Stuart A. Laven, Jr.

The scenario is common enough: following a slow quarter, a borrower misses a debt service coverage ratio (DSCR), fixed charge coverage ratio (FCCR), or other financial covenant test required under its revolving credit facility. If the borrower is otherwise generating reasonable top line income and servicing the debt on time, the lender is unlikely to exercise nuclear options – like blocking availability on the line – and instead, it will likely amend the line of credit agreement. In various ways and from multiple angles, the amendment will try to rein in what the lender’s asset-based lending (ABL) underwriters perceive as newly increased credit risk from its defaulting borrower.

While the situation might be common, businesses can be caught off-guard if they aren’t prepared or understand their options. Borrowers aren’t without recourse in these situations, and there are practical considerations to keep in mind when responding to a lender’s amendment to credit facility.

Common Ways Lenders Seek to Resolve Financial Covenant Defaults

In these situations, the amendment often contains a waiver of the financial covenant default, but the waiver will be subject to various conditions, including paying the lender some kind of fee. The amendment may also suspend one or more upcoming financial covenant tests for a quarter (or longer), or, if the covenants remain intact, the amendment may soften or “reset” the ratios for one or more forthcoming quarterly test dates. Alternatively, the amendment may swap the DSCR, FCCR, or other traditional ratio covenant for a new covenant that prioritizes monitoring liquidity over other performance metrics.

Independent of the financial covenants, the amendment may also tighten the borrowing base by limiting the borrower’s ability to borrow against certain categories of inventory or accounts receivable (AR) previously deemed eligible.

How Businesses Should Respond to Amendments to Their Line of Credit

With the proposed amendment in hand, the highest priorities for a borrower’s finance team and their counsel should be maximizing line availability and minimizing the risk of a near-term liquidity crisis. Doing so will provide a reliable cash forecast with as much visibility into future cash flows as possible under prevailing business conditions. This sounds easy enough, but in reality, the lender’s credit underwriting process may impose constraints. It is typically very difficult to get ABL lenders to make significant moves away from their internal number-crunching borrowing base calculations, financial covenants, and other credit risk metrics.

With those sobering limitations in mind, the borrower’s best bet is often to focus on chipping away at financial covenants that pose the highest risk of a near-term default with the ultimate goal of deferring stricter covenant tests to as late a date as possible. By pushing the more challenging covenant tests to a later date, the business has as much time as possible to improve performance without running out of credit availability. The same strategy applies to the borrowing base formula and, more specifically, to the definitions of “eligible” accounts and inventory: create as much incremental availability as possible as early as possible.

Tactics When Negotiating Amended Credit Terms

Achieving these complimentary objectives of liquidity and availability requires a strategic analysis of the proposed loan amendment and a keen eye for technical detail. While every situation is different, there are a few tactics that frequently come into play when negotiating amended credit terms following a financial covenant default:

• Suspending or Softening Covenants. In many situations, ABL lenders proactively offer to suspend covenant testing for at least a quarter. Whether a lender will do so absent a borrower request depends on whether the lender is comfortable with existing availability under the borrowing base and the strength of the cash forecast. If the lender does not offer to suspend the covenant test for the next quarter, there may be an opportunity to propose a ramp-up structure with a very soft (i.e., feasible) ratio for the upcoming test date, followed by increasingly stringent minimum ratios in the subsequent two to four quarters. The lender’s primary objective in financial covenant testing is to get an early warning of a potential significant default before it’s too late to recover. Accordingly, some lenders have a degree of flexibility in setting the DSCR or FCCR minimums for near-term test dates.

• Replacing Ratio Covenants with Simplified Milestones. Some lenders are unwilling to suspend go-forward covenants but will replace them with simplified performance thresholds. When doing so, lenders typically require monthly or quarterly minimums for EBITDA, revenue, or liquidity (with “liquidity” being some measurement of cash on hand minus certain deductions). This is rarely something for the borrower to initiate; rather, the lender will propose the change. But that doesn’t mean there is no room for negotiation. For example, with an EBITDA milestone, a borrower may be able to increase add-backs in the calculation/definition of “adjusted” EBITDA, as discussed in more detail below. With a liquidity milestone, a borrower might be able to limit deductions from the definition of “liquidity” (such as certain categories of aged accounts payable and contingent liabilities).

• Modifying the TTM Testing Period. Most DSCR and FCCR covenants presume a trailing twelve-month (TTM) test period, although some facilities shorten the period while the loan is in its first year. Some lenders are sticklers for a TTM test period, but others may be receptive to a shorter lookback (which may help covenant calculations if performance has been trending positive in recent months). If the lender won’t agree to a shorter test period, and the three most recent quarters are the most favorable, a borrower may be able to “synthesize” a TTM by using its average EBITDA from the well-performing three quarters as the EBITDA number for the one underperforming quarter.

• Expanding Add-Backs in “Adjusted EBITDA.” Since DSCR and FCCR typically hinge on a calculation of “adjusted” EBITDA (or, in some FCCR calculations, adjusted EBIT), it’s worth pursuing tweaks to the loan agreement’s EBITDA definition that might increase the calculated number. Even though EBITDA is not a GAAP-defined measurement (it is simply a term of custom practice widely used to gauge operational performance), the basic definition of EBITDA is consistent and difficult to change. But there is no hard and fast rule as to what “adjustments” can or cannot be included in “adjusted EBITDA.” In many credit agreements, the laundry list of add-backs included in “adjusted EBITDA” consists of a broad category of extraordinary or non-recurring items labeled as “restructuring costs.” These restructuring costs are frequently subject to a cap, which may be a hard dollar cap or a percentage of unadjusted EBITDA. Some lenders will be receptive to raising the cap on subcategories of restructuring costs, like legal and audit fees, employee severance (if a reduction in force or similar cost-saving measure is anticipated), and interim management expenses.

• Maximizing the Borrowing Base: Foreign and In-Transit Inventory. The heart and soul of ABL financing is the value of the borrower’s collateral (namely, AR and inventory), and more specifically, the liquidation value of that collateral. So it should come as no surprise that ABL underwriters do not like to lend against AR or inventory that might be difficult or costly to liquidate if the loan goes sideways. Accordingly, lenders often devalue or exclude inventory warehoused outside the U.S. or in transit to the U.S. from an ABL borrowing base. However, some credit agreements permit some quantum of foreign and in-transit inventory in the borrowing base, subject to a hard dollar cap. Depending on the circumstances, some lenders will permit an increase to the cap, especially with respect to in-transit inventory.

If the revolver is in good stead, with plenty of availability, will any of these strategies ever come into play? The technical, macroeconomic answer is maybe. While not specific to ABL facilities, some recent data suggests default rates in the broader commercial loan markets will trend upward in 2024. A February 2024 report from the interagency Shared National Credit (SNC) Program—which publishes annual reviews of syndicated bank and nonbank loans over $100 million—reported an 8.7% increase in overall originations from 2022 to 2023. However, that same report also observed a 38.3% increase in the dollar volume of loans designated as “classified” and “special mention” —two categories of loans categorized as high peril of payment default under the OCC’s credit risk rating rules. If this trend persists, and the anticipated reduction of interest rates takes longer than many have hoped, the volume of ABL borrowers finding themselves in financial covenant defaults will likely expand.