UK: Liquidity Covenants To The Fore

AT A GLANCE

In this article, Stuart Brinkworth explores what a liquidity covenant is and the issues facing sponsors and lenders in negotiating them. With interest rates remaining at record levels and businesses still struggling with increased costs and the fall-out from the cost-of-living crisis, many businesses have been unable to meet leverage maintenance covenant requirements in their deals. As a quid-pro-quo for covenant relief, lenders often seek to impose a minimum liquidity covenant to ensure the business remains operationally solvent during the covenant relief period.

Key Points

• Although the use of liquidity covenants in distressed situations is a tried and tested approach by lenders, there is no "one size fits all" when it comes to the implementation of a liquidity testing regime.
• There are many touch points for negotiation including the timing of liquidity covenant testing, what is deemed to be a breach and whether there should be a cap on the number of cures.
• Much will be driven by the extent of the distress and the level of support the sponsor will be willing to provide.

WHAT IS A LIQUIDITY COVENANT AND WHY IS IT INTRODUCED?

A liquidity covenant is a requirement for a business to maintain a minimum amount of available cash on a balance sheet. This amount is based on the required minimum cash needs for the business to cover its operational costs (including servicing debt) on an on-going basis, plus an amount of agreed headroom. The liquidity covenant is often misrepresented as amounts required to fulfil the obligation under the finance documents – but this is not correct.

Lenders will consider introducing a liquidity covenant where the business has breached or is forecast to breach the leverage covenant on a going-forward basis over an extended period of time. The role of auditors in bringing to the fore future covenant compliance where they are being asked to sign-off on a going concern basis can often trigger a suspension of leverage covenant testing.

It should be noted that lenders are unlikely to require the introduction of a liquidity covenant for one-off or short-term leverage covenant breaches where a short-term waiver is more appropriate. The liquidity covenant comes into play in conjunction with a full suspension of leverage covenant testing for a pro-longed period – typically 12-24 months – and is often implemented with some form of plan to bring performance back on track (to increase EBITDA) and/or to de-lever the business to ensure that at the end of the liquidity covenant testing period the business is able to return to either its original leverage test ratios or newly agreed ones. The period during which the leverage covenant is suspended is often referred to as the "Exceptions Period" in the facilities documentation. During the Exceptions Period, lenders will benefit from enhanced financial information, including cashflow projections, as well as impose more restricted rights for the borrower, which we will come on to.

"LIQUIDITY" IN GREATER DETAIL

It is worth just touching on the meaning of liquidity. The sponsor will want to ensure that this is defined as widely as possible. So will want, for instance, all cash on balance sheet to count towards the test. However, lenders will focus on cash which is "available" to the Group and therefore link liquidity to the often-defined term "Cash" in the Facilities Agreement – which is also used to determine what cash can net off debt for the purposes of a net leverage test. This definition excludes blocked/trapped cash and cash used as collateral, by way of example, or cash held in investments that cannot be converted to cash within a relatively short timeframe. Lenders may also try and argue for excluding cash that would be needed to meet longer-term trade creditors where repayment terms have been stretched beyond a particular period. However, borrowers will want to retain their ability to reallocate resources and manage/ defer spend and so lenders will often seek to impose restraints on creditor stretch elsewhere.

Other items counting towards liquidity often include:

• "Cash Equivalent Investments"; and
• available amounts under committed RCF/ancillary facilities – the focus here being on "available" – so where a drawstop is in place any such amounts cannot be included in calculating Total Liquidity.

Typically amounts committed but not yet injected under any sponsor equity commitment letter are not included within the liquidity test until those amounts have been contributed to the borrower group. However, lenders will sometimes allow amounts that have been triggered under the equity commitment letter to count towards liquidity during the contribution period.

Liquidity can sometimes also exclude cash injected by the sponsor unless pursuant to a pre-agreed commitment or as a permitted equity cure. Lenders argue that there should not be unlimited cures for the liquidity covenant. Sponsors will, of course, look to resist this, or at least have permitted carve-outs where, for instance, they are providing funding for particular agreed items (for instance, covering the costs of an independent business review or other advisers or implementing a restructuring plan).

