We expect this increased complexity is here to stay. However, it is truly becoming very difficult — and in some cases impossible – for investors (and potentially for the issuers themselves!) to determine the ability of an issuer to take various actions under the indenture. It is no longer the case of glancing at the financial statements to calculate the leverage applicable to the covenants, for example, rather it requires a serious dissection of the relevant definitions. A cynic could say these complexities are borne from the goal of creating greater flexibility for issuers without simply raising the headline figures (i.e., greater basket sizes or higher leverage ratios). Regardless of their merit, they can conspire to create unexpected and potentially staggering flexibility. For example, unclear EBITDA add-backs and the “super grower” concept inflate EBITDA, cherry-picking the test date and exclusions from the leverage numerator can create greater headroom under the leverage ratio, and on and on.

To help you navigate this complex space we have started this series, “Trials and Tribulations of Calculating Covenant Capacity”. The multi-part series will be divided by topic, covering concepts such as shrinking numerators, the effects of IFRS 16 treatment, financial calculation mechanics and the inflation of EBITDA.

Shrinking Numerators

To kick off this series, we are going to look at leverage calculations, however, we are only going to look at the numerator. When it comes to the leverage ratio, a lot of ink is spilt over the ways in which issuers and borrowers can increase EBITDA (the denominator in most leverage calculations) with little acknowledgement given to the ways in which the numerator can be decreased. Leverage calculations are important to understand because leveraged-based capacity shows up under a number of covenants, including the debt covenant, restricted payments (also see (un)Restricted Payments part 2), permitted investments and even sometimes asset sales. In addition, it can show up in the permitted liens or permitted collateral liens definitions (which allow the issuer to secure debt), and may impact the availability of portability in the event of a change of control.

The numerator of most leverage ratio calculations is comprised of “Indebtedness” (note the defined term) less cash and cash equivalents. There are some other formulations, or additional factors that may come in which we will flag throughout this piece (for example, secured debt leverage ratios look at secured debt), but that’s it for the most part. Therefore, one would think, you go to the financial statements, tally up the relevant debt, subtract the cash, et voila. However, as the definition of “Indebtedness” can include or exclude any number of items, it’s critical to check it in each deal.

It’s also important to note at this stage that definitions change dramatically across deals, but for the purposes of our analysis below, we try to set out what our standard expectations are, and we also highlight the typical ways in which it can be modified (perhaps unexpectedly). But, as always, we will do our best to flag for you the permutations which are truly unique or are slowly creeping in.

Ultimately it’s important to keep all of this in context, what we are talking about is lowering the numerator of a ratio calculation, thereby artificially lowering the leverage ratio — allowing for potentially unexpected capacity under various covenants. As Louis Brandeis famously claimed, “sunlight is said to be the best disinfectant”.

What is “Indebtedness”

As alluded to above, the term “Indebtedness”, as used in all of the basic ratios and calculations across the covenants, is a covenant term and not an accounting term, it cannot be deduced by just using the financial statements. Any analysis must begin with a review of the definition of “Indebtedness” to determine what is considered debt for the specific deal under review and then look at the latest financial statements to determine the amount of any debt to be included.

Below we break down some of the most common and key terms that are used in the definition of “Indebtedness”, which often contains a rather lengthy list.

Debt for borrowed money

What constitutes debt is sometimes limited to “debt for borrowed money”. Debt, as used in common parlance, tends to be broader, including any obligation to pay someone, whereas “debt for borrowed money” is a more specific concept. It only refers to amounts where someone paid money and the other party is obliged to pay them back. There are a lot of common types of “debt” (real liabilities!) that are not “debt for borrowed money”, such as tax liabilities and trade liabilities, but they do not result from borrowing money from another party.

Bonds, debentures, notes or similar

The definition of “Indebtedness” will typically include the principal obligations under any bonds, debentures, notes or “similar instruments”. This is intended to capture capital markets type debt that the issuer may have outstanding (although arguably it would also be captured by “debt for borrowed money” above).

Other

The following are some other pieces of “Indebtedness” of note which are almost universally included within the debt covenant:

• Capitalised Lease Obligations — these usually consist of finance leases/leases capitalised on the balance sheet under IFRS (or applicable accounting standards), but note this is usually a defined term and it’s important to double check the definition;
• Guarantees of Debt — essentially guarantees provided by members of the Restricted Group in respect of any debt;
• Disqualified Stock and Preferred Stock — these are comprised of some features that resemble debt. For example, Disqualified Stock can be subject to mandatory redemption provisions and mature before bonds whereas Preferred Stock pays a fixed dividend; and
• Indebtedness secured by a Lien — essentially any debt that is secured by a Permitted Lien (i.e., secured on non-Collateral assets) or a Permitted Collateral Lien (i.e., secured on Collateral assets).

