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Appeal of Shared National Credit (Third Quarter 2014)


A participant bank appealed the special mention ratings assigned to a term loan and a revolving credit facility during the 2014 Shared National Credit (SNC) examination.


The appeal asserted that the facilities should be rated pass. The appeal disagreed with the adjusted earnings before interest, tax, depreciation, and amortization expense (EBITDA) and repayment capacity calculations, which did not add back pre-opening expenses or management fees. The appeal stated that the add back of these expenses is customary and widely accepted among lenders that specialize in the restaurant industry. Pre-opening expenses are considered non-recurring and can be shutdown with stoppage in new unit development. Management fees, when subordinated, allow the banks to shut off payments. In addition, growth capital expenditures (capex) should be excluded due to the company transitioning to franchised openings, which substantially eliminate the need for growth capex.

The appeal argued that the bank-calculated EBITDA, adjusted for the three expense items above, results in sufficient repayment capacity to amortize 100 percent of the senior debt in 6.35 years and 50 percent of total debt in 4.43 years.

The appeal disagreed with the statement that stagnant EBITDA was the result of the company’s decision to slow new unit growth and focus on building its franchisee base. The appealing bank argued that this shift in strategy should be viewed positively because the move to a “franchisor” model requires less capital from the borrower and should provide additional “free” cash flow as franchisee royalty income increases.

The appeal also stated that the criticism of the company’s financial performance, below projections since 2011, as a primary factor in the rating was not supported with detailed comparison of actual results against projections. The appeal stated that the bank did not have access to original projections or budgets before its participation in the facilities in 2013 so the bank’s underwriting focused on historical results for 2011 and 2012 rather than a comparison to the company’s projections.

The appeal argued that the company’s leverage profile was mitigated at the time of underwriting by the company’s net senior secured and net rent-adjusted leverage ratios that were 3.25 times and 5.15 times, respectively, if subordinated mezzanine debt was excluded. The appeal states that a 50 percent excess cash flow provision will further reduce debt and the facilities require 35 percent amortization over 5 years. Additionally, the capital structure includes subordinated unsecured mezzanine debt, and the lenders have instituted a covenant allowing the ability to block the cash interest payments for up to 180 days.


The interagency appeals panel of three senior credit examiners concurred with the SNC examination team’s special mention ratings for the two facilities.

The appeals panel determined that the adjustments to EBITDA were appropriate. Pre-opening expenses and sponsor management fees are not considered allowable EBITDA add backs since they were paid in cash and projected to recur annually (per the budget prepared by company management). In addition, the company’s capex forecast increased substantially between the original underwriting proposal in May 2013 and projections updated in early 2014. The revised capex estimates were prepared by company management subsequent to the strategic shift towards increased franchising, reflecting expected outlays required to support its strategic decision. While pre-opening expenses may, in theory be shut off, the company’s growth strategy clearly assumes such expenses.

The appeals panel determined that the SNC examination team utilized revised projections in its determination that financial performance did not meet expectations. While the bank’s underwriting may have focused on historical results rather than the company’s projections, OCC Bulletin 2013-9, “Guidance on Leveraged Lending,” dated March 22, 2013 states that performance to plan is a key element of credit quality that should be considered during the underwriting process. When assessing repayment capacity, examiners place emphasis on the reasonableness of bank prepared projections under base case and downside scenarios. Using base case projections, the borrower’s ability to generate free cash flow sufficient to amortize debt over a reasonable timeframe is marginal.

The appeals panel determined that borrower leverage was high, as depicted by total outstanding debt equal to 5.3 times adjusted EBITDA as of December 31, 2013. The company-prepared budget did not forecast any debt reduction from the excess cash flow sweep feature. While the tiered debt structure and ability to temporarily restrict cash interest payments provide a limited degree of protection to the senior lenders, these features did not adequately mitigate the company’s current high leverage posture or the marginal capacity to repay debt.