The Liquidity Crunch

Published Date
Apr 1, 2020
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The global economy has been greatly impacted by the COVID-19 pandemic and a significant drop in oil prices. The combination of these two factors coupled with the uncertainty surrounding the length of time COVID-19 will hold a significant portion of the world’s population captive has brought the primary debt markets to a grinding halt.

Many businesses, such as those in the travel and hospitality industries and businesses providing “non-essential” goods and services, have been mandated by a number of governments around the world to close their doors until further notice. This has led to a liquidity crunch and an urgent need for businesses to understand the options available to them to access liquidity within the framework of their existing capital structures to facilitate their survival during this period of suspended or reduced trading.

This article provides a summary of the issues companies and creditors should consider when determining the possible forms of funding available under existing bond and/or term loan covenant packages. Creditors providing such liquidity facilities may require a priority position with respect to liabilities owed to existing creditors, particularly in relation to distressed companies and this article explores some of the creative ways such priority could be achieved in the critical search for liquidity.

Is the Proposed Funding ‘Indebtedness’ for the Purposes of the Incurrence Covenants?

The gating question that must always be asked is whether the new funding constitutes “indebtedness” for the purposes of the incurrence covenants. It is not unusual for there to be a lengthy list of exclusions from the definition of indebtedness and, therefore, there is a possibility that a company’s ability to incur such excluded indebtedness may not be limited by the debt covenant at all. Some of the typical exclusions from the definition are, in fact, financial obligations, such as loans from shareholders that are structured to be equity-like from the perspective of the bondholders or term loan lenders (e.g., maturity outside the maturity of the bond or loan, no security, subordinated to the bond or loan) and certain types of receivables financing. Importantly, items that are excluded from the definition of indebtedness under the incurrence covenants are typically excluded from the calculations of leverage, which may also impact the ability to incur other indebtedness under the incurrence covenants, as discussed below.

If the Proposed Funding Is Indebtedness, Does the Company Have Capacity to Incur Such Indebtedness?

In determining a company’s capacity to incur indebtedness, the debt covenant in the credit documentation will provide a laundry list of permitted indebtedness or “baskets.” The following is a list of the most common debt baskets available to companies, including commentary around the ease with which each debt basket can be utilised and the implications for the company’s capital structure:

  • Existing Credit Facilities: the easiest and most obvious way to access cash is to drawdown on existing committed credit facilities, including, for example, revolving credit facilities, delayed draw facilities and capex lines. Existing credit facilities can be drawn by a company simply completing and delivering a borrowing request to the facility agent and, depending on the currency of the borrowing, the proceeds of the loan will be made available to the company within a few days (or an even shorter period of time) thereafter. Companies should be mindful of the permitted use of the proceeds of any drawdown. The proceeds of a revolving credit facility can typically be applied for general corporate purposes, whereas the permitted use of proceeds for delayed draw facilities and capex lines may be for more limited purposes. Companies should be mindful that drawing the revolving credit facility beyond a certain amount (typically 30-35% of the total commitments excluding non-cash drawings) may trigger the requirement to comply with a financial covenant.

  • Credit Facilities Basket: in bank/ bond transaction structures, the credit facilities basket is a potential candidate for any type of third-party financial indebtedness as the definition of credit facility is often drafted very broadly. These baskets are often sized initially to provide for additional capacity or “headroom” above the originally committed revolving credit facility. However, companies should be aware that if they use this basket for additional debt, it may effectively preclude them from drawing their revolving credit facility in full if they do not have any additional capacity to do so at the time. As discussed below, the huge benefit of accessing this basket is that creditors usually benefit from “super senior” priority status, meaning such creditors will be paid out before other creditors from the proceeds of any enforcement of the transaction security. This is perhaps the simplest way to afford liquidity providers with the first priority status they are likely to require in relation to companies in financial distress.

