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Junk-Rated Firms Using Overdrafts Risk Test Breach as Sales Fall

Ruth McGavin and Marianna Aragao

(Bloomberg) -- Leveraged European companies using emergency credit lines while the pandemic wipes out their earnings, risk breaching conditions on the debt, potentially driving them into technical default.

Companies that have raised leveraged loans in Europe currently have revolving credit facilities -- a kind of corporate overdraft -- worth about 58 billion euros ($63 billion) at their disposal, data compiled by Bloomberg show.

These have become a lifeline for some companies as quarantine measures force customers to stay at home or compel retailers, restaurants and cinemas to shut down in order to slow the coronavirus’s progress. But drawing on these loans just when revenues evaporate means some are likely to fail covenant tests by exceeding conditions on how much they can borrow as a ratio to core earnings.

The tests commonly come into force when more than 35%-40% of the facility is drawn. A breach can ultimately lead to default across the capital structure, imposing losses on shareholders and lenders.

A&O Hotels and Hostels Holding AG is among the junk-rated companies at risk and theater operator Cineworld is already negotiating with its banks, Moody’s Investors Service said in reports published this week. A spokesman for A&O declined to comment. Cineworld didn’t respond to a request for comment.

Breathing Space

Banks can choose to give the company breathing space by waiving the breach or resetting terms. Alternatively, fresh capital from lenders or shareholders can be injected ahead of time to ensure the borrower passes the test.

“We are working on a number of financial covenant reset amendment processes for borrowers with maintenance financial covenants as companies see their Ebitda suddenly diminishing, with creditors asking shareholders to inject additional equity in consideration of such resetting,” said Korey Fevzi, partner at law firm Shearman & Sterling in London.

Policy makers are also responding. The Bank of England on Thursday said it was giving banks extra flexibility on accounting rules and told lenders they should consider waiving covenant breaches rather than automatically treating them as defaults.

Time, Flexibility

Companies will have several months to find a solution unless they were already underperforming. Revenues have only recently taken a hit and most tests offer headroom before a borrower is deemed to be in breach. But if Europe remains locked down in the second quarter, they will face a tougher time with later assessments.

“A lot of companies will be compliant with their March covenants requirements, but assuming that in April, May, and possible June the economy continues to be virtually shut down, we’ll see issues with the June covenant in most industries as a result,” said Patrick Schoennagel, a managing director in Houlihan Lokey’s capital markets group.

Borrowers usually have 30-45 days from quarter-end before they have to announce whether they’ve passed or failed.

Even then loose documentation may give the borrower or private equity sponsor ways to avoid or delay the test. Some companies are exploring what adjustments they can make to earnings to account for the impact of the virus.

“In connection with this, there is a great deal of focus from finance directors on what adjustments can be made to Ebitda for losses relating to the coronavirus pandemic,” said Shearman & Sterling’s Fevzi. “We expect this to be a key battleground in the coming days and weeks.”

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