TESTING AND BREACH

Testing

A liquidity covenant is tested (meaning certified compliance via a compliance certificate) on a periodic basis and more frequently than the standard quarterly covenant test. More often than not this is monthly so that compliance certification can be combined with other reporting to ensure an efficiency of information delivery both for the borrower and the lenders. However, in more precarious situations testing may take place on a weekly or bi-weekly basis. Clearly it is better for lenders that a breach is notified and remedied quickly, which is more likely where the gaps between compliance certification are shorter.

Because of this potential time lag between breach, notification and remedy (which could be as long as seven weeks or so where a breach occurs in week one of a monthly test), we have also seen lenders try and impose forward looking testing whereby the covenant must also be complied with on a look forward basis, tested at the time of the delivery of the 13-week cashflow forecast. The purpose of this approach is to trigger a default before actual liquidity problems arise and to encourage the sponsor to take steps to ensure an actual breach is avoided. The look forward testing element is also often used to trigger advances under any equity commitment letter that the sponsor has provided. While sponsors have reluctantly entertained such requests, they have sought to limit the look forward time period. Clearly a projected breach in week 12 or 13 may never arise or arise by a different amount, and so sponsors will often limit the look forward breach to one occurring in weeks one to four, five or six of the projected period covered by the 13-week cashflow forecast where the chances of actual breach are more real and the amount required to prevent such breach from occurring more ascertainable.

Breach

A liquidity covenant is often expressed as an "at any time" covenant, so the requirement is to maintain liquidity at all times at least at the agreed minimum level. This presents a legal interpretation problem for the sponsor and borrower as "at all times" does literally mean at all times. Thus, any intra-period dip (intra-day, intra-week, intra-month), even momentarily, means that the covenant is breached, even if liquidity at all other times was above the required minimum level.

Of course, it's unlikely that the lenders intend the covenant to breach in this way, so some thought needs to be given to what is deemed to be a breach/event of default. There are many ways of deeming a breach, such as:

• an event of default arising only where there have been breaches for a number of days or consecutive days in a period, eg two days in a week or three of four days in a month;
• testing based on average closing balances over a period; or
• testing based on weekly closing balances.

Lenders may feel that there is not a lot of leeway on what is deemed to be a breach/event of default, although that may depend on where the covenant is set and how precarious the financial position of the borrower is. For instance, it may be appropriate to have an average balance of £5m, but with an immediate breach of £4m as an absolute floor. The point being that lenders will need to have the ability to act quickly at some point if short-term funding is required and the sponsor is not willing or able to step up.

A breach of a higher level of liquidity that sits above the covenant level may also be used to trigger enhanced information rights (see below).

CURE

Being a financial covenant, the liquidity covenant should be capable of being cured by the sponsor injecting cash which then gets added to liquidity. Some thought needs to be given by the lenders as to what restrictions, if any, need to apply to a cure of the liquidity covenant. A standard formulation of an equity cure would limit the number of times it can be used during the Exceptions Period and often not in consecutive testing periods. Any injection of cash should not notionally count forward to following testing periods. Instead, liquidity should always be tested on an actual basis including the balance of cash remaining that has been injected.

Where an equity cure is permitted, often lenders require a minimum cure amount to ensure that any cure is meaningful and would not typically restrict over-curing.

A big point of negotiation is often on whether there should be a cap on the number of cures. Sponsors will want the ability to inject cash as often as they see fit and often do not understand why a lender would stand in the way of a sponsor offering financial support to the business. Lenders, however, do sometimes take the view that they want to be able to step into the business if it is repeatedly breaching the liquidity covenant and so want their rights to crystalise and do not want the sponsor blocking a crystalisation of rights by constantly injecting cash. Of course, the reality of PE investing is that a sponsor will not keep propping up a business just to block a lender – there has to be some form of return on any investment made, so really it is an unlikely scenario.

INFORMATION RIGHTS

As mentioned above, the introduction of a liquidity covenant comes with enhanced information rights, typically:

• a "liquidity report" which includes a 13-week cashflow forecast;
• right to appoint a board observer; and
• regular lender meetings with management.

