The COVID-19 pandemic--coupled with volatility in the energy markets--brought to an abrupt end the longest expansion of the U.S. corporate credit cycle. In the second quarter, the U.S. gross domestic product (GDP) declined at an annualized rate of 32.9%, the largest such drop for the nation.

Many middle-market companies, especially the ones that are consumer-facing, have experienced intensified liquidity pressures and have capital structures that might not be sustainable over the long run because of their lack of scale. However, the dynamics of lending in the middle-market segment generally allow for more efficient monitoring and intervention outside of formal processes (such as bankruptcy).

U.S. middle market CLOs rated by S&P Global Ratings require credit estimates (a point-in-time confidential indication of the likely credit rating) for the underlying middle-market entities that back the CLOs. Last year, we reviewed over 1,000 credit agreements of term loans for these middle-market entities. Almost all of them had some form of financial maintenance covenant. Most of the middle-market CLOs that we rate have indentures with provisions requiring CLO managers to notify us of any amendments or other changes that have a material bearing or affect the underlying entity issuing the loan. (For details on how we monitor middle-market entities, see "Monitoring Middle Market Entities Amid COVID-19," Aug. 6, 2020.)

The steep decline in revenue and earnings has affected the ability of many middle-market companies to stay in compliance with financial maintenance covenants. The affected companies have gone back to lenders to get waivers for their defaults. This has given lenders and borrowers an opportunity to modify the terms of their agreements to fit the times and circumstances. Below we highlight some of the themes we observed in the approximately 100 amendments we received to middle-market credit agreements.

Capital Injections From Sponsors And Equity Cures

Sometimes called "rescue capital," capital infusions from sponsors are needed when a borrower's balance sheet requires realignment and additional borrowing is not the best option--or perhaps not an option at all. For a sponsor considering additional borrowing for a portfolio company, one of the main concerns is the borrower's ability to repay. But when it comes to a sponsor infusion, the analysis usually revolves around the borrower's growth potential, which affects the sponsor's ability to extract that capital later through a dividend or another method.

Many credit agreements, especially those for middle-market deals, allow for what is called an "equity cure." Although deal-specific variations can add complexity, the basic principle behind the equity cure provision is straightforward: Borrowers that have breached--or are near breaching--a financial maintenance covenant can have the sponsor inject additional equity capital into the firm. In the covenant calculation, this new capital will generally be treated as additional EBITDA. The provision is mainly meant to allow a sponsor to remedy a temporary underperformance that is causing a financial maintenance covenant breach or near breach. In reviewing such provisions, we have observed that lenders tend to limit the overall number and successive instances of these cures. They do so to prevent sponsors from masking any systemic borrower issues that could lead to further deterioration from cure to cure and potentially reduce the ultimate recovery on the loan.

In more than 20% of the agreements that we reviewed, there was an infusion from the private equity sponsor to address the liquidity issues. In addition to being used for balance-sheet strengthening, working capital, and general corporate purposes, contributions were used to pay-down outstanding revolvers or swing-line loans so companies could draw on them later.

Borrower Liquidity Is A Primary Concern For Lenders

Given many borrowers' reduced revenues and earnings, a significant portion of the amendments addressed borrowers' immediate liquidity needs. Apart from infusions from sponsors, companies also borrowed from their revolvers. Some borrowers also raised more debt to shore up their working-capital needs. A few companies that were eligible (private equity-owned, but without the affiliation clause or a NAICS code beginning with 72, and fewer than 500 employees per physical location) were able to tap into the Paycheck Protection Program (PPP).

Lenders also helped companies preserve their liquidity by providing relief from scheduled principal amortization payments either postponing the scheduled amortization payments for several quarters or all the way to maturity. There were also amendments that reduced scheduled amortization amount and the balance owed was added to the final bullet payment In several agreements, interest owed to lenders was broken into partial cash and partial payment-in-kind (PIK), either over the next few quarters. We consider all of these transactions to be distressed exchanges under our criteria (see "Rating Implications Of Exchange Offers And Similar Restructurings, Update," May 12, 2009). In exchange for these changes, lenders took the opportunity to tighten the language around some provisions.

Financial Maintenance Covenants Are Focusing More On Liquidity

Financial maintenance covenants are more prevalent in the middle-market segment. Theoretically, this gives middle-market lenders a chance to address repayment risks earlier in the distress cycle, as companies will breach these provisions as their revenues are suppressed in a downturn. Our review of credit agreements last year found that 90% of the agreements had a leverage-based financial maintenance covenant. This is not surprising given it's perhaps the most comprehensive test in capturing the firm's ultimate capacity to repay its debts.

Lenders were willing to waive leverage-based financial maintenance covenant breaches and enter into general forbearance agreements. These lenders also agreed to reset and loosen leveraged-based financial maintenance covenant thresholds--in some instances to maturity. Variations around the specific language included suspension of testing for two to three quarters.

Given that liquidity was the primary concern, several agreements added minimum liquidity financial maintenance covenants. Presumably this was done with the objective of giving lenders an early signal of imminent payment defaults. The provisions required testing and the reporting of the liquidity of the borrowers weekly or biweekly.