Not all debt is “Indebtedness”

Once we understand what is considered debt within the definition of Indebtedness, working through the definitions and concepts above. Remember, if an item does not constitute “Indebtedness” not only does it alter the leverage ratios but incurrence of those items is not restricted by the debt covenant.

Carve-outs to the definition of “Indebtedness” can come in several forms. First, is simply by omission, it’s always important to consider what is not listed in the definition. Furthermore, the end of the definition may contain specified carve-outs, such as Subordinated Shareholder Funding and Receivables Facilities. The definition of “Consolidated Total Indebtedness” and “Consolidated Secured Indebtedness” used in the ratio calculations may contain further exclusions - these exclusions can either be found within the definitions themselves or under the Financial Calculations section.

Common Carve-outs from “Indebtedness”

The following are items which we increasingly see carved out of deals, or are items to watch out for in the future.

Letters of credit / bank guarantees / capitalised lease obligations / grandfathered lines of credit / rolled over debt

An increasing amount of deals exclude items such as letters of credit, bank guarantees, capitalised lease obligations, grandfathered lines of credit and rolled over debt, from the definition of “Indebtedness”. The rationale for excluding this type of debt is that issuers tend to see “debt” as longer term and/or structural pieces of debt as opposed to the items listed above which tend to be quite small and contingent with drawings under the items fluctuating due to things like seasonal operations, and these are more closely linked to their operations. The challenge is that these could still amount to significant levels, which might materially impact the leverage calculation if they were included.

Subordinated Shareholder Funding

Subordinated Shareholder Funding is often excluded from the definition of “Indebtedness”. Although as the name suggests, such debt is deeply subordinated and in a liquidation event, holders would be the last to be repaid, it can still represent a significant proportion of the capital stack and skew the leverage ratios.

Pension Obligations

It is typical to see “Pension Fund Obligations” carved out of the definition of “Indebtedness”. Firstly pension fund obligations can vary significantly in size, for example, any acquirer of Boots will have to subsume the £8bn worth of pension scheme guarantees. Secondly, depending on the country and the deal, they can sit at different levels in the capital stack. For example, Assemblin (a Nordic technical installation company) excludes its Pension Guarantee Facility from its definition of “Indebtedness” yet this SEK 240m Facility ranks super senior to all other debt in the capital stack. In the UK, pension fund obligations are often unsecured and, therefore, generally rank behind a secured creditor although there is a push by Parliament to give pension schemes stronger positions.

RCF Drawings / for the purpose of working capital needs

A particularly contentious exclusion is RCF drawings or RCF drawings for the purpose of working capital needs. RCF draw-downs can be quite significant, one of the biggest uses for an RCF, working capital needs, can be cyclical in nature and might mean the company draws down when they otherwise have less liquidity. In addition, there are for example, moments where companies facing pressure can draw the RCF, such as during Covid-19 where many issuers opted to draw down on their RCFs in full to maximise their liquidity during a time of crisis. Of course, to the extent that ratios are calculated using only net debt, i.e., deducting cash or cash equivalents, there will be no adverse impact on ratios until the cash is actually spent. This kind of debt can be considered both “long term” (even if drawings must be repaid within 12 months, the facility will remain outstanding longer) and “structural” to the business. Furthermore, RCFs in a structure with secured bonds tend to be “super senior”, meaning they are at the very top of the capital stack and therefore drawings under them can immediately impact risk levels for debt further down (regardless of the reason for drawing!). Given all of this, it’s hard to see why they should be excluded from the definition of “Indebtedness” (and therefore leverage ratios).

In FY 2021, just over 25% of the deals issued excluded RCF drawings for working capital purposes from the ratio calculations. As can be seen in 9fin’s Covenant Pushback tool, there has been some, but not a ton, of pushback in this space with bondholders not permitting Golden Goose and Iliad to exclude RCF drawings to finance working capital needs from ratio calculations during marketing.

Novel Drafting

Explicit Exclusions: Excluding Debt from Ratio Calculations

Typically, ratio calculations exclude debt basket debt incurred on the determination date, in order to allow ratio debt and basket debt capacity to be used concurrently — i.e., it eliminates the need to do any artificial splitting of what is economically the same financing transaction into two separate transactions. The Modulaire Group drafting goes much further than this though, running contrary to how investors would intuitively expect leverage ratios to operate, it contained novel drafting that permits the issuer to exclude debt outstanding under most debt baskets from ratio calculations.

