The audio portion of the conference may be accessed via the telephone or by using your computer's

speakers. Please refer to the instructions emailed to registrants for additional information. If you

have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.

Presenting a live 90-minute webinar with interactive Q&A

Structuring Financial Covenants, EBITDA,

and Events of Default to Maximize Borrower

Protection and Lender Remedies

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

THURSDAY, OCTOBER 27, 2016

Paul W. Hespel, Partner, Pepper Hamilton, New York

Alexandra Margolis, Partner, Nixon Peabody, New York

Tips for Optimal Quality

Sound Quality

If you are listening via your computer speakers, please note that the quality

of your sound will vary depending on the speed and quality of your internet

connection.

If the sound quality is not satisfactory, you may listen via the phone: dial

1-866-873-1442 and enter your PIN when prompted. Otherwise, please

send us a chat or e-mail sound@straffordpub.com immediately so we can

address the problem.

If you dialed in and have any difficulties during the call, press *0 for assistance.

Viewing Quality

To maximize your screen, press the F11 key on your keyboard. To exit full screen,

press the F11 key again.

FOR LIVE EVENT ONLY

Continuing Education Credits

In order for us to process your continuing education credit, you must confirm your

participation in this webinar by completing and submitting the Attendance

Affirmation/Evaluation after the webinar.

A link to the Attendance Affirmation/Evaluation will be in the thank you email

that you will receive immediately following the program.

For additional information about continuing education, call us at 1-800-926-7926

ext. 35.

FOR LIVE EVENT ONLY

Program Materials

If you have not printed the conference materials for this program, please

complete the following steps:

• Click on the ^ symbol next to “Conference Materials” in the middle of the left-

hand column on your screen.

• Click on the tab labeled “Handouts” that appears, and there you will see a

PDF of the slides for today's program.

• Double click on the PDF and a separate page will open.

• Print the slides by clicking on the printer icon.

FOR LIVE EVENT ONLY

AGENDA

Purposes of financial covenants and ratios

Financial maintenance covenants

Covenant-lite loans

Incurrence covenants

Balance sheet and cash flow based financial covenants

Financial definitions

• Consolidated Net Income

• Consolidated EBITDA

• Consolidated Fixed Charges

Financial information in credit agreements

Borrower’s response to financial maintenance covenants

• Springing covenants

• Equity cure rights

Excess cash flow sweep

Events of default and remedies

5

PURPOSES OF FINANCIAL COVENANTS AND RATIOS

• Monitor the borrower’s financial performance on a regular basis

– maintenance covenants

• Limit the borrower’s ability to take certain actions – incurrence

covenants

• Interest rate margins and commitment fees

• Mandatory prepayment stepdowns – excess cash flow, asset

sales

6

FINANCIAL MAINTENANCE COVENANTS

• Require borrower to achieve certain financial performance tests on a

periodic basis

• Cash flow lending - leverage ratios, interest coverage ratio, fixed

charge coverage ratio

• Performance levels typically tied to borrower’s model provided to

lenders before commitment

• Consequences of breach of a financial maintenance covenant

• Failure to comply results in an event of default (no grace period)

• Borrower loses access to revolving credit facility

• May trigger a cross-default under borrower’s other indebtedness

• Lenders have right to accelerate loans and exercise remedies

7

COVENANT-LITE LOANS

• Covenant-lite loans contain only incurrence based financial

covenants

• Covenant-lite is prevalent in large cap market and higher

end of middle market

• Typically available when credit market conditions favor

borrowers

• Highly rated leveraged borrowers and private equity

sponsors have greater ability to negotiate favorable terms

• Absence of financial maintenance covenants reduces

borrower’s risk of default

8

INCURRENCE COVENANTS

• Incurrence based covenants are not tested periodically but must be

satisfied, giving pro forma effect to the relevant action, to enable the

borrower and its subsidiaries to take certain actions otherwise prohibited

• Ratio baskets:

• Debt

• Liens

• Restricted payments

• Junior debt prepayments

• Permitted acquisitions and other investments

• Debt incurrence – debt covenant baskets and incremental facilities

• Ratio debt – pro forma compliance with maximum leverage ratio (first lien,

secured, total) or minimum fixed charge coverage ratio or interest coverage

ratio

9

INCURRENCE COVENANTS

• Debt incurrence

• (xxvi) Indebtedness incurred to finance a Permitted Acquisition; provided that either