Many of the liquidity-based amendments also implemented a surveillance-style monitoring system, looking out 90 days. Lenders required borrowers to submit a 13-week cash-flow projection, along with the actual performance for the previous period, with appropriate reconciliation statements highlighting variances. Many of these agreements also had a lender call to explain and discuss performance, projections, and milestones.

EBITDA Addback Provisions

Because EBITDA plays such a large role in financial maintenance covenants--via various leverage ratios and the interest coverage ratio--lenders have pushed to tighten the scope of what is eligible to be added back to EBITDA. Our ratings and credit estimates reflect our independent view of a company's EBITDA, leverage, and cash flow, regardless of how they are defined in credit agreements.

A topic of interest among market participants is whether COVID-19-related expenses--also referred to as "lost revenue"--can be construed as extraordinary losses. There have also been questions around whether COVID-19-related costs can be considered a one-time, nonrecurring or unusual costs and be added back to EBITDA. For our analysis, we don't consider lost revenue related to COVID-19 as something to be added back to EBITDA. Further, we generally don't add back COVID-19-related costs to EBITDA for leverage or other calculation measures.

In the documents we reviewed, there were a handful of credit agreements that unambiguously addressed this issue on a pre-emptive basis. In these amendments, the lenders added a clause to the definition of EBITDA that explicitly disallowed addbacks of all losses, costs, expenses, and charges arising from COVID-19. Some documents allowed for a one-time addback for COVID-19-related expenses, which was capped at a certain percentage of EBITDA. One agreement allowed COVID related expenses to be added back--but only in 2020.

A less-prevalent modification, but still related to COVID-19, replaced much of the generic and broad language pertaining to business interruption insurance being an eligible category for adding to EBITDA with requirements that such insurance proceeds must be received before they can be added to EBITDA. Many companies have filed claims under their business-interruption insurance policies that seek compensation for the mandatory business closures, but whether they can collect on such claims is uncertain. This type of language is meant to prevent companies from using that category to add back funds that are contingent on a court ruling.

Steps To Limit Asset Transfers

Now that lenders have had the opportunity to impose tighter controls over borrowers, many have inserted various forms of so-called J. Crew blockers. Most of these amendments are in the section of the credit agreement outlining the terms around the designation of unrestricted subsidiaries. We saw amendments that removed the concept of an unrestricted subsidiary in its entirety. There was also an instance of an amendment (in effect until December 2021) that disallowed the designation of any subsidiary as an unrestricted subsidiary.

One credit agreement removed the borrower's ability to form new unrestricted subsidiaries without the permission of the lenders. This credit agreement already had direct language intended to prohibit the transfer of material intellectual property from a restricted subsidiary to an unrestricted subsidiary, which was in the section describing the procedure for designating a restricted subsidiary as an unrestricted subsidiary. Nevertheless, it still took this measure to block any asset transfers to an unrestricted subsidiary.

From a credit rating or estimate standpoint, asset transfer is an example of an event risk that, in our view, is relatively uncommon at this point. Moreover, they are extremely difficult to reasonably foresee and quantify in our analysis. Consequently, we typically do not directly factor these risks on a forward-looking basis, but we capture any actual developments in our ongoing ratings surveillance process.

Transitioning From LIBOR

It appears likely that LIBOR will cease to be a benchmark rate by the end of 2021. Last year, the Alternative Rates Reference Committee (ARCC) proposed two approaches for loan documents to transition from LIBOR. The first is through an amendment, where the occurrence of an event (such as LIBOR cessation or the announcement that LIBOR is no longer viable) requires the borrower and agent to identify a replacement benchmark, which the lenders can reject within a certain timeframe. The second approach is hardwired and continues to be fine-tuned. It looks at a similar trigger event that calls for a waterfall of replacement rates and spreads relating to a Secured Overnight Funding Rate (SOFR).

Many borrowers and lenders have prepared for the cessation of LIBOR as an available benchmark upon which they can base their margin. Some credit agreements we looked at contemplated the amendment approach, where the trigger is the non-availability of LIBOR as a benchmark. After the trigger event, the agent and the borrower determine a new benchmark, which the lenders have up to five days to reject.

Some of the credit agreements mention the SOFR as a possible alternative, but they do not commit to it. Instead, the agreements settle on determining a rate after LIBOR is no longer available, taking into account any regulatory recommendations or prevailing market conventions for replacing LIBOR at the time. The credit agreements also make room for any margin adjustments that will need to be made for the new benchmark rate, again taking into account regulatory or other recommendations and prevailing market conventions at the time. Lastly, the credit agreements allow for the administrative agent or lenders to opt-in to a new benchmark rate before LIBOR is no longer available.

Looking Ahead

Most middle-market companies that took a hit due to the pandemic were able to address their immediate liquidity needs through sources including revolver draws, sponsor infusions, and tapping into the PPP. These efforts appear to have stabilized their immediate liquidity needs. However, their medium- to long-term prospects will depend on the speed, strength, and duration of the economic recovery.

For some of the affected companies, the sustainability of their operations and balance sheet will come under question if the pace of economic recovery does not pick up as expected. Even if the spread of the virus is contained, there could be a permanent shift in behaviors that will have a long-term impact on companies in the more vulnerable sectors, such as fitness and entertainment facilities, dine-in restaurants, travel, non-essential brick-and-mortal retail.