General

The Debt covenant’s purpose is to (1) limit the amount of additional debt that the Restricted Group can incur and (2) govern which Restricted Group entities can incur any such debt. This second point is important in limiting the risk that the bonds could become structurally subordinated to debt incurred by non-Guarantor Restricted Subsidiaries, which do not provide credit support to the bonds. This is explained in more detail in our report Restricted Group - not all Subsidiaries are created equal.

As with other high yield covenants, the Debt covenant is a negative, or incurrence, covenant, meaning that the covenant is only tested when the Restricted Group wants to incur debt. This is in contrast to a maintenance covenant, as seen in traditional loan agreements, which requires the company to maintain certain financial ratio levels over the life of the instrument. The Debt covenant is drafted as a general prohibition on incurrence of “Indebtedness” by the Restricted Group, subject to a number of exceptions.

Check your cap structure first

As a general matter, it’s important to review the Debt and Liens covenants in the context of the issuer’s specific capital structure, taking into consideration the bonds’ priority position relative to other debt (e.g., senior secured, senior, subordinated) as well as the extent of the bonds’ guarantor coverage and security / collateral package.

For instance, if the bonds are issued by a holding company with no (or limited) guarantees from operating subsidiaries, you will want to pay close attention to the ability to raise structurally senior opco-level debt. On the other hand, documentary protections limiting non-guarantor debt may be relatively less important in a bond with robust guarantor coverage.

Similarly, in the context of “senior notes” that are effectively subordinated to existing senior secured debt, you’ll want to understand how much further debt can rank ahead of them — including on a senior secured or junior lien basis or otherwise.

Conversely, if you are reviewing senior secured bonds, you’re likely to be less concerned about future second lien debt and more concerned about incremental senior secured debt capacity and whether there is scope to add super senior debt, or debt secured on non-collateral assets (particularly if the security package is limited).

What counts as “Indebtedness”?

“Indebtedness”, as typically defined, includes not only debt for borrowed money and instruments such as bonds, notes and debentures, but also capitalised leases, hedging obligations, disqualified stock, preferred stock of Restricted Subsidiaries, reimbursement obligations in respect of letters of credit or bankers’ acceptances, certain deferred purchase price obligations and third-party debt guaranteed by, or secured by assets of, a member of the Restricted Group.

The “Indebtedness” definition typically excludes “Subordinated Shareholder Funding” (i.e., deeply subordinated, equity-like instruments issued to shareholders), pension and workers’ compensation-type liabilities and certain ordinary course obligations. Receivables / Securitization Financings and pre-IFRS 16 operating leases are also sometimes excluded from “Indebtedness.”

It’s important to be aware of what is and isn’t included in the “Indebtedness” definition, as anything that is not captured within the definition will not be caught by the Debt and Liens covenants. For instance, deals by Liberty Global portfolio companies routinely exclude “Finance Leases” from the scope of the relevant definition (note: replaced with “Lease Obligations” in the creeper list amendments for the latest Virgin Media - O2 bond). In leveraged loan agreements for care facility operators, we’ve also seen “Indebtedness” carve-outs for real estate financings related to these facilities.

Ratio Debt

As mentioned above, the Debt covenant limits the Restricted Group from incurring “Indebtedness” unless an exception applies. The first main exception is the “Ratio Debt” clause, which is typically set out in the first paragraph of the Debt covenant. This clause permits the Restricted Group to incur debt if a certain ratio test would be met on a pro forma basis after the debt is incurred.

Typically, the Ratio Debt clause uses a Fixed Charge Coverage Ratio (“FCCR”) test, customarily set at 2x. This can generally be thought of as an “interest cover” test measuring the Restricted Group’s ability to service its ongoing debt obligations. The 2x FCCR test is a fairly low bar; as mentioned in Part 1 of our report on the Restricted Payments covenant, this 2x FCCR test is elsewhere used in the covenants as a very basic “health check” on the issuer.

