positive, and its leverage ratio was a thin 1.5. And yet CFO David Dreyer has recently spent some long days trying to renegotiate a leverage-ratio covenant and extend the tenor of the company's revolving line of credit.
Cash expenses for a restructuring (such as severance packages) were weakening the company's EBITDA (earnings before interest, taxes, depreciation, and amortization), but not to a degree that would appear to violate its loan covenants. The difficulty for Dreyer was that AMN Healthcare's banks and loan investors were examining every fee and rate with the intention of repricing the debt package. It was taking a lot to convince them not to extract more than the situation called for. "Even with the relationship banks, the process is night and day compared with what it used to be," Dreyer says.
Welcome to the harsh new world of loan covenants. Like AMN Healthcare, more and more companies are having to renegotiate covenants as the recession weakens earnings. "We're doing a lot of amendments — many more amendments than new deals," says Larry Mack, executive vice president, KeyBank Debt Capital Markets.
A number of highly leveraged firms are now breaching the leverage ratios, fixed-charge coverage ratios, and net-worth minimums that were set in stronger, more-liquid markets. According to Standard & Poor's Leveraged Commentary & Data, there were 98 covenant amendments (publicly disclosed ones, that is) to high-yield corporate loan agreements in the first quarter of 2009, up from 62 in the previous quarter. Experts expect just as many, if not more, in the second quarter.
Other, less-leveraged companies will also be talking to their lenders about amending covenants. (According to one academic study, between a quarter and a third of all public companies will trip a loan covenant over a 10-year period.) And the conversations may not be pleasant. When credit was abundant, many banks felt they were taken advantage of, says Steven Bavaria, managing director of leveraged finance at credit-rating agency DBRS. "The gun was at their heads to reduce fees and spreads," he says. "Now some of the same borrowers have to go hat in hand and ask for covenant relief. They shouldn't expect a warm, helping hand from the bankers."
Still, if the CFO warns lenders of a potential covenant breach early on, the experience need not be painful. Banks may even waive the violation, in hopes the company can recover by the next reporting period.
Penalties, Fees, and More
A company that breaches or is close to breaching a covenant will usually pay for the indiscretion. The penalty may be in the form of a pricing increase, upfront fees, a LIBOR floor, or the reduction in size of revolving credit commitments. Tighter covenants or new ones may replace the old, depending on the situation.
In the first quarter of 2009, lenders charged an average 204 basis points in interest and 56 basis points in one-time fees in exchange for easing loan terms, according to S&P. Arrangers are asking for fees of up to $1 million just to consider a loan amendment, says AMN Healthcare's Dreyer, and consent fees — payments to the members of a loan syndicate — are up three- and fourfold. "The pricing is the most shocking thing right out of the gate," Dreyer says.
Banks need to reprice risk, but there are other reasons why customers are paying more. When borrowers come to KeyBank wanting a covenant amendment, there is now both a credit decision and a capital decision to be made, says Mack. "As the credit quality deteriorates, we're required to keep additional capital, so we have to be compensated for that," he explains. "Our capital costs have increased — the bank market is charging more for everything." Even if the lead bank in a syndicate has a solid relationship with the borrower, it has to give other participants "market terms," says Mack.
Penalties are increasing partly because the market will bear it, says John Walenta, a director at Oliver Wyman, but partly for legitimate reasons as well. Deteriorating corporate credits force banks to spend more time managing loan portfolios. "There's an opportunity cost for the banks — they're not out cross-selling," Walenta says.
Still, Walenta can see why escalating fees and price increases drive CFOs mad. "The bank is concerned about the company's liquidity, but at the same time it's extracting fees and rate hikes," he says. Generally, CFOs who haven't been to the loan markets recently are in for a surprise, says James Moran, head of corporate lending for Credit Suisse's investment-banking arm. "There is an element of sticker shock in terms of what the market requires to amend a financial covenant," he says.
Can We Talk?
It's best not to run from the shock. On the positive side, a loan-covenant violation can be resolved with some-thing less punitive than an asset seizure or liquidation. "It's an opportunity to have a dialogue with the company," says Greg Becker, president of Silicon Valley Bank. "There is a serious violation only 1 out of 10 times."
