Debt Considerations in Challenging Markets

2 Dec

Economic Backdrop

As reported in the recent Office of Budget Responsibility, ‘Economic and Fiscal Outlook, November 2022’, rising energy, food, and other goods prices have pushed up the interest base rates to levels not seen since the 2008 financial crisis. The outlook predicts that the squeeze on real incomes, rise in interest rates, and fall in house prices will all weigh on consumption and investment, tipping the economy into a recession lasting just over a year from the third quarter of 2022, with a peak-to-trough fall in GDP of 2 per cent.

This threat of recession together with rising interest rates presents many different challenges for borrowers, with available liquidity of primary concern, especially where existing facilities are approaching maturity.

How can borrowers manage these challenges?

Review current finance arrangements

It would be advisable for borrowers to review their current financing arrangements and conduct their own risk assessments focusing on: (i) when current facilities are due for renewal; (ii) business dependence on current debt profile and forecast requirements for the next 2-3 years; (iii) impact of rising interest rates: are current facilities fixed or floating (higher borrowing costs may be adversely affecting cashflows); (iv) current business performance against financing covenants and stress testing those covenants on the basis of higher interest rates over the next twelve months (the Bank of England, in their November Monetary Policy Report, has projected the base rate to rise to 5.2% by Q4 2023). Once borrowers have assessed their current circumstances, various options could be considered:

refinancing or consolidating existing loans (borrowers may be able to lock in preferential terms and some are choosing longer tenors, thereby provided longer term certainty);
moving to a fixed rate interest product may offer borrowers increased cashflow certainty;
amend the terms of existing facilities to provide increased headroom in financial covenants, reducing the risk of a covenant breach; and
agree more achievable payment structures to fit a business’ expected cashflow forecast.

Consider other financing options

Bank debt is not the only form of finance available. Borrowers could consider alternative finance providers (many of whom are very active in the Northern Irish market) and also alternative forms of debt, such as receivables financing (also known as invoice discounting) or other asset based lending. This may be particularly helpful if cashflow is under pressure. Borrowers should work with advisors to ensure that repayment profiles align with the cash-flows of the business and financial covenants are achievable across the term of the proposed loan (having consideration for the projected base rate rises in 2023).

Be prepared

Where borrowers are making approaches to their financiers for either revised credit terms or refinancing options, bear in mind the final decision will rest with a credit department that will analyse the risk profile of the application commensurate with the risk appetite of the lender.

In order to pre-empt any issues arising at this stage, borrowers can assist their financiers by providing detailed analysis of underlying business plans and the impact of inflation, rising interest rates, energy prices and wages. Borrowers should be willing to work with advisers to build a credit case. Credit teams will be assessing how cashflow will be impacted by increased costs.

Signs of distress and next steps

An initial sign of borrower distress is usually a covenant breach by the borrower. Rising interest rates will impact financial covenants based on interest/debt service cover, and rising energy and labour costs will impact cashflow and some sectors are seeing a reduction on property values which impacts loan to value covenants. Borrowers should:

try to pre-empt a breach ahead of time and engage with financers early (this could also avoid the risk of triggering cross-defaults elsewhere);

check how often covenants are tested – is this likely to be a one off or is the borrower likely to default at the next test date also?

o if a one off and this can be evidenced to the lender, a waiver letter may be appropriate; or

o if multiple and continuous covenant breaches are expected, a covenant reset may be more appropriate and lenders will likely require sight of an updated business plan and financial model. Lenders in such circumstances may require tighter controls such as cash sweeps, extensive reporting requirements, revised amortisation schedules or higher pricing terms.

check finance documents for grace periods and cure rights which may have been negotiated when the financing was put in place. Usually a cure right will be limited on how often it can be used and not be permitted to be used consecutively. The most common cure right allows for the injection of equity following a financial covenant breach and the pro forma recalculation of the financial covenant default ratios, to remedy the breach.

In the case of more significant defaults, engaging early with financers is key with a view to coming to a consensual arrangement (especially where refinancing with an alternative lender is not an option). Such arrangements may involve standstill agreements (whereby the lender agrees not to enforce subject to certain agreed milestones); consensual sale of secured assets or debt for equity swaps.

Guidance:

If you require further information about anything covered in this briefing, please contact Aisling Owens or your usual contact at the firm on +44 (0) 28 9099 8207. This publication is not designed to provide legal or other advice and does not deal with every important topic or cover every aspect of the topics with which it deals. Publication date: 2 December 2022.

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