For instance, existing target debt, all general debt basket debt, and debt under all other numerical baskets were not included in testing the ratios. The ratios also exclude all revolving and working capital debt. Therefore, when working out the issuer’s leverage for purposes of covenant capacity, you would need to back-out a decent amount of debt. One argument for this construct could be that if you use your leverage ratio, and then the baskets, you kind of end up in the same place, but the counter is that in the situation where an issuer does not meet its leverage ratio, it must use its baskets to incur additional debt, but in this case that would not impact their ability to reduce other debt (not incurred under the baskets) to reduce their leverage and have further (and unexpected) capacity. Note this novel approach also runs to portability — meaning they could artificially make portability available. This novel drafting also appeared in Multiversity but was removed during marketing.

Similarly, in Virgin Media-O2’s 4.75% SSNs due 2031, covenant ratios excluded certain debt such as the “Credit Facility Excluded Amount” (£500m / 25% Annualised EBITDA) and the general debt basket (£330 million / 3% Total Assets).

Cheeky Omissions: What isn’t covered in the Ratio?

As well as looking at the exclusions, it is important to look at what is included and what is silently left out of the ratio definitions. For example, the definition of “Senior Secured Net Leverage Ratio” (”SSNL”) can vary from bond to bond. One would think that the definition would include all first lien debt within the restricted group. However, we have seen the SSNL ratio defined to include (1) both first lien and second lien debt, (2) any secured debt in the numerator, or (3) only debt that is secured on a first lien basis on the collateral. In point (3), the “collateral” could be significantly limited, i.e., a soft package including only share pledges, inter-company loans, bank accounts, etc., with no hard asset security pledged (note this is the common package in European bonds). If the numerator only includes first lien debt that is secured on the same collateral, it could exclude any loans or bonds secured on other assets such as real estate assets or assets in a target entity where the existing financial structure is kept in place. Huge variation as to what is included in the ratio definition requires potential investors to have a good read of the relevant definitions.

IFRS 16 treatment

IFRS 16, where all leases are required to be recognised on the balance sheet, has been in operation since 1 January 2019 — see our explainer here. As a result, operating leases must be capitalised rather than expensed through the P&L statement, meaning both debt and EBITDA increase. Issuers dealt with this change in different ways: (1) they could amend these provisions to reflect the impact of IFRS 16, or (2) carve out what would have formerly been considered an operating lease from their debt calculations after 1 January 2019. Whatever approach is taken, it should be treated consistently throughout the documents and the related definitions.

However, in some cases, there is a mismatch in the treatment of IFRS 16 where the deals have (1) pre-IFRS 16 operating leases excluded from numerator of leverage calculations but (2) IFRS 16 effect included in calculating EBITDA (the denominator). For example, Arrow and Aggreko (both sponsored by TDR Capital) excluded pre-IFRS 16 operating leases from debt treatment under the covenants, but attributable expenses were not backed out of covenant EBITDA. It is not always obvious that there is a mismatch, the discovery of which requires a dive into the definitions.

Such treatment can artificially increase EBITDA and decrease debt. Not only does this potentially increase the sizes of baskets that have an EBITDA grower attached but it can lower the issuer’s leverage allowing access to leverage-based baskets that would otherwise not have been available.

See the Red Flag Review Checklist below for tips on how to spot a mismatch.

If you need to quickly review what counts as Indebtedness for covenant purposes, or identify an IFRS 16 mismatch, what should you look out for? The following is intended to be a short list to help you focus your review on the key points.

Where to look for various debt exclusions in the Description of Notes:

1. Review the definition of “Indebtedness”, which is usually divided into two sections; what does and what does not constitute “Indebtedness”? Is anything important omitted?
2. Review relevant ratio definitions, i.e., “Consolidated Net Leverage”, “Senior Secured Net Leverage”, “Consolidated Total Debt”, or similar:
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3. Financial Calculations section of the DoN: look out for drafting that (1) excludes RCF drawings / for the purpose of working capital needs (2) debt under key debt baskets.
4. Sometimes the final paragraphs under the debt covenant contain further exclusions not found elsewhere.

How to spot an IFRS 16 treatment mismatch:

1. Either:
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2. but at the same time the issuer does not have to make this same election or apply consistent treatment for EBITDA.