There's a new cooperative urgency for all sides.

While the COVID-19 pandemic has wreaked havoc on customers, employees, and equity owners of restaurants, health clubs and innumerable consumer-facing businesses, it has also brought their lenders to the table as interested stakeholders, often with an cooperative urgency that many businesses and their owners have welcomed.

As lenders have become more engaged, certain trends in the leveraged finance market for these businesses is beginning to emerge.

The “Known Unknowns.” While thought leadership in the early stages of the pandemic focused itself of which letter of the alphabet a recovery would take (“v-shaped,” “u-shaped,” “w-shaped,” etc.) it has become clear that debt markets are no closer to settling on a consensus than they were months ago.

Recent U.S. upticks in infection rates cut against the earlier outlooks of a permanently “bent curve,” but digging deeper within those markets show that regional and even local differences in rates make financial modeling and revenue performance outlooks even more difficult for market participants to feel confident in. Coupled with the broad array of government entities overseeing responses and mandates and the continually evolving arsenal of federal and state assistance programs, that uncertainty will need to be reduced in order for true global market consensus positions to evolve.

Breadth of lenders. Despite that uncertainty, the debt markets for restaurants, health clubs, and consumer-facing businesses have expanded exponentially in the past decade, which has allowed borrowers to access a wider variety of funding sources and kept debt markets somewhat open and flexible during the pandemic.

While local, regional, and national banks have always called upon the industry, private debt funds, business development companies, family offices and other providers of private credit have spent considerable energies over the last decade to establish the teams and expertise to successfully provide credit solutions for acquisitions, growth and refinancing within the industry.

The effects of a wider debt supply to the industry has offered chances for borrowers to realize some debt service relief from banks, while many private debt providers have been able to step in with substantial covenant relief.  Additionally, the wider universe of providers and capital has created competition among them, in turn allowing for some limited new deal activity to still get tackled during the midst of the current crisis.

Trends. While that true global market consensus needs time to settle, there are certain trends in leveraged finance that are fighting their way through to a new kind of “normal”—specifically:

Leverage. The amount of leverage credit providers is willing to provide is proportionally lower for all but the most attractive deals. This means most acquisition financings deals are now requiring equity contributions in upwards of 50 percent, while pre-pandemic levels settled around the 35 percent mark.  Additionally, true bank-style financings have found more traction, as those banks can often ask for lower pricing and taking away the higher leverage many private credit providers found success in offering.

COVID-19 Accounting. The pandemic has surfaced several question lenders and borrowers alike have not tackled before, although common ground seems to be emerging:

“Lost revenues”—while some borrowers initially worked to include revenues “lost” due to COVID-19 shutdowns as addbacks to net income in their calculations of EBITDA, the request has subsided a bit, which is expected based on the fundamentals—e.g., such amounts have never traditionally been recognized as expenses or even items under GAAP and credit documentation does not typically allow for the adjustment

Finding “EBITDA”—approaches here have a broad spectrum, but borrowers and lenders are working together to determine how to define and think about EBITDA metrics when and as business volume increases.  To date, approaches include annualizing post-pandemic EBITDA until a full year of performance is achieved, adjusting for pandemic-related losses and calculating performance relative to pre-pandemic levels (e.g., taking 2019 earnings and adjusting them with customer counts for 2021)

PPP loans—importantly, the influx of PPP loan proceeds can vary EBITDA amounts in terms of whether the funds are forgiven (and thus recognized as income), ensuring spends with the proceeds are appropriately accounted for and how to account for the loan amounts before they are forgiven (or if they never are).  Solutions here vary widely but tend to include counting the proceeds as debt if they remain outstanding after an agreed-upon date.

Derek F. Ladgenski is a Commercial Finance partner at Katten Muchin Rosenman LLP. Derek counsels lead arrangers, administrative agents and lenders on cash-flow acquisition and recapitalization financings, “take private” transactions and debt financings.

Expert Takes, Feature, Finance