Private equity requests for flexibility may backfire during pandemic

By Kristen Haunss

NEW YORK, May 28 (LPC) - The unprecedented coronavirus crisis may have become a headache for private equity sponsors that have pushed for loose lending terms to finance leveraged buyouts as they saddled their portfolio companies with debt.

At the heart of the matter is a provision in credit agreements that allows additional time to deliver audited financial reports. The language may allow businesses to delay reporting a potential covenant breach if one arose. Now, during the global health crisis, the added flexibility is forcing auditors to take a harder look at companies' financial well-being.

Most credit agreements require the delivery of 'clean' audited year-end financial statements certified by an independent accountant without doubts regarding a company's ability to continue operations.

According to Moody's Investors Service, the failure to deliver financial statements that meet this requirement may constitute an event of default.

The Securities and Exchange Commission (SEC) requires public companies to file an annual report within 90 days after the end of their fiscal year. Private businesses, not subject to the same specifications, have pushed that to 120 days.

The coronavirus pandemic has interrupted supply chains, closed retail operations leading to massive layoffs amid government-mandated shutdowns and reduced consumer demand. In response, as companies saw sales plummet, many drew on their revolving line of credit or sought short-term funding to ensure access to liquidity, changing the fiscal picture of the business.

If a company filed its financials within 90 days of a fiscal year ending December 31, it may have only had about two weeks of coronavirus impact before an accountant had to certify its fiscal health. Many US state government-mandated shutdowns went into effect in mid-March.

Companies that had pushed to report in 120 days may have experienced six weeks of coronavirus fallout. The resulting lower revenue, potential tripped covenants, or additional debt on the balance sheet may lead an auditor to question whether that business can continue operations long term.

A decrease in revenue attributed to the pandemic after the fiscal period ended, but before earnings were delivered, could raise accounting concerns about impairments, according to Conor Moore, national leader of the private enterprise practice at accounting firm KPMG. If the loss resulted in a covenant breach, and a company could no longer meet its debt obligations, an auditor may say the business can no longer operate as a going concern.

If a company makes a large revolver draw during that same period after the fiscal quarter-end but before reporting earnings, an auditor may need to make an additional footnote in the report, he said.

Companies drew more than US$229bn from revolvers between March 11 and May 19, according to Refinitiv LPC data.

The audit process itself has been challenged as accounting firms may be unable to travel to examine inventory or meet executives in person while the financial health of a business changes rapidly, adding another wrinkle to the process. The SEC is allowing some publicly traded companies with a Covid-19 related issue an additional 45 days to file certain disclosure reports.

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The US$1.2trn US leveraged loan market, which companies rely on to back mergers and acquisitions, benefited over the years from increased demand for floating-rate paper, which can serve as a hedge to rising rates. The inflow of cash to the asset class allowed companies to borrow with limited protections for lenders.

Many private equity-backed companies requested to push the timeframe for reporting annual earnings to 120 days, and sometimes even longer for the first audit following a buyout, according to Jake Mincemoyer, head of law firm White & Case's Americas banking group. Many have also asked for additional time to report quarterly earnings.

"When credit markets get frothy for different reasons, the borrower gets away with more favorable conditions," said Victoria Ivashina, a finance professor at Harvard Business School.

The extended reporting timeframe was intended to be a positive for borrowers.

For companies with a financial maintenance covenant in their credit agreement, while the tests are calculated as of quarter-end, the compliance with the covenant is frequently required to be reported when the financial results are delivered, which could be a month later.

"With the longer reporting time frame, it may just push out the amount of time the company has to report compliance," Mincemoyer said. "It may give more breathing room to the company."

Despite the proliferation of covenant-lite credits – 81% of institutional loans issued in the first quarter lacked a full package of lender protections – April was the largest month on record for amendments, according to Citigroup and LPC data.

While some lenders have gotten comfortable offering additional time, other investors oppose it.

"There is just a disconnect where lenders don't have visibility into a company and what its financials look like," said Jessica Reiss, head of leveraged loan research at Covenant Review. (Reporting by Kristen Haunss; Editing by Michelle Sierra)