Springing covenant

A springing covenant stays dormant as long as the condition set in the agreement is not met. In European leveraged financings, it applies to the revolving credit facility (RCF): a net leverage ratio is tested on a test date only if RCF outstandings exceed a threshold. If outstandings fall back below that threshold on later dates, the ratio is no longer tested. The threshold is expressed as the higher of a percentage of RCF commitments and a fixed amount calculated at signing. The first thresholds were between 25% and 30%. In 2017, many borrowers obtained 35%, some 40% and a few 50%. The borrower negotiates the exclusion of certain drawings from the calculation: letters of credit, which remain contingent liabilities, and ancillary facilities with no cash drawn. The right to accelerate after a covenant breach belongs to the majority of RCF lenders. Term loan lenders invoke cross default after them. Recent equity cure clauses allow the shareholder to inject funds that repay the RCF below the threshold, which cures the breach. In asset-based loans, the same mechanism triggers the lender’s control over collections when excess availability falls below a threshold set in the agreement. For a borrower that draws its RCF to fund swings in its working capital, a low threshold makes the test close to certain.

A company has a €40m RCF with a trigger threshold of 35%, or €14m, and a net leverage covenant at 5.0x. On 30 June, it has drawn €18m and its leverage reaches 5.3x. The covenant is tested and breached. The shareholder contributes €4m, which repays the RCF: outstandings return to €14m, the drawing condition is no longer met and the breach is deemed cured.

• The trigger threshold and its basis: percentage of commitments or fixed amount
• The drawings excluded from the calculation, including letters of credit
• The level of the tested ratio and its headroom against the business plan
• The equity cure mechanism and its effect on the threshold
• The majority required to amend or waive the covenant