Allan S. Brilliant
New York +1 212 698 3600
Given the volatile economic environment caused by the COVID-19 pandemic, business development companies (“BDCs”) need to proactively manage their loan portfolio companies to mitigate risk and avoid surprises that may arise in the foreseeable future. This OnPoint discusses the strategies and work-out plans that BDCs, whether holding first lien, second lien, mezzanine or unsecured debt, need to employ in advance to address any defaults or liquidity issues that may arise.
By being proactive about reviewing loan documents, examining collateral packages and understanding their credits in advance, BDCs can better position themselves to manage and address defaults when they occur. Accordingly, prudent lenders should update their credit analyses on all material credits, not only those in industries most negatively impacted by the COVID crisis. A BDC should understand and familiarize itself with the borrower’s operations and business plan and how they are impacted by the current crisis, including whether the borrower’s business plan is viable in the current environment and the borrower’s liquidity situation. Doing so will enable the lender to anticipate possible covenant defaults, liquidity problems, revolver draws, requests for additional financing and potential covenant or payment waivers. Furthermore, understanding how a borrower makes its business decisions, whether this understanding comes from a relationship with management or by understanding the borrower’s relationship with its financial sponsor, may inform the decisions a lender may have to make later on.
BDCs should also analyze whether there are any gaps or weaknesses in the credit, including any issues with the priority or perfection of security interests, gaps in the collateral package (including any unencumbered assets), or any material risks of any guarantees provided. Any issues with respect to perfection of security interests need to be rectified immediately so as not to risk avoidance of the lender’s lien in a potential bankruptcy. Knowledge of these types of issues in advance will place the lender in a valuable position to be able to identify exactly what its list of demands are when it comes time for the borrower to request to amend the loan documents or seek a waiver of defaults in what will undoubtedly be in a compressed time frame. Under such circumstances, the BDC will need to consider the need to request additional collateral that was not included in the original collateral package, remedy collateral defects, force management changes, require the company to retain outside advisors, or increase its own economics by raising interest rates.
BDCs should also be aware of the other lenders in the credit (if any). Minority lenders should create alliances and maintain an open line of communication with the majority lenders and ensure that their interests and goals are aligned. If there are multiple credit facilities, lenders should understand what effect that may have in connection with any potential workout negotiations.
BDCs should also examine any payments and transfers they have received from the borrower for potential preference or fraudulent transfer issues in the event the borrower files for bankruptcy. However, a lender should never turn down a payment or avoid receipt of additional collateral even in light of a risk of avoidance of such a transfer. It is better to take the payment and deal with any avoidance issues should they arise.
Having conducted an analysis of the current situation, BDCs should then create an enforcement road map and have an understanding of what the downside risks are and the best exit strategy, whether it be a sale of a portion or all of the company, a refinancing, a bankruptcy or an out-of-court restructuring. If there is a division of the company that is not profitable, it may be worth analyzing whether to sell such division and reorganize around the core profitable portion of the business. In addition, understanding the company’s business operations may affect the decision as to whether the company should restructure in or out of bankruptcy. For instance, if the company has burdensome leases or executory contracts (contracts under which both parties have continuing obligations to perform, i.e., service contracts), bankruptcy would allow the company to reject such agreements. However, if the company does not have access to liquidity, the cost of bankruptcy along with potential preference payments previously made to the BDC may move the needle away from having the company file for bankruptcy.
When creating a game plan and strategy a BDC will proceed with, the BDC should also give consideration as to how it will handle similar issues across its portfolio and whether the similarly situated credits will be treated the same, and if they will not be, what the potential for reputational risk is in the market. BDCs should also consider whether the company requires additional liquidity that the BDC is willing to provide or how that fits into its own portfolio needs with respect to its own financing.
Many companies are currently experiencing a liquidity crisis and are inclined to draw down on any funding available under their existing credit facilities. In doing so, they need to satisfy conditions to funding, including, but not limited to:
While the drafting of the MAE representation is a key determinant in the borrower’s ability to satisfy borrowing conditions, a common formulation of the MAE definition provides two potential triggers that are relevant (or may become relevant) as the present economic disruption continues:
(i) a material adverse effect on the financial condition of the borrower; and
(ii) a material adverse effect on the ability of the borrower to perform its obligations under the credit agreement (which is sometimes limited to payment obligations instead of future financial covenant tests).
Some variations of the MAE representation may only require that the borrower represent that there is no occurrence of an MAE as of the date of the borrowing. A lender-favorable MAE representation may include a forward-looking element by requiring the borrower to represent that since the closing date of the loan agreement, no event has occurred that has resulted in, or could reasonably be expected to result in, an MAE.
A borrower’s ability to make the MAE representation is dependent on a number of factors, including:
Thus, depending on how the MAE definition is drafted, the credit agreement may provide protection to a lender that chooses not to fund. In this respect, it is important to understand whether the MAE is drafted as a condition precedent to funding; if its, it may be the borrower’s burden to prove that such condition has been satisfied.
While the COVID-19 pandemic could arguably create a basis for invoking an MAE clause, a lender should exercise caution if it relies on an MAE clause to refuse to fund. Not only should the lender consider the reputational risks, but the legal risks associated with a judicial finding requiring lenders to bear the burden of proof of demonstrating that an MAE justified their refusal to lend. MAE clauses can vary and case law suggests that the standard for declaring an MAE is very high; the event that triggers an MAE must be highly significant and expected to last for a lengthy period of time and is a fact-intensive inquiry with a heavy emphasis on the precise drafting of the MAE provision. Accordingly, a lender that has made the decision to not fund should keep a full record and factors supporting such decision should be preserved in anticipation of litigation to meet its burden of proof.