(i) the Interest Coverage Ratio after giving Pro Forma Effect to the incurrence of

such Indebtedness and such Permitted Acquisition is either (x) equal to or greater

than 2.0 to 1.0 or (y) equal to or greater than the Interest Coverage Ratio

immediately prior to the incurrence of such Indebtedness and such Permitted

Acquisition for the most recently ended Test Period as of such time or (ii) the Total

Leverage Ratio after giving Pro Forma Effect to the incurrence of such Indebtedness

and such Permitted Acquisition is either (x) equal to or less than 5.0 to 1.0 or (y)

equal to or less than the Total Leverage Ratio immediately prior to the incurrence of

such Indebtedness and such Permitted Acquisition for the most recently ended Test

Period as of such time ….

• Grower baskets

• The greater of $___ or __% of Consolidated EBITDA

• Enables upsizing of baskets in connection with acquisitions without

need for amendment

10

BUILDER BASKETS

• “Available amount” builder baskets for investments, restricted payments

and junior debt prepayments

• Starter basket (fixed dollar, sometimes with grower component) +

retained excess cash flow or 50% consolidated net income

• Plus:

• Declined mandatory prepayments

• Equity injections and issuances

• Returns on investments

• Net proceeds of sales of Unrestricted Subsidiaries

• Net proceeds of debt and disqualified equity issuances that are converted

into qualified equity

• Leverage test for use of builder basket for dividends (sometimes

investments)

11

• Balance sheet based financial covenants are determined taking into account balance sheet items, i.e., components of assets, liabilities and shareholders’ equity.

• Net Worth (Assets minus Liabilities)

• Tangible Net Worth (Tangible Assets (excluding intangibles such as intellectual property rights and goodwill) minus Liabilities)

• Debt-to-Equity Ratio (Liabilities divided by Stockholders’ Equity)

BALANCE SHEET AND CASH FLOW BASED FINANCIAL COVENANTS

12

• Cash flow based financial covenants attempt to measure excess cash generated by the borrower/issuer to service or “cover” payment obligations/liabilities. EBITDA in most cases being a proxy for such excess cash.

• Leverage Ratio (Ratio of Debt to EBITDA)

• Interest Coverage Ratio (Ratio of EBITDA to Interest Expense)

• Fixed Charge Coverage Ratio (see below for definition)

• Various credit facilities where balance sheet and cash flow based financial covenants are used.

• Investment grade debt

• Highly leveraged borrowers

• Covenant-Lite and Covenant-Wide

BALANCE SHEET AND CASH FLOW BASED FINANCIAL COVENANTS

13

• Maximum Total Leverage Ratio/First Lien Leverage Ratio/Secured Leverage Ratio:

• Total/First Lien/Secured Funded Debt to EBITDA

• What is included in Funded Debt ?

• "Net Debt" approach (i.e., calculation "net of unrestricted borrower cash and cash equivalents") is common. Negotiation typically revolves around caps and thresholds with respect to cash/cash equivalents which is netted from the debt calculation, including whether such cash needs to be maintained through controlled deposit arrangements.

FINANCIAL COVENANTS MOST TYPICALLY USED IN LEVERAGED LOAN FACILITIES

14

• Minimum Interest Coverage Ratio (in any case, above 1.00 to 1.00)

• Ratio of EBITDA to Interest Expense

• Interest Expense computed in accordance with GAAP, with adjustments, most typically, for:

• interest income

• gains or losses on swaps or other derivatives to hedge interest rate risk

• fees and costs related to financings, including debt issuance costs and debt discounts

• non-cash interest expense

• Minimum Fixed Charge Coverage Ratio

• Ratio of EBITDA to Fixed Charges (see below for definition)

FINANCIAL COVENANTS MOST TYPICALLY USED IN LEVERAGED LOAN FACILITIES

15

• Maximum Capital Expenditures (used to be common; Capital Expenditures generally governed through the Fixed Charge Coverage Ratio and/or a limitation on Capitalized Leases; remains a separate covenant in some lower middle market deals)

• Capital Expenditures computed in accordance with GAAP, including Capitalized Lease Obligations, but often adjusted to exclude the following:

• capital expenditures funded with permitted asset sale proceeds, proceeds from condemnation or events of loss, or paid for with trade-ins or exchanges

• equity funded capital expenditures

• capital expenditures paid for by a third party (for instance landlords)

• any consideration related to a “Permitted Acquisition”

• Concept of “carry-forward” of permitted Capital Expenditures from one fiscal year to the next.