What's more, the lack of liquidity in markets takes away some of banks' leverage. If a lender did seize a company's assets, it could have trouble selling them. "Nothing is off the negotiating table," says Vanessa Spiro, a partner in banking and finance at Jones Day. "That's the most interesting part of this downturn."
Still, if a company is going to trip a covenant, the CFO should give the bank plenty of warning. Borrowers need to be transparent with their lenders and explain why they're missing projections, says Mack, as well as give lenders time to process the information. The amount of lead time depends on the seriousness of the breach. Nine months to a year is not unheard of. At minimum, give the lending group a couple of weeks, advises Mack.
There's no certainty, of course, that a bank will reward a company for giving early notice of a potential covenant violation. Even if the violation is forecast a year ahead and the company has a strong balance sheet and cash flow, say CFOs, lenders are still ratcheting up rates and demanding an upfront fee. That's especially true if a loan is priced below market.
Take the case of chemicals maker Huntsman. Anticipating a long global recession, the company recently sought relaxation of a maintenance covenant in its $650 million revolver, despite not being in violation. The lenders agreed to increase the loan's senior secured leverage ratio for a year starting in June, but Huntsman had to pay 50 basis points and a 225 basis points increase in the LIBOR spread.
A Margin for Error
If a breach is a minor one — a mere "foot-fault," as Credit Suisse's Moran says — the bank may waive it and await the business's recovery for a quarter or two. Or it could grant a temporary forbearance. After all, as much as lenders like financial covenants, they also want to deploy capital.
A few years ago, Ed Cordell, now vice president of finance at Given Imaging, a medical-device maker, took over as CFO of a highly leveraged LBO company. The retail-equipment maker had already tripped covenants, but the CEO thought it could work with the banks to negotiate amendments within six months. The forecasted revenue growth in the company's three-year plan never materialized, however, causing the company to be plagued with covenant problems for two years. Still, the banks didn't call the loan or seize assets.
"Sometimes a bank will ride it out," says Cordell. "Our banks didn't want to incur the legal cost of amending the covenants until they got a plan that was achievable." Based in the United Kingdom and France, the banks also were loath to take over the operations of a U.S. company.
Looking back, Cordell wishes he had scrutinized the three-year plan more closely. "When you go in with an operating plan, you have to have a high degree of confidence you can hit it," he says, "so that the bank doesn't set the covenants without room for execution error."
"We want to give borrowers enough cushion to run their businesses," says Moran. That cushion in financial ratios is usually 15% to 20% below the projection. If a CFO says he can produce $100 million EBITDA, the covenant shouldn't be much above $80 million. But if a company habitually misses its covenants and comes back two and three times for a reset, "a fatigue factor sets in," Moran says. "Then we start setting the covenants tighter."
Make New Friends
For a company with cash flow and liquidity, it's possible to push back against the bank's offer, says Walenta. Even if the company doesn't win, it does get its objections on record. If a company has to play ball with its existing syndicate, it should at least "make them feel a little pain in the negotiation," Walenta says — especially if the lenders' decreased appetite for risk is one of the drivers of an amendment. "Make the banks remember that when the world returns to normal, you want to renegotiate [the agreement]."
Don't be too adversarial, though. Communication is what's critical, on both sides, says KeyBank's Mack. "The more you know each other, the less of a surprise it is going to be. That creates a much stronger relationship, and allows for more flexibility."
Of course, that assumes the lenders want a relationship. "Are there aggressive hedge funds, which will seek to maximize yield, or relationship commercial banks that would be more reasonable?" asks Dana Klein, managing director in syndicated-loan capital markets at Credit Suisse. Some investors look forward to a covenant default so they can raise interest rates, Moran says. That causes the loan to trade better and increases the return to investors.
Avoiding those lenders, and building ties to syndicate members other than the loan administrator, are advisable when a facility is first signed. By the time a covenant is tripped, it's too late. "This is exactly the environment where you may regret being with a syndicate you have no history with," Walenta says. "If you've been much more transactional in your dealings with banks, you may find that you don't have as many friends in the banking world as you thought."
Vincent Ryan is a senior editor at CFO.