The liquidity report

Lenders will require a liquidity report to be delivered periodically – which can be weekly, bi-weekly or monthly, depending on the severity of the circumstances. The basis of this report is a 13-week cashflow forecast that projects liquidity for the next 13 weeks (usually at the end of each week during that period beginning with the week in which the report is to be delivered, although in some situations daily forecasting may become necessary). However, the lenders may also sometimes ask for:

• historical liquidity balances as compared to forecast;
• confirmation as to compliance with the liquidity covenant (although this of course would be covered by the compliance certificate and where the liquidity report is to be delivered more frequently than the test of the covenant, the sponsor/borrower will want to ensure that this does not mean more frequent testing); and
• how any projected breach is going to be remedied, ie by an equity cure or other means such as deferring expenditure.

Where the 13-week cashflow forecast projects a breach of the liquidity covenant during the look forward period, as mentioned above, it may in itself create an event of default if not remedied. However, it may also trigger enhanced rights such as more regular calls with management to discuss how such breach is to be avoided or managed or the right to appoint a financial adviser.

Board observer

A board observer is an appointee of the lenders (often appointed by the majority lenders) that is entitled to attend specific meetings of the Group. The observer is not a director (executive or otherwise) and has no rights or liabilities as regards the direction and/or conduct of the management of the Group. The role of an observer is a non-participating role – so the observer has no right to speak at meetings or vote. The observer is there solely to note what is discussed and report back to lenders – who then can discuss any matters arising at the management meetings (see below).

The observer right is usually granted in a separate side letter and made a personal right to the lenders at that time, so long as they continue to hold a minimum amount of the total commitments. So, if the lenders sold out then the right to an observer may well fall away. The observer usually attends meetings at which the financial position of the Group is discussed and should be given the same notice and same information as is given to directors.

The sponsor/borrower will often want a right to exclude the observer from any meeting or part thereof where any proposal to be made to the lenders, or any proposal made by the lenders, is to be discussed or to discuss any dispute with the lenders. There are also standard exclusions where attorney/client privilege would otherwise be waived by the board observer's attendance.

The sponsor/borrower will want to ensure the information gathered by the observer is kept confidential and not passed on to anyone who is not a lender – in particular, it will want to ensure that the lenders do not disclose any such information to potential transferees until they actually become lenders.

There will need to be an agreement over fees, costs and expenses of the observer (especially if the lenders intend to appoint a third party). The borrower may agree to meet these up to a cap.

Management meetings

As part of the implementation of a liquidity testing regime, lenders will also want to have regular meetings/calls with management to discuss the on-going performance of the Group and any matters highlighted in the liquidity report or management accounts. The frequency of these meetings/calls will differ depending on the severity of the situation. They are often monthly but can be bi-weekly or even weekly. The sponsor/borrower will want to ensure that these calls do not distract management and so will want to restrict their frequency, with certain triggers such as a projected or actual breach of liquidity triggering more frequent calls. Similarly, where the performance of the Group improves (eg by Adjusted EBITDA/Pro Forma Consolidated EBITDA exceeding a certain agreed level) this can trigger a step-down in call frequency.

Other restrictions during the Exceptions Period

As mentioned above, the implementation of a liquidity testing regime may also result in certain rights under the finance documents being suspended or restricted. Examples of this are:

• EBITDA/ratio or fixed baskets may be reduced/suspended to avoid cash leakage and disposal of assets;
• restrictions on the ability of the borrower to raise further financial indebtedness or factor book debts whether on a recourse or non-recourse basis;
• restriction on "permitted acquisitions";
• restrictions on the "permitted payments" regime to ensure that any payments to investors are restricted;
• restrictions around creditor stretch; and
• where Adjusted EBITDA/Pro Forma Consolidated EBITDA is to be tested during the Exceptions Period, restriction on cost savings and Exceptional Items add-backs, in particular.

SUMMARY

The use of liquidity covenants in distressed situations is a tried and tested approach by lenders. However, there is no "one size fits all" when it comes to the implementation of a liquidity testing regime. As always, there are many touch points for negotiation, but ultimately much will be driven by the extent of the distress of the underlying business as well as the level of support the sponsor will be willing to provide.

Originally published on the 26^th of February, 2024.

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