OTHER FINANCIAL COVENANTS

16

• Consolidated Net Income

• Concept of “Normalized Earnings/Income,” i.e., earnings/income are adjusted to remove the effects of revenues and expenses that are unusual or one-time influences, which should help stakeholders understand a borrower’s true earnings from its normal operations.

• “Consolidated Net Income” commonly defined as the net income (or loss) of any Person on a consolidated basis for the relevant period taken as a single accounting period determined in conformity with GAAP.”

CONSOLIDATED NET INCOME

17

• Typical “normalizing” adjustments/exclusions for Consolidated Net Income in loan documents are:

• gains or losses related to the early extinguishment of debt or derivative instruments

• the net income of any Person that is not a Subsidiary of the Borrower, except to the extent of the receipt of any dividends or distributions from such Person

• the effects of any purchase accounting in an acquisition context

• impairment charges or asset write-offs or write-downs

• any non-cash expenses resulting from employee benefit plans, or the grant of Stock appreciation or similar rights

• gains or losses related to the fluctuations in currency values

CONSOLIDATED NET INCOME

18

• Consolidated EBITDA is the cash flow generated by the borrower and its restricted subsidiaries in the ordinary course of business that is available to service debt

• Used in cash flow ratios (leverage, fixed charge coverage, interest coverage ratios)

• Measures recurring operational strength without the impact of non-ordinary course or non-recurring items

• Highly negotiated and contains adjustments based on specifics of the transaction

• EBITDA measurement is backward looking and covers the last twelve months (the “test period”)

CONSOLIDATED EBITDA

19

EBITDA ADJUSTMENTS

• Non-ordinary course and non-recurring items deducted from CNI are

added back to eliminate charges that distort the measurement of the

Borrower’s ability to generate cash flow

• Non-cash expenses based on an accounting convention (e.g.,

depreciation and amortization)

• Interest expense

• Tax payments

• Extraordinary, unusual or non-recurring losses or expenses (with a

corresponding deduction for extraordinary, unusual or non-recurring

gains).

• Extraordinary items are both unusual and infrequent

• Non-recurring are unusual or infrequent – sometimes capped

20

EBITDA ADJUSTMENTS

• Business optimization and other restructuring charges relating to

employee retention, severance or relocation, closure or

consolidation of facilities, excess pension charges

• Loss from discontinued operations or non-ordinary course asset

sales

• Transaction fees and expenses (may be capped and have an

incurrence time limit) incurred in connection with [financing,

acquisitions]

• Non-cash charges (with a corresponding deduction for non-cash

gains) (e.g., losses from the write-down of assets, non-cash equity

compensation, unrealized foreign currency losses)

• Management, monitoring, consulting and advisory fees, indemnities

and related expenses (sponsor deals)

21

EBITDA ADJUSTMENTS

• Permitted material acquisitions or dispositions of a business

unit or subsidiary

• EBITDA of acquired or divested entity is given pro forma

effect from the beginning of the test period.

• Acquisition-related debt immediately included in leverage

ratio is offset by retroactive credit for incremental EBITDA.

• Historical results of a significant divestiture are eliminated –

this may improve EBITDA if the business that was sold was

generating negative EBITDA.