While 2x FCCR is by far the most common level for the Ratio Debt test, occasionally we’ve seen this set at a different level, for example, at 2.25x or 2.5x in the most conservative deals, or at 1.75x in very aggressive deals. Issuers in certain industries sometimes use a leverage test (telecom - selected examples here) or an LTV test (real estate - selected examples here) as an alternative to the FCCR test. Some aggressive deals offer the issuer the option to incur Ratio Debt subject to meeting either an FCCR or a leverage test (selected examples here).

Which entities can incur Ratio Debt?

Depending on the drafting in the particular deal, Ratio Debt incurrence by non-guarantor Restricted Subsidiaries may be capped, in order to mitigate the risk of structurally senior debt incurrence described above. The cap is typically formulated as the greater of a fixed amount and a percentage of EBITDA (some examples here), and it may apply just to Ratio Debt or as a combined cap together with non-guarantor debt incurrence under specific Permitted Debt baskets (to be discussed in Part 2 of this report).

In some conservative deals, non-guarantor Restricted Subsidiaries may be restricted from incurring Ratio Debt altogether (a couple of examples here).

However, these types of limits on non-guarantor Ratio Debt incurrence are often absent from recent deals, which could leave investors exposed to the risk of structural subordination, especially if guarantor coverage is weak.

Note that the mere presence of a cap isn’t enough to protect against structurally senior debt — a cap may be more or less protective depending on the level at which the cap is set and which Debt baskets within the scope of the cap. And these caps would also not protect against structurally senior debt via a drop-down, “J.Crew”-style financing being raised at an Unrestricted Subsidiary.

Secured Ratio Debt

While the 2x FCCR Ratio Debt test permits the issuer to incur additional debt, the ability to secure Ratio Debt is typically more limited. This will usually depend on whether a secured leverage test is met, or else whether another Permitted Lien or Permitted Collateral Lien clause is available (to be discussed further in the Liens covenant report).

The secured leverage test is sometimes included in the Ratio Debt clause (examples here) but is sometimes set out instead in the Permitted Collateral Liens definition (examples here). Some bond deals include a secured leverage ratio test as a limb in the Credit Facilities basket (examples here); this is particularly common where there is a term loan B in the structure, as the Credit Facilities basket will often mirror the incremental facilities capacity in the senior facilities agreement.

Depending on the specific formulation, the issuer may need to meet both the FCCR and the secured leverage test in order to incur secured Ratio Debt, or it may only need to meet the secured leverage test (i.e., may not need to test the FCCR - this is usually the case where the secured leverage test is located in the Credit Facilities basket).

In a senior secured bond deal, Ratio Debt that is secured on a pari passu basis on the collateral will require a Senior Secured Net Leverage Ratio (”SSNLR”) test to be met on a pro forma basis after the debt is incurred. The test level is often set right around the opening SSNLR, but this is not always the case.

Ratio Debt that is secured on a second / junior lien basis may be subject to a separate Total Secured Net Leverage Ratio (”TSNLR”) test or might be subject only to the more permissive 2x FCCR test.

Practical considerations

Although the 2x FCCR baseline is a fairly low bar that may permit significant additional debt incurrence, in practice it’s fairly uncommon in European leveraged finance structures (which typically involve a security package) for an issuer to raise unsecured Ratio Debt. Unsecured debt would be effectively subordinated to the secured debt, to the extent of the value of the assets that secure such debt. Investors would therefore likely require a much higher coupon for the riskier unsecured debt. As a result, the SSNLR (and/or TSNLR) test is often a more meaningful practical constraint on Ratio Debt incurrence.

Notwithstanding the above, we can’t be too quick to write off the 2x FCCR Ratio Debt clause entirely! The lowly 2x FCCR test could become very important in certain situations, for example, if it can be used to incur structurally senior non-guarantor debt or if there are any Permitted Collateral Liens or Permitted Liens clauses (e.g., a general basket) that could be used to secure the debt either on collateral or non-collateral assets (to be discussed further in the Liens covenant report).

