DUBAI, UNITED ARAB EMIRATES, July, 2023
Over the last years, an increasing number of LBOs has been leveraged through debt funds rather than typical bank debt. As a result, the dynamics of negotiating a stand still agreement or waivers for financial covenant breaches has changed, depending on who the debt provider is.
Most loans in LBO transactions are financed based on flexible Euribor rates. Since such rates have substantially increased since 2021, debt service of portfolio companies has increased lately. If such development is coupled with an even slight decrease in revenues or earnings, portfolios have a tendency to run into financial covenant breaches very quickly. This is what we currently see across the industry.
The way to address this situation however changes, depending on who the debt provider actually is. Traditional banks often discussed a waiver or standstill rather quickly at reasonable terms. We see an increase of reporting standards and monitoring, but also time limited headroom for financial covenants, particularly in situations where, besides the covenant breach itself, no increased risk exists that the debt service cannot be upheld. Only in those cases, banks are typically asking for minimum liquidity covers, CROs or equity cures in order to protect their exposure. Double sided trusts or restructuring shareholders only come in to play when the asset is close to insolvency.
Debt funds however seem to act differently and more opportunistic. Since covenant breaches typically provide for a termination right under the financing agreements, they might try to use that situation to get hands on the asset. We see debt funds trying to force the equity holder into standstill agreements with rather harsh demands on minimum liquidity covers, less FC headroom or equity options, which, should the asset fail to meet those KPIs, give the debt fund the ability to immediately take the asset from the equity provider like a hostile takeover. This particularly is the case, if the operating business is very sound and leaves a chance to subsequently put it to market at a huge profit for the debt fund.
In those situations it is important to know what the debt fund can or cannot actually do, even if they have a technical right for termination, and what the outcome of an abuse of those rights would be. It is also important to understand how to defend the asset against an attack on the equity side, in particular if the asset on a forward-looking basis is profitable and within the budget again, and the covenant breach is only based on an LTM view of current and past financials.
Discussions with debt funds in those situations tend to become rough very quickly. Having the right team is very important for the PE fund to safeguard against losing its asset. A balanced approach is important, but also the ability to quickly increase the heat if necessary. The upcoming months will be highly entertaining.
Holger Scheer
Saxum Global Consulting FZCO
+971 54 578 5620
hs@saxumglobal.com
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