22

EBITDA ADJUSTMENTS

• Cost savings, operating expense reductions and synergies related to

restructurings, cost savings initiatives or other initiatives projected by

Borrower in good faith to result from [Specified Transactions]

• Timing of the action

• “Taken or initiated” vs. “committed to or expected” during the test period

and taken within specified time thereafter (e.g., 18 or 24 months)

• “Projected in good faith to be realized”

• Projected results are “net of actual benefits realized” to avoid double counting

• “Reasonably identifiable” and “factually supportable”

• Certification from management

• Frequently subject to an aggregate cap, e.g., 15% of EBITDA (before

giving effect to cost savings adjustment)

• Calculated on a pro forma basis from the beginning of the test period

23

• Fixed Charge Coverage Ratio

• Various approaches as to what “fixed charges” are to be measured in the financial covenant; commonly defined as the ratio of

• (a) Consolidated EBITDA minus [unfinanced] Capital Expenditures,

• to (b) the sum of: • interest expense

• scheduled principal payments

• taxes

• restricted payments

• management fees to sponsor entities

CONSOLIDATED FIXED CHARGES

24

• Most often based on “generally accepted accounting principles in the United States as in effect from time to time (GAAP)”

• Sometimes flexibility to convert to IFRS, International Financial Reporting Standards issued by the International Accounting Standards Board (IASB), subject to:

• delivery of reconciliation statements to GAAP

• at the request of Borrower, Administrative Agent or Lender, ability to amend financial ratio calculations or thresholds to eliminate effect of the election to implement IFRS

• “Frozen” GAAP vs. ability to adjust to change in GAAP

FINANCIAL INFORMATION IN CREDIT AGREEMENTS

25

• Proposed changes to lease accounting under GAAP/IFRS

• remedial language in credit documentation

• Pro Forma Calculations:

• to give effect to specific transactions such as divestitures, acquisitions, incurrence or repayment of debt, a restricted payment or the designation of a Subsidiary as restricted or unrestricted

• to include changes in Net Income/EBITDA as a result of such specific transactions including Net Income/EBITDA in the context of an acquisition

• to reflect the repayment or incurrence of indebtedness as of the first day of the applicable testing period for the applicable financial covenant that is computed on a pro forma basis

FINANCIAL INFORMATION IN CREDIT AGREEMENTS

26

• Restricted/Unrestricted Subsidiaries

• Designation of Subsidiaries as Unrestricted

• Covenants, including financial covenants, applicable only to Loan Parties and their Restricted Subsidiaries

• Additional information delivery requirements to assess impact of the Unrestricted Subsidiaries on financial covenant compliance, such as for instance the delivery of consolidating financial statements relating to the Loan Parties and their Restricted Subsidiaries, on the one hand, and any Unrestricted Subsidiaries, on the other hand

• Treatment of indebtedness at par value, rather than fair value, for purposes of computation of financial covenants

FINANCIAL INFORMATION IN CREDIT AGREEMENTS

27

BORROWER’S RESPONSE TO MAINTENANCE COVENANTS

Springing maintenance covenants:

• Covenant-lite deals with a revolving credit facility contain a “springing”

financial maintenance covenant solely for the benefit of the revolving lenders

• Springing covenant is tested only when the borrower’s utilization of the

revolving commitments exceeds a threshold, usually 25-35% of the total

revolving commitments

• Breach of the springing covenant entitles only the revolving lenders to

exercise remedies

• Default of the term loan in the same loan agreement is triggered only if the

revolving lenders terminate commitments and accelerate their loans

28

• Financial Covenant for ABL Facilities

• Generally limited to a "springing" Fixed Charge Coverage Ratio or Interest Coverage Ratio, tested only when ABL availability is less than a negotiated % of the ABL commitment (and/or the borrowing base)

• Treatment of letters of credit (exclusion of cash collateralized LCs, inclusion of non-cash collateralized LCs above a certain $ threshold)

• No cross-default in any related cash flow based term loan agreement based on a “springing” financial covenant breach under the ABL, unless the earlier to occur of (i) the passage of a certain period of time (45-90 days), (ii) acceleration of the ABL facilities and/or (iii) exercise of remedies

SPRINGING COVENANTS: ABL FACILITIES

29

• Ability of company to cure financial covenant default with proceeds of equity issuances contributed to the Borrower/typically a standstill on remedies during the [10 Business Days] period in which a cure can be exercised

• Typical Negotiated Limitations:

• Cap on number of cures during the term of the facility

• Whether cures may be made in consecutive fiscal periods (cures typically limited to no more than 2 per fiscal year anyway)

• Ability to cure with the issuance of subordinated debt (in addition to issuance of common stock or qualified preferred)

• Whether the cure proceeds must be applied to prepay term loans (requirement more typical in the lower middle market)

• Contributed amount not to be used for any other purposes

• Used frequently?