Calculating the SSNLR

How the SSNLR is defined varies across deals and can have significant practical consequences on the issuer’s capacity to incur secured debt. Moreover, covenant leverage calculations may potentially differ from the metrics included in the issuer’s ongoing reporting.

There are a number of points to consider, and this topic could easily fill a separate report (look out for one in the near future, and in the meantime check out our recent webinar with A&O, AFME and ELFA on the topic of calculating covenant capacity). But, to get started, here are a few general pointers:

1. Cash netting: Historically, senior secured leverage tests were calculated as gross senior secured debt divided by EBITDA. Nowadays, this is almost always a net test (hence the “N” in our default acronym), meaning that the ratio’s numerator will deduct pro forma cash and cash equivalents. This formulation means that the more cash the issuer has, the lower its leverage ratio calculation will be. There is no cap on the amount of cash that can be netted, and netting is allowed regardless of how the cash balance will ultimately get applied (i.e., no requirement to apply the cash towards debt reduction).
   
2. Numerator:
   
   - Scope: Historically, the SSNLR numerator often included debt secured by liens on any assets, including non-collateral assets (effectively senior to the bonds - see eDreams ODIGEO as an example), and sometimes even unsecured debt of non-guarantors (structurally senior to the bonds - see Renk AG as an example). Recent deals typically limit the numerator to debt of the Issuer and Guarantors secured on a first-lien basis on the collateral.
   
   - Exclusions: In some recent sponsor deals, ratio calculations exclude certain revolving and/or working capital debt (examples here), and other items may also be excluded - this means that the SSNLR numerator might be lower than the total amount of senior secured debt that is actually outstanding on the calculation date. To figure out what’s excluded, you may need to look not only at the SSNLR definition and related definitions, but also under other headings such as “Financial Calculations” or “Certain Compliance Calculations”.
   
3. IFRS 16: In some deals, pre-IFRS 16 operating leases are excluded from leverage calculations. However, the issuer may be permitted to calculate EBITDA including the effects of IFRS 16, creating a “mismatch”. Because IFRS 16 has the effect of boosting EBITDA (reduction in rental expense; increase in depreciation and interest expense), this mismatch results in a lower leverage figure than if numerator and denominator were calculated on a consistent basis. Other deals may require numerator and denominator to be calculated on a consistent basis, but give the issuer optionality in whether or not to apply IFRS 16 for leverage calculations, so that they can take whichever approach gives a more favourable result.
   
4. EBITDA add-backs: A higher covenant EBITDA brings the ratio down, so the more flexibility an issuer has to adjust EBITDA, the easier the SSNLR test will be to meet.
   
5. Test timing: It’s increasingly common for deals to provide broad test date flexibility, such that the issuer may be able to calculate its pro forma SSNLR (including expected synergies etc.) on the date it enters into a definitive agreement or committed financing, the date it gives notice of a refinancing or on another date, in lieu of testing the ratio on the date it actually incurs the debt. In other words, it may be able to “lock in” capacity for a future financing transaction even if the SSNLR is no longer met at the time the transaction closes. This is important because it gives the issuer optionality to select the most favourable test date, even if it is aware that it may not meet the test in the future, due to EBITDA fluctuations or otherwise.

What should you look out for in reviewing the Debt covenant, in particular, the Ratio Debt provision on a particular transaction? The following is intended to be a short list to help you focus your review on the key points.

1. Consider the overall capital structure and the bonds’ ranking, guarantor coverage and security package. These factors will shed light on the most important areas of risk.
   
2. Are there significant / off-market exceptions to the “Indebtedness” definition?
   
3. Does the Ratio Debt test differ from the standard 2x FCCR test? If so, is this commercially justified?
   
4. Can Ratio Debt be incurred by non-guarantors?
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5. What levels are the SSNLR and/or TSNLR tests set at? How are these ratios calculated, and in particular are there significant exclusions (i.e., certain types of debt, etc.), off-market adjustments or other calculation quirks that might make the tests easier to meet?