Equity cure provisions are a ubiquitous feature of facility agreements in the European leveraged finance market. In simple terms, an equity cure provision will allow a sponsor to inject additional capital into the group to remedy or "cure" a financial covenant breach so that the breach does not trigger an event of default. Any additional capital is typically required to be injected by way of equity or subordinated debt with the financial covenants being retested on a pro forma basis taking account of the capital injection.
In principle, inclusion of an equity cure provision has benefits for both a sponsor and the lenders. From a sponsor’s perspective, an equity cure will allow it to fix a financial covenant breach before it becomes an event of default and thus avoid having to request a formal amendment or waiver from the lenders (and, indeed, avoid a situation where the lenders are entitled to take enforcement action). From the lenders’ perspective, an equity cure can result in the sponsor injecting additional subordinated funds into the group thereby showing its continued support and commitment to the business.
There is no standard Loan Market Association (LMA) form of equity cure clause and, whilst equity cure clauses generally share common features across most leveraged facility agreements, they remain a key point of negotiation. This is because the detailed terms of the clause will have a significant impact on the potency of the cure for both sponsors and lenders. This briefing summarises some of the key terms which the parties are likely to consider when negotiating an equity cure clause.
Number and frequency of cures
The most basic question to be considered by the parties is the number of times that a breach of a financial covenant can be cured and the frequency with which the cure right can be exercised by a sponsor. In recent years, the norm in the European leveraged loan market has been to permit three or four cures over the life of a facility with no more than two cures in a financial year and a restriction on cures being applied in respect of consecutive financial quarters.
The principle behind these restrictions is that an equity cure exists to remedy a period of abnormal underperformance and should not allow the sponsor to mask on-going, systematic underperformance by the borrower by repeatedly ‘drip-feeding’ funds in order to avoid a financial covenant breach.
Cure amount
In order for a cure to be effective, the amount injected needs to be sufficient to ensure that the financial covenants will be complied with when re-tested on a pro forma basis (although, as noted below, the amount required to ensure compliance will depend on how the cure amounts are deemed to be applied for the purpose of the pro forma calculation). However, the parties will need to consider if the sponsor will be permitted to inject more capital than the amount which is strictly necessary to cure to the financial covenant breach (a so-called "over cure").
From a sponsor’s perspective, an over cure should be welcomed by lenders as it demonstrates the sponsor’s continued support for the business and increases the cash available to the group thus providing an additional equity “buffer” to the lenders. Lenders frequently accept such arguments particularly where the cure amount (or a portion of it) is required to be applied in prepayment of the outstanding facilities (see below). Where this is not the case, however, lenders may wish to consider whether an over cure can potentially be used by a sponsor to mask continuing underperformance by the borrower and create artificial headroom in the financial covenants. This is particularly the case when one considers that a cure will typically impact the calculation of the financial covenants for the most recent testing period (when the financial covenant breach occurred) and the following three testing periods. An over cure can therefore potentially be used to create headroom for a twelve month period and, in so doing, circumvents a restriction on non-consecutive cures.
Application of equity cure amounts
As noted above, equity cure rights operate by providing that financial covenants will be recalculated on a pro forma basis for the test period in which a breach occurs to include any equity cure amounts. However, the manner in which the equity cure amount is treated for the purposes of that pro forma recalculation can have a significant impact on the effectiveness of the cure. In particular, in respect of the leverage covenant, the question arises as to whether the cure amount is deemed to reduce the borrower’s debt or increase its earnings before interest, taxes, depreciation, and amortisation (EBITDA).
The market norm is to retest the leverage covenant on the basis that the cure amount is deemed to reduce the borrower’s debt although a sponsor’s preferred position would be for the cure amount to be deemed to increase EBITDA (a so-called "EBITDA cure"). Deeming the cure amount to increase EBITDA will mean that any capital contribution will have a significantly greater effect for the purposes of re-calculating the leverage covenant than a reduction in the debt. As a result, where an EBITDA cure is permitted, a sponsor will be able to affect an equity cure by contributing significantly less capital than would otherwise be the case.
As a distinct but related issue, the parties will need to agree if some or all of the cure amount is required to be applied in actual mandatory prepayment of the facilities or, alternatively, if the borrower is permitted to retain the cure amount.
Round-tripping
Care should be taken to ensure that any cure amount is not permitted to be immediately paid back out of the obligor group by way of a dividend or repayment of subordinated debt to the sponsor. Such a circumstance would allow a sponsor to “round trip” cash in order to get the artificial benefit of the equity cure for the purpose of retesting its financial covenants without in reality providing additional capital to the borrower on a permanent basis. As such, the interaction of the equity cure clause with the provisions restricting dividends / repayment of subordinated debt will need to be reviewed carefully.
Equity cures v deemed cures
Distinct from equity cures, deemed cures provide that a financial covenant breach is deemed to be cured if, at the next financial covenant test date, the company is in compliance with its financial covenants and the lenders have not taken any enforcement action in the meantime. On the basis that financial covenants are normally tested quarterly, such a deemed cure mechanic effectively gives the lenders around three months in which to decide whether to take action in response to the financial covenant breach.
A note on the US market
There are some important differences to consider between a traditional European style equity cure provision (as described above) and the form typically found in New York law governed loan agreements. For instance, EBITDA cures are commonplace in the US market but are not often accepted in the European market. In contrast, whilst in New York law loan agreements, over cures are typically prohibited, such a restriction is often absent from European leveraged loan agreements.
Whilst US-style equity cure provisions have not generally been adopted in the mid-cap European leveraged market, they are increasingly influencing the equity cure provisions in large-cap European leveraged facilities. Lenders under those facilities should be cautious of incorporating the sponsor-friendly aspects of US-style cure provisions without also adopting the more restrictive provisions which are common in the US-style provisions but are not common in the European market. An obvious example of this would be combining an EBITDA cure (common in US facilities) with an over cure provision.
The current market: a snapshot of the “typical” equity cure provision
Based on a sample of 56 English law governed leveraged loan facility agreements which were signed in the period from July 2014 to May 2015 (and sourced through data made available by DebtXplained), we have set out below a summary of the prevalence of the key terms referred to above.
3-4 cures permitted
Prevalence (% of loan agreements): 96%
EBITDA cure permitted (including where any EBITDA cure right is limited / subject to restrictions)
Prevalence (% of loan agreements): 22%
Cure amount required to be applied in mandatory prepayment of facilities (either fully or partially)
Prevalence (% of loan agreements): 29%
Over cure expressly prohibited
Prevalence (% of loan agreements): 12%
Deemed cure permitted
Prevalence (% of loan agreements): 34%