  • Incremental Facilities Basket: if a company has an existing term loan B facility, the incremental debt and incremental equivalent debt baskets provide a quick and simple solution to incur pari passu first lien indebtedness. The incremental debt permits companies to borrow an additional term loan or revolving credit facility (or increase the commitments applicable thereto) under the same credit agreement subject to certain parameters (or incremental equivalent debt which is indebtedness that can be incurred outside of the credit agreement, for example, in the form of high yield bonds). The incremental debt basket is available to borrowers and guarantors only; it cannot be used by non-guarantor entities to raise indebtedness. The size of the incremental debt basket varies depending on the size and creditworthiness of the credit group; however, for large sponsor backed term loan B facilities, it is customary for the incremental debt basket to contain a “freebie basket” that can be used irrespective of the company’s leverage ratio plus an unlimited amount subject to a leverage ratio test. Companies should be mindful of whether there is any current Most Favored Nation protection in credit documentation and, if so, whether there are any carve outs to such protection in which new incremental debt or incremental equivalent debt can be raised.

  • Ratio Basket: the ratio debt basket will only be available to companies when certain metrics of financial health are maintained after factoring in the incurrence of the indebtedness. In bond transactions, a common formulation for the measurement of financial health is a permission to incur unlimited amounts of additional indebtedness if the ratio of EBITDA to fixed charges is not less than 2.00:1.00 after taking into account the new indebtedness and the use of proceeds therefrom. In term loan transactions, the ratio debt basket provides different ratio tests depending on the type of indebtedness being incurred (for example, first lien leverage ratio in respect of first lien indebtedness, senior secured leverage ratio in respect of indebtedness secured by a junior lien and a total net leverage ratio or interest coverage ratio in respect of unsecured indebtedness). The ratio basket for unsecured indebtedness typically permits such indebtedness to be incurred by issuers/borrowers, guarantors and non-guarantor restricted subsidiaries (subject to a cap for non-guarantor restricted subsidiaries). Financial covenant testing will be very important here and, in particular, whether or not a company can add back losses, costs and expenses in respect of COVID-19 may, in many cases, be the difference between having additional debt capacity or not.

  • Capitalised Lease Obligation Basket: the capitalised lease obligation basket may provide a source of potential capacity depending on the company’s intended use of proceeds as this basket is increasingly broadly drafted to include indebtedness incurred to finance the purchase, improvement, repair, renewal etc. of property (including the purchase of stock of a person owning such property). In addition, these baskets tend to be relatively unused by many European companies; as for IFRS definitions that are frozen pre-IFRS 16, the term “leases” excludes operating leases from the definition of indebtedness generally.

  • General Debt Basket: the general debt basket provides additional capacity for potential funding and does not require the proceeds to be used for any particular purpose. The general basket has increasingly become a basket for additional secured debt. Lenders providing funding to companies need to carefully consider whether any previous debt incurred by the company using this basket has reduced the available capacity.

  • Local Lines of Credit/Non-Guarantor Debt Baskets: the local lines of credit basket may be relevant for companies with international operations, and this often permits debt to be incurred by a non-guarantor restricted subsidiary. In addition, a basket for non-guarantor debt may provide a source of capacity for structurally senior debt (as discussed below, this debt is often also permitted to be secured by assets of a subsidiary other than the issuer/borrower or guarantors).

  • Contribution Debt: the contribution debt basket typically allows a company to incur an amount of indebtedness that is equal to (or in top tier sponsor transactions in the U.S., up to two times) the amount of equity contributed to the group.

  • Unrestricted Subsidiaries: these subsidiaries fall outside of the credit group, and therefore their activities are not limited or regulated by the covenant package, including their ability to incur indebtedness and grant security over their assets. To the extent unrestricted subsidiaries own assets of value, liquidity providers may be willing to lend to such subsidiaries on the basis that only the liquidity provider will have access to their assets for security purposes.

Is the Funding Secured?

In the European leveraged market, there are typically two types of permitted liens: “Permitted Collateral Liens” and “Permitted Liens.” If it is proposed that the new funding will be secured by the same assets that secure the existing indebtedness, the security interest will need to fall within the definition of Permitted Collateral Lien. If it is proposed that the new funding will be secured by different assets to any existing secured indebtedness, the security interest will need to fall within the definition of Permitted Lien. The definition of Permitted Collateral Lien usually regulates which of the Permitted Collateral Liens may rank super senior in relation to security enforcement proceeds in bond deals, which is typically the credit facility basket referred to above. By way of comparison, bonds and loans primarily syndicated in the United States often do not draw a distinction between “Permitted Collateral Liens” and “Permitted Liens,” usually just having a single category of permitted liens.

