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Alice Holian

Brian Dearing

In Part One of “Trials and Tribulations of Calculating Covenant Capacity” we discussed shrinking numerators and the effects of IFRS 16 treatment. In Part Two, we dive into how certain financial calculation mechanics, such as reclassification and re-allocation, can create unexpected covenant capacity by drawing on other, potentially unrelated, capacity.

(Please note that in addition to links to a number of our other 9fin Educationals, this article contains links to saved searches within the 9fin platform which allows users to access search results directly from our articles. If you would like to see these searches in action, please complete your details here for a free trial.)

Most investors are comfortable with the standard reclassification mechanics — i.e., you incur debt under a specific basket day one, and later deem that you incurred it under another basket (like the Ratio Debt basket). In practice the ability to shift around capacity within the covenants, particularly between ratio-based and fixed amount baskets, can create numerous avenues for engineering further covenant flexibility.

In addition to reclassification, the ability to re-allocate across covenants is a recent emergence in the high yield bond and leveraged loan space. Initially limited to just specific covenants, in certain recent sponsor deals we have seen issuers have the ability to shift capacity across pretty much all relevant covenants.

The following offers a primer on the workings of reclassification and re-allocation and how these tools impact covenant capacity. As always in our 9fin Educational series we provide links throughout to tools on 9fin.com so you can view the relevant language in context.

Issuers generally have the ability to reclassify debt incurred under permitted debt baskets (via the debt covenant), sometimes automatically, and thereafter treat them as if they had been incurred under another permitted debt basket, or more importantly, the Ratio Debt basket. The only limitations, if reclassification of a specified basket is otherwise permitted, is that at the time of reclassification they must: (i) be permitted to incur the debt under that other basket (i.e., the other basket has capacity, or they meet the applicable ratio test, etc.), and (ii) if it is secured debt, there is a corresponding Permitted Lien or Permitted Collateral Lien allowing them to secure the debt under the new basket.

One of the biggest uses of this concept, from an issuer’s perspective, is to reclassify debt incurred under fixed permitted debt baskets into the Ratio Debt basket. At the time of reclassification there is very little impact, but this move becomes very valuable in the situation where a company’s performance begins to decline (and they would have lost capacity under the Ratio Debt test because their EBITDA is declining, etc.), but fixed baskets are, for the most part, always available. By shifting the debt to the Ratio Debt basket when times are good, they can save their fixed baskets for rainy days.

This sounds complicated, but it’s really a matter of semantics as issuers are not required to inform anyone (except, perhaps, the trustee on certain technical matters) on which basket it uses to incur debt, or for that matter, take any other action governed by the covenants.

In the majority of deals the debt covenant will prohibit the reclassification of any debt outstanding on the issue date under the Credit Facilities Basket as Ratio Debt or other Permitted Debt. In some cases, reclassification of any debt (i.e., future debt and not just debt outstanding on the issue date) under the Credit Facilities basket is prohibited. This is an exception to the general reclassification permission described above.

The Credit Facilities basket typically represents a large amount, if not the majority, of the debt in the capital structure. If the issuer were to reclassify capacity under the fixed amount limb of the Credit Facility basket as Ratio Debt, the issuer could incur further incremental debt in excess of the Ratio Debt thresholds, significantly increasing debt capacity (investors may not anticipate this level of debt incurrence).

Additionally, as debt incurred under the Credit Facilities Basket is typically permitted to rank pari passu on the same Collateral as the issuer’s existing SSNs, the ability to reclassify debt incurred under the Credit Facilities Basket as Ratio Debt could significantly dilute the collateral (but only to the extent Ratio Debt itself could be secured, because even if you can reclassify, you must have a corresponding Permitted Collateral Lien). Sometimes, the prohibition on reclassification of day one Credit Facilities debt is omitted, either as a drafting error or deliberately as in Athenahealth.

Reclassification is not just limited to the debt covenant, most deals permit reclassification across the Builder Basket (permitting the issuer to utilise capacity that has otherwise built-up over time), Permitted Payments and Permitted Investments (PIs) as long as the RP/ PI would be permitted under the new basket. Note that the same concerns apply here as did in the debt covenant, where an issuer can sweep all RPs previously made under the Permitted Payments baskets into a leverage-based RP basket they would have access to the fixed baskets again (to be used even if leverage increases in down times).