EQUITY CURE RIGHTS

30

• Excess Cash Flow (ECF) computed based on Consolidated Net Income or based on Consolidated EBITDA

• Percentage is negotiated, but typically start at 50% of ECF. Step-downs (25%, 0%) based on performance threshold standards built in.

• Borrowers request that ECF sweep commence with completion of the first full fiscal year under a new credit arrangement.

• Key is to identify important deductions to sweep, such as 100% credit for voluntary prepayments, deductions for acquisitions, investments, restricted payments and capital expenditures made with internally generated cash.

• ECF that is not swept (including as a result of lenders declining proceeds) may sometimes increase "Builder Basket".

EXCESS CASH FLOW SWEEP

31

EVENTS OF DEFAULT

• Payment defaults

• Principal – immediate event of default

• Interest, fees, other amounts – 3 to 5 business days grace

• Covenant default

• Negative covenants and certain affirmative covenants – immediate event of default

• Other covenants – 30 days grace [after notice from Administrative Agent]

• Financial covenant breach subject to equity cure in sponsor deals

• Breach of financial covenant that applies only to the revolver does not default the

term loan until the revolving lenders terminate commitments and accelerate the

revolving loans

• Material inaccuracy of representation or warranty – grace period is

point of negotiation

32

EVENTS OF DEFAULT

• Default on other debt above an aggregate threshold amount

• Judgment default

• (not covered by insurance/indemnity) above an aggregate threshold amount that has

not been satisfied, vacated, discharged or stayed or bonded pending appeal for [60]

days or judgment creditor acts to levy or attach assets to enforce judgment

• Insolvency defaults

• Exclusion of immaterial subsidiaries

• Liens or guarantees under the Loan Documents or any material Loan

Document cease to be in effect or are challenged by Loan Parties

• ERISA defaults

• ERISA Event that has resulted in or [would/could] reasonably be expected to result in an MAE or

• failure by a loan party or ERISA Affiliate to pay when due (after applicable grace period) an

installment payment with respect to its withdrawal liability under a Multiemployer Plan which

[would/could] reasonably be expected to result in an MAE

33

EVENTS OF DEFAULT

• Change of Control

• [Before an IPO] Permitted Holders cease to directly or indirectly own more than 50%

of voting shares of Holdings

• any “person” or “group” (within Sections 13(d) and 14(d) of the Exchange Act), excluding

Permitted Holders, becomes direct or indirect “beneficial owner” of more than [the greater of]

(x) [35%] of voting shares of Holdings [and/or] (y) percentage of voting shares of Holdings

then directly or indirectly owned by Permitted Holders

• Permitted Holders either own more than 50% of voting shares of Holdings or otherwise have

power (contractually or otherwise) to elect majority of board of directors

• [After an IPO] any “person” or “group”, excluding Permitted Holders, becomes direct

or indirect “beneficial owner” of more than [35%] of voting shares of Holdings

• A “change of control” or similar event under other material indebtedness

• Holdings fails to own 100% of the Borrower

• During any 12-month period, board of directors of Holdings fails to consist of a

majority of “continuing directors”

34

REMEDIES

• Insolvency events of default result in automatic termination of commitments

and acceleration of loans and obligations

• Upon any other event of default, at the Required Lenders’ request,

Administrative Agent shall:

• terminate commitments

• accelerate principal, interest and all other amounts

• require the Borrower to cash collateralize L/C obligations

• [subject to intercreditor agreement], exercise all rights and remedies under the loan documents

and applicable law

• Collective action provision

• Protective provisions

• Borrower waiver of presentment, demand, protest or other notice

• Lenders’ setoff rights against deposits

• Payments set aside

• No action/inaction of Lender constitutes a waiver

• Borrower consent to jurisdiction, waiver of objection to venue, waiver of jury trial

35

Thank You

Paul W. Hespel

Pepper Hamilton

hespelp@pepperlaw.com

Alexandra Margolis

Nixon Peabody

amargolis@nixonpeabody.com