As the UK begins to emerge tentatively from lockdown, amendment and waiver processes continue on leveraged finance facilities for businesses which have been hit by COVID-19. A recurring feature has been the introduction of the liquidity covenant, hitherto unfamiliar to many outside the restructuring world, including the younger generation of acquisition financiers.
In many cases, lenders have acknowledged that corona-depleted EBITDA levels will not result in a meaningful leverage test, and so have resorted to the liquidity covenant to measure the barest of necessities (in these bearish times): how much cash does a business have, and how much can it get its hands on?
Consequently, stakeholders and their advisers have spent much of their time hunched over their kitchen tables, installed in the attic or, for those lucky enough, stationed in their home offices, debating the nuances of how these tests should operate.
So what constitutes liquidity? As ever, cash is king, and will form a key component. Lenders are best advised to start from the usual defined term "Cash" with the protections that brings, and may on occasion tighten that further by counting only the Cash that the business is capable of accessing within an even shorter timeframe. Cash Equivalent Investments may also be counted, but as this test is designed to measure resources available to the business in the short term, should arguably only contribute to liquidity if capable of becoming cash quickly.
Liquidity tests will also often look at what potential sources of cash the business can avail itself of. Most obviously, facilities agreements will generally include an RCF and, for any businesses out there which haven't yet drawn theirs in full, available commitments under it will usually be counted. It may not, in all circumstances, be appropriate to refer simply to the "Available Facility" under the RCF here, given that definition glosses over the status of any drawdown conditions. If the facility has been draw-stopped by a Default which the lenders have chosen not to waive, then that tap has been turned off. If the company is able to access working capital facilities outside the remit of, but still permitted by, the Finance Documents, then it may argue that those should also be counted, although lenders should carefully consider before including any uncommitted facilities given they don't provide certainty of funding.
The liquidity covenant will be tested against a cashflow forecast produced and delivered by the company. Given the heightened stakes, delivery of these forecasts, and the related testing, will be at least monthly (rather than quarterly), and in some instances bi-weekly or even weekly.
The covenant itself will often be two-pronged, consisting of a look-back and a look-forward test. In both instances, debate will focus around whether a hurdle amount on a given date (often month-end) needs to be met; whether an average liquidity position over a given period needs to be achieved; or whether an agreed level must be met at all times. The first of these grants the group the most latitude, but any average figure or "at all times" test level will need to factor in the inevitable ebb and flow of cash through the business, and the chosen formulation will, therefore, to a large degree influence the agreed minimum liquidity level. As to how far into the future the test will look, 13 weeks is agreed as a suitable period on most deals but some CFOs are being asked to look a full 12 months down the line in their projections.
As with other maintenance covenants, the sponsor or shareholders are likely to ask that the liquidity test is capable of being equity cured post-breach. Indeed, they may well have provided an equity injection as part of the amend and restate process which introduced the liquidity test. If the concept is agreed, lenders will still look for some controls around the number of times the equity cure mechanism can be used to keep the business artificially afloat, and will expect cure rights to be exercised more quickly in the case of the liquidity test than for other covenants. They may also insist that the covenant is cured with some additional headroom, so that in the current fast-changing economic environment the sponsor intervention is backed up by a sufficiently substantial equity contribution. This being said, when negotiating any equity cure provisions, lenders should remember that as the liquidity covenant tests cash, sponsors are free to make equity contributions at any stage prior to a test date to ensure covenant compliance.
Interaction with any 'deemed cure' provisions is also something to be considered. If a breach of the liquidity covenant could be cured by delivery of a healthier cashflow forecast sometimes as little as one or two weeks later, should the lenders be forced to sit on their hands when they believe that the business is teetering on the brink? The company may argue it should, if the transgression was just a blip and cashflows have since corrected.
Market participants who weren't around for the demise of Lehman et al. have certainly had a crash course on these issues since lockdown began. Lenders may well have been exploring other forms of liquid therapy over these past turbulent months, but liquidity covenants are set to be their friend and companion for the duration of the "new normal", and their trusted guide to whatever awaits us beyond.
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