Reclassification is one thing, but re-allocation is a whole different kettle of fish. In some cases, the issuer can re-allocate capacity across the Restricted Payments (RPs), Permitted Investments (PIs), debt, and liens covenants as opposed to within a single covenant as with reclassification.

In sponsor-backed deals it is becoming increasingly common to allow the issuer to convert RP capacity (either selected RP baskets or all RP baskets) into debt capacity using the Available RP Capacity Amount concept.

Similarly, in a handful of aggressive sponsor-backed deals the issuer can go the other way and make RP/PIs if funded from the conversion of certain elements such as, among other things, permitted debt (collectively dubbed, the “Available Amount”).

In some cases, PI and junior debt prepayment capacity can be used instead for general RP capacity. Examples of this are Cirion (Patagonia) (see “Available Investments Amount” for PIs and “Available Restricted Debt Amount”) for junior debt prepayments, as well as a second similar formulation in Miller Homes, Titan, Granuul, and Kem One).

One might query whether this is better or worse for investors. For example, prepaying junior debt (that is otherwise meant to get paid behind senior debt) would appear to be bad, but, is it really different, or worse, than an issuer simply making a cash dividend? Having said this, it’s also important to note that repaying debt could reduce the issuer’s interest expense, so perhaps it’s better? What is clear though is that it is hard to make these arguments when it comes to PIs.

The flexibility to re-allocate capacity blurs the distinction between the various covenants. These blurred lines means that covenant capacity across covenants should be considered together (especially in the case of RPs and PIs) rather than as distinct concepts.

As alluded to above, PI capacity can increasingly be converted into RP capacity, and it’s sometimes hard to argue why this should be the case. This is diluting the value of even have a separate RP / PI concept, because even if a PI is value leaving the restricted group, investments are typically considered to still retain some value to the group. For example, PIs may leave the issuer with a residual claim over an investment, or ideally it might even return cash to the Restricted Group. However, dividends are purely value leaving the Restricted Group. It is for these reasons that PI baskets and ratio-based baskets tend to be set higher than their RP-equivalents — meaning the issuer could use their PI ratio basket at a higher leverage than their RP ratio basket. Allowing an issuer to re-allocate PI baskets as RP baskets undermines this distinction — investments should be (at least in covenant land where we have separate RP and PI covenants) different than dividends, and it’s unclear why they should just be treated the same.

On a separate note, the Available RP Capacity Amount concept uses theoretical cash to convert RP capacity into concrete debt capacity, i.e., it does not require the issuer to actually have the cash on its balance sheet which you would need to make a cash dividend, simply that they had RP capacity at all. Similarly, with the Available Amount, is it really justifiable that if the company can incur (or has incurred — depending on which interpretation applies — see our separate 9fin Educational where we discuss the various interpretations) debt it should then have carte blanche to distribute that amount?

It is important to ensure that with respect to any re-allocated capacity, the basket from which the capacity is originally derived correspondingly reduces. This closes the infinite capacity loop which would occur if, for example, an issuer could raise debt with RP capacity, and the RP basket didn’t reduce correspondingly. In that example, the issuer could in theory dividend that cash out immediately. Fortunately, we haven’t seen an example of a deal missing this language as of the date of writing.

Re-allocated capacity could sometimes, particularly in more aggressive transactions, be converted unequally. It is not necessarily as straightforward as a one-to-one ratio. For example, you may be able to convert RP capacity into debt capacity (i.e., the Available RP Capacity Amount) on a 1:2 basis (e.g., 200% of the converted capacity). Disproportionate conversion, for example, via the Available RP Capacity Amount, sometimes receives investor pushback, as seen in Arcaplanet, Modulaire Group and Multiversity. You can stay on top of which deals received pushback by using 9fin’s Covenant Pushback tool.

If you need to quickly review of the reclassification and re-allocation mechanisms in a particular deal, 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.

Check whether drafting in the Debt covenant allows the reclassification of Credit Facility debt incurred on the Issue Date (typically it should not). In addition, check whether the day one Credit Facilities are deemed incurred under the Credit Facility basket.

Check whether the issuer can re-allocate capacity across the various covenants:
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Check whether any converted capacity is proportionate (i.e., on a 1:1 basis, and not 1:1.5 or 1:2).

Check whether any re-allocated capacity is correspondingly reduced in the original basket.

Trials and Tribulations of Calculating Covenant Capacity — Part 2 — Rejigging Capacity

(Re)Calculating Covenant Capacity

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