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Equity cure and ECF: Traps and tricks

by contributor Benjamin Cheng, Shearman & Sterling LLP | Published September 6, 2012 at 2:00 PM

Equity cure and excess cash flow sweeps are common features in syndicated bank loans utilized in leveraged buyouts. The contractual provisions relating to these features are often negotiated and placed in various parts of the documents, which lead to possibilities for drafting maneuvers as well as unintentional mistakes.

In deals sponsored by private equity firms, syndicated bank facilities containing financial covenants often allow the borrower to cure a breach of the financial covenants via equity injection, which is treated as additional Ebitda for the borrower. This feature is often subject to these restrictions: (i) The injection has to be made within 10 business days after the delivery of financial statements; (ii) there cannot be more than two quarters in each four consecutive quarters, or more than five quarters over the life of the loan, for which a cure is made; (iii) the equity injections are disregarded for all purposes other than the cure; (iv) each injection cannot be greater than the amount required for the cure; and (v) for calculations of the financial ratios, debt is not reduced by the injected amount for the quarter in which the injection is made and for subsequent four-quarter periods that include such quarter. The first three of these restrictions are often straightforwardly documented.

From lenders' standpoint, the fourth restriction is needed to cap how much outside equity can boost the borrower's financial ratios to levels not commensurate with the borrower's actual performance. However, in some precedents in the market, the Ebitda definition contains add-backs for charges paid by third parties or with proceeds of equity issuances. These add-backs permit Ebitda to be increased by equity sponsors' payments not reflective of the underlying credit, hence negating the monitoring purposes of the financial covenants. In addition, many sponsor deals also allow buybacks of the term loans, which, if done at a discount, could increase the borrower's Ebitda by increasing income and add-backs for tax payments. Therefore, the effects of loan buybacks on Ebitda are often expressly excluded in the loan documents, but notably that is not always the case in market precedents.

The fifth restriction sometimes does not appear in the loan documents, and when it does, it is often not expressly stated to apply beyond the first four-quarters period. Without this restriction, the equity injection is double-counted in the leverage ratio since it increases Ebitda in the denominator, whereas in the numerator, debt is decreased by loans prepaid with the injected amount, and for purposes of measuring the financial ratios, such double-counting would occur in each four-quarter period that includes the quarter during which the injection is made.

For term B loans, lenders often expect to be prepaid with the borrower's excess cash flow, or ECF, which is based on the borrower's Ebitda or consolidated income, with deductions and additions designed to calculate the amount of the borrower's internally generated free cash for the last fiscal year. Common deductions from ECF include capital expenditures, permitted investments and certain types of dividends and debt repayments. From lenders' point of view, if such cash payments are not funded by the internally generated cash of the borrower (for example, if they are funded by the issuance of debt or equity), they ought not to be deducted from the calculation of ECF because they do not affect the borrower's internally generated free cash. Therefore, lenders' counsel often would want to limit the deductions to those that are funded by "internally generated cash" of the borrower, whereas counsel to borrowers or sponsors would try to reword these limitations in a narrow way.

A common deduction is the amount used to pay certain specific dividends for the period. These dividends are often limited to those made in connection with the exercise of employees' stock options, the payment of expenses and taxes by the sponsor or parent entity, and a certain percentage of proceeds from public offerings. Some precedents, however, also deduct dividends made from the general basket (which in turn is calculated based on ECF from the previous fiscal year), which would result in lenders being entitled to a smaller percentage of ECF for prepayments than they might otherwise expect. For example, assume the internally generated free cash for each year before this deduction is $100. If 50% of ECF for each year is subject to mandatory prepayments, lenders would receive or be offered 50% of $100 (that is, $50) for prepayments at the end of the first year, with the other $50 left for the general dividends basket for the second year. At the end of the second year, up to $50 of dividends payments made under that general dividends basket could be deducted from $100, leaving only $50 as ECF for the second year, of which only 50% (that is, $25) will be subject to prepayments of the loans. Similarly, at the end of the third year, up to $25 of dividends payments made from the general dividends basket could be deducted from $100, leaving only $75 as ECF for the third year, of which only 50% (that is, $37.50) will be subject to prepayments of the loans. Hence, in the subsequent years, instead of 50% or $50, lenders would only be entitled to a discounted amount for prepayments because of this deduction for dividends made under the general dividends basket.

Payments of long-term debt are also often deducted from ECF. Optional prepayments of the term B loans during the fiscal year are often permitted to reduce the amount subject to prepayments of the term B loans on a dollar-for-dollar basis (that is, 100% reduction). The purpose of this arrangement is to avoid discouraging optional prepayments of the term B loans. Customarily, optional prepayments of other debt are deducted in the calculation of ECF before giving effect to the prepayment percentage (which is often 75% or 50% without accounting for any performance-based step-downs), to calculate the actual amount that is subject to mandatory prepayments. The net effect is that only 75% or 50% of such optional prepayments of other debt would reduce the amount subject to prepayments of the term B loans. The rationale is that the prepayments of other debt are not as valuable to term B lenders as optional prepayments of their term B loans and should only be given the same level of credit as most other deductions such as capital expenditures. However, in some market precedents, these prepayments of other types are also permitted to reduce the amount of ECF required to be subject to prepayments on a dollar-for-dollar basis (that is, 100% reduction instead of 75%/50% reduction), further reducing the amount of ECF sweep to which lenders are entitled.

These are only a few of the many possibilities by which a slight obscure change in the loan documents would alter the economic outcome significantly. It takes close attention from sophisticated participants to ensure these seemingly routine but complex provisions truly reflect the parties' business understanding.

Benjamin Cheng, a counsel at Shearman & Sterling LLP, represents arrangers, sponsors, lenders and borrowers in various financings, with an emphasis on acquisition financings, leveraged lending, restructurings and asset-based financings.

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Equity cure and ECF: Traps and tricks

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