If a lien is being granted in favour of new creditors in respect of assets that also secure the existing debt, the company must rely on a permission available in the definition of Permitted Collateral Lien, examples of which are:

  • Unlimited amounts of debt secured by assets that also secure the existing debt subject to compliance with a pro forma secured leverage ratio. As with the debt covenant, it is essential to read all of the relevant definitions as they often deviate from traditional accounting concepts.

  • Specific baskets/permissions included in the debt covenant, such as the credit facility basket, incremental facilities basket, general debt basket, capitalised lease obligation basket or local liens basket. As with the corresponding debt covenant, these specific baskets are available without the need to comply with any financial covenant.

If the lien is being granted on assets that do not secure the existing debt (whether the existing debt is secured or unsecured), the company must rely on a permission available in the definition of Permitted Lien, such as:

  • A general fixed amount not tied to any specific basket of the debt covenant. Some companies have a leverage based ratio basket, which tends to be a leverage ratio based on total debt rather than only secured debt.

  • Specific baskets/permissions by reference to permissions in the debt covenant, such as the credit facility basket, incremental facilities basket, general debt basket, capitalised lease obligation basket, local lines basket or debt under certain forms of receivables financings. As with the corresponding debt covenant, these specific baskets are available without the need to comply with any financial covenant.

  • Unlimited amounts of debt secured by assets of non-guarantor subsidiaries. The existing covenant package may have limits on the amount of structurally senior debt (i.e., debt incurred by non-guarantor subsidiaries) that can be incurred as existing creditors do not have a direct claim on the assets of such non-guarantors. The advantage of this for a new creditor providing a liquidity facility is that the debt owed to them will be effectively senior with respect to the liabilities owed by such non-guarantor subsidiary and the security provided by that subsidiary.

Intercreditor and Jurisdictional Considerations

No analysis of the feasibility to layer additional debt into a capital structure is complete without a careful review of the intercreditor agreement, which governs the relationship between the different classes of creditor. In order for a liquidity provider to benefit from the super senior or pari passu status we have described above, such creditor or their representative will need to become a party to the intercreditor agreement and thereby agree to its terms, including their rights/obligations with respect to the other creditors. Providers of liquidity facilities will want to carry out a careful analysis of their rights to vote under the intercreditor agreement, including in relation to any instructions to the security agent to enforce the transaction security, which will vary depending on whether they have the super senior or pari passu status we have discussed. If a shareholder is willing to provide a liquidity injection, but requires the benefit of security and guarantees from members of the group, it will be important to analyse the intercreditor agreement to verify whether and to what degree it may be disenfranchised.

If the liquidity provider is lending to a non-guarantor subsidiary and benefitting from security not provided to existing creditors, there may be no requirement for such liquidity provider to become a party to the intercreditor agreement since there will be no sharing of guarantees and security.

In the event new debt is incurred in order to provide a liquidity facility that shares in the existing guarantee and security package benefitting existing creditors, there may be a requirement for such guarantees and security to be confirmed by the relevant group company members or for such security to be re-issued. The steps that are required to be taken will depend on the jurisdiction of the relevant guarantor and the governing law of the existing security documents. Depending on the extent of the existing guarantee and security package, including the number of jurisdictions involved, these steps may be time consuming and costly. Liquidity providers may agree for some of these steps to be carried out on a post-funding basis so as not to delay the provision of the urgently required liquidity.


Every capital structure and covenant package is unique and will require a careful case-by-case approach and analysis, including taking into consideration each creditor class, the underlying covenant package of each tranche of debt, the respective rights and obligations of the creditors with respect to other creditors under the intercreditor agreement and any local law issues relating to existing guarantee and security packages.

Further to the authors listed below, additional contacts on this subject included various partners from the London Finance and Capital Markets practices.

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This content was originally published by Shearman & Sterling before the A&O Shearman merger