Credit facilities often require borrowers to maintain certain financial health throughout the term of the credit facility, as measured by a borrower’s ability to demonstrate compliance with certain financial ratios on a quarterly or annual basis. These types of financial covenants are known as “maintenance covenants”. Many of these maintenance covenants are calculated using the borrower’s earnings before income, tax, depreciation and amortization (EBITDA) as part of the financial ratios. Failure to comply with these maintenance covenants is usually grounds for the lender to call an immediate default under the loan.
Due to the ongoing economic impacts of COVID-19, borrowers may see a decline in EBITDA which could lead to a failure to satisfy their maintenance covenants. One way borrowers can stave off an event of default under the credit facility related to a failure to meet their maintenance covenants is to utilize an equity cure. Close examination of the original loan documents is important to understanding the borrower’s equity cure rights and limitations.
What Is an Equity Cure?
An equity cure is a provision popular in middle market, sponsor-backed credit facilities that permits owners of a borrower to infuse cash into the borrower as an equity investment, thereby increasing the borrower’s EBITDA. The increased EBITDA is used to recalculate the borrower’s compliance with its maintenance covenants and prevent default under the loan. Equity cures work in the borrower’s favor during downturns but not all credit facilities contain such a cure provision. Borrowers should review their loan documents for an equity cure provision, and if one does not exist, consider negotiating one into their next upsize or amendment.
When Can an Equity Cure Be Exercised?
The mechanics of an equity cure vary based on the credit facility. The loan documents will require intervals upon which the borrower must submit financial statements to test its compliance with the maintenance covenants – often quarterly or annually. Typically, agreements require the equity cure be exercised within 10 to 15 days after a borrower’s delivery of required financial statements. A careful reading of the loan documents is important to ensure the equity cure is exercised properly.
Limitations of the Equity Cure
Typically an equity cure is a limited cure right, meaning the loan documents limit the borrower’s exercise of the equity cure to a maximum cure amount (e.g., no more than the amount needed to meet the maintenance covenants) and a number of times (e.g., no more than three times during the term of the loan and never in two consecutive quarters). Sometimes the cure amount is disregarded for purposes of meeting other covenants under the loan documents or determining addbacks or baskets for EBITDA. These limitations are designed to prevent the borrower from masking prolonged financial problems. Additionally, the equity cure is only as good as the borrower’s ability to receive a cash infusion from its equityholders on short notice.
How Will the Equity Cure be Factored in Going Forward?
Borrowers should pay careful attention to whether their equity cure only counts toward the current compliance period or is carried forward to future compliance periods. Lenders in the United States typically permit the cure amount to be factored into the borrower’s maintenance covenants for four rolling quarters, whereas European-style equity cures disregard the cure amount for all future quarters even if the maintenance covenant is based on a four-rolling quarter basis. Borrowers should consider whether a one-time equity cure will be sufficient to avoid defaults for the foreseeable future, or whether the borrower should approach the lender with a plan for additional covenant compliance relief, together with the proposed equity cure, as a complete package.
The equity cure permits borrowers experiencing temporary declines to prevent default under their credit facility. Borrowers should carefully review their loan documents for the availability of an equity cure, its limitations and how to exercise it.
Contact Hirschler’s Finance Team for assistance with interpreting, exercising or negotiating your equity cure provision.
Luis F. Ruiz