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A participant bank appealed the special mention ratings assigned to a revolving credit and two term loan facilities during the 2015 Shared National Credit (SNC) examination.
The appeal indicated that the facilities should be rated pass because the borrower’s high leverage was mitigated by a highly flexible cost structure, strong market position, and ability to repay 52.7 percent of total debt over a seven-year timeframe.
The appeal argued that the base case December 31, 2014, earnings before interest, taxes, depreciation, and amortization (EBITDA) should be adjusted upward due to headcount reductions and real estate consolidation savings that were accounted for in 2015 but realized in 2014. This resulted in the 3.0 percent to 3.5 percent negative variance to the projected EBITDA. EBITDA in first quarter 2015 was up 27 percent from the same period in 2014, despite revenues being up only 2 percent, demonstrating that the company was delivering on projected cost savings. The company was on track to meet the 2015 budgeted EBITDA.
The appeal stated that 52.7 percent of debt repayment over seven years is reasonable and reduces leverage to a low level. Furthermore, the borrower’s fiscally prudent decision to preserve cash rather than pay down debt with balance sheet cash at December 31, 2014, was not an indication of the borrower’s unwillingness to de-lever. This decision was due to ongoing integration efforts with respect to an acquisition, preserving cash for tuck-in acquisitions, and using cash for one-time capital expenditures. The appeal also argued that the excess cash flow sweep mechanism is based on specified targeted debt amounts, effectively requiring debt to be amortized.
An interagency appeals panel of three senior credit examiners concurred with the SNC examination team’s originally assigned risk ratings of special mention.
The appeals panel agreed that the borrower had a highly flexible cost structure and strong market position; however, these characteristics did not mitigate the borrower’s high leverage and inability to amortize debt over a reasonable period. Total leverage at year-end 2014 was high and was based on actual fiscal year 2014 performance, which was less than originally projected due to a delayed closing by two months and a delayed realization of synergies. The appeals panel determined it was inappropriate to adjust fiscal year 2014 EBITDA with synergies that occurred in first quarter 2015 due to a delayed closing. Synergies and cost savings will be reflected in 2015 results.
The company’s ability to meet 2015 projections was uncertain given delays in achieving synergies in 2014. Increased EBITDA due to cost savings in the first quarter of 2015 does not represent performance in the prior year and may or may not be indicative of fiscal year 2015 results.
The appeals panel noted that the borrower was unable to amortize debt in a reasonable period based on bank projections showing that free cash flow would amortize only 64 percent of senior debt in seven years. The achievement of these debt reduction benchmarks is questionable given the 18 percent EBITDA miss early in the plan combined with the failure to reduce total debt by $40 million in accordance with original projections. The borrower had the capacity to de-lever as originally projected with cash on the balance sheet at fiscal year-end 2014, but chose not do to so. Reducing debt according to plan would have left the borrower with $360 million to achieve other objectives. Not de-levering according to plan coupled with an EBITDA miss of 18 percent in the first year brought into question both the willingness and ability of the borrower to achieve debt reduction benchmarks.
The appeals panel disagreed with the premise that the excess cash flow sweep provision effectively requires amortization. An excess cash flow feature is contingent in nature on the borrower generating enough cash flow to trigger the provision, and debt repayment is not guaranteed by this provision. Amortization is a required payment regardless of cash flow levels. The lack of meaningful amortization on the first lien and the second lien term loans is a weakness inherent in the credit structure. The borrower choosing not to reduce debt with available cash is a byproduct of the credit structure, in that no meaningful amortization is required on the two term loans despite projections to reduce debt.
The appeals panel concluded that the first lien term loan has no financial covenants and the revolving credit has a springing first lien leverage covenant that is tested when usage exceeds a pre-specified capacity. Depending on the circumstances, the first lien lender could call its loans at an inopportune time for the second lien lender, where there was insufficient collateral to repay the second lien term loan. The absence of meaningful financial covenants gives the bank group virtually no flexibility in identifying and reacting to deteriorating operating performance.
The appeals panel noted that the actual EBITDA shortfall cited in the write-up illustrates the stress on cash flow. Capex related to expansion was a cash expense, was not a one-time charge, and was not discretionary. As such, the original voting team used actual capex for the fixed charge coverage calculation. The insufficient amount of EBITDA to cover fixed charges was not the primary factor supporting the special mention rating, but does underscore the potential weaknesses evident from the deteriorating financial performance.