Avoid costly oversights by double-checking 5 key provisions

Once the term sheet is done and everyone agrees on the deal, the rest can be left to the attorneys, right? Not so fast!

Redbridge has seen multiple examples of terms—even relatively important terms—changing from what was on the term sheet, and we’ve encountered even more examples where what was on the term sheet did not match with the borrower’s understanding of the terms.

A minor mistake in documentation may be fixable, but it can also be a warning sign for misunderstandings, sloppy drafting and even a purposeful change to the terms without prior agreement. Loan agreements are complex, and mistakes can be extremely costly in terms of wasted time, missed business opportunities and damaged relationships.

Common sources of problems

Although transactional attorneys managing relationships usually have years of experience, it should be understood that often a relatively junior attorney may be executing the first draft of the document for the bank, and a junior associate for the borrower’s counsel may be handling the first review. Newer attorneys lack the hard-won experience to spot potential trouble signs and to understand the issues that may turn into hot buttons for the borrower.

Attorneys rarely start from a clean piece of paper when drafting loan documentation; they usually adapt documentation from the bank’s standard form or a previous transaction. Each borrower has different priorities and business drivers, so what works for one client rarely works for another. The bank’s standard agreement is usually more conservative than the terms and restrictions offered to a particular borrower. Many items are glossed over in the term sheet. Each of these items can potentially limit the borrower’s flexibility and lead to inadvertent defaults as many borrowers do not read and fully understand their documentation.

Key provisions to scrutinize

While each agreement is unique, it’s wise to pay attention to these five elements:

1. Defined terms: A list of defined terms appears near the beginning of the document. They drive the understanding and interpretation of the rest of the agreement. If a defined term has a different meaning than the plain English that a borrower assumed, it could be a serious fight to win a court battle. Trace all capitalized terms in the credit agreement to all of the defined terms, sometimes three layers or more. Often one defined term contains a reference to a second defined term and so on.
2. Financial covenants: These covenants should be tailored to the business plan and expected results. For example, if your company plans to use existing cash on the balance sheet to invest in the business or pay shareholders, make sure that expenditures made from excess cash do not flow through Fixed Charge Coverage Ratios. Even when companies are clear about requirements, the documentation can default to the cookie-cutter situation.
3. Nonfinancial covenants: Similar to financial covenants, these provisions should align with plans and expectations. Pay close attention to the process to waive or amend the covenants. Consider allowing the agent bank to have some discretion, within certain limits, to avoid the delay caused by the agent getting approval first and then going to the banks, which will all move at different speeds.
4. New trends: When banks struggled with energy loans in the mid-2010s, they began inserting “cash hoarding” language into credit agreements. If more than a certain amount of cash is on the balance sheet for more than a defined number of business days, the borrower must repay the line of credit. This has expanded beyond the energy space, and Redbridge has seen this in some agreements for COVID-impacted industries. Although agreements currently have representations and warranties to state that the company does not believe there is a potential default, cash hoarding language limits the availability of the revolver in a much more structured and severe manner.
5. Rate structure: Consider the grid pricing levels, leverage vs. ratings-based pricing, and the timing and frequency of permitted borrowings. Borrowing procedures can force companies to borrow at the alternate base rate due to required minimum notice or a limited number of permitted LIBOR/SOFR borrowings outstanding. The alternate base rate can be 1.5% or more above the LIBOR/SOFR rate! Paying attention to the mechanics of the borrowing process is important.

How to protect yourself

These five elements are by no means an exhaustive list of potential problems and concerns when negotiating loan documentation. Redbridge’s process involves drafting a detailed term sheet, which includes defined terms, detailed baskets, covenants and borrowing mechanics for the financing. This process eliminates last-minute surprises during closing, allows the borrower to dictate terms to the banks and eliminates documentation time by up to 50%.

Schedule time with us today to learn more about market trends and how Redbridge can help!

Financial implications

Corporate credit ratings have a wide range of financial implications, such as the amount of trade credit received, terms of bank financing, and coupon paid on public debt.

Financial implications include:

1. The interest rate paid on debt is highly correlated to the credit rating. Most banks and many investors use a “risk adjusted return on capital,” or RAROC, to evaluate profitability and guide lending and investment decisions. A 3% interest rate to a company with somewhat shaky prospects is intuitively different from a 3% loan to Walmart. Which loan would you want to make?
2. Similarly, credit ratings influence the other terms of debt, such as required collateral and covenants. An investment-grade borrower (BBB- rating and above) can generally borrow without collateral, while some riskier companies may only be able to borrow if the lender has all assets of the company as collateral and even controls the company’s bank accounts and lockboxes!
3. Vendors may use a credit rating to determine the need for prepayment or extension of payment terms, which influences the amount of working capital and need for borrowing.
4. Given that your banks are using the risk rating to determine their RAROC, a higher credit rating can enable your banks to earn more money without you paying more and limit complaints about side business from your banks. Bank ratings can vary by two or even three notches from bank to bank.

Strategic implications

Credit ratings also have strategic implications for the business profile for customers, suppliers, employees and investors.

Strategic implications include:

1. A company’s credit rating represents its credit profile and riskiness to investors, employees, customers, vendors, and lenders. Customers and vendors will be hesitant to transact with a company if they fear it will default and declare bankruptcy.
2. A higher credit rating allows banks to approve larger requests for credit more quickly. This can be an important consideration for mergers and acquisitions.
3. Higher rated companies have access to additional sources of liquidity, such as commercial paper, and can put supply chain finance programs into place for vendors, potentially improving pricing.
4. Managing the story rating agencies tell is a way to influence the public discourse about a company’s risk profile and future prospects. If the rating analyst does not understand the business and publishes less favorable opinions, lenders and investors may believe the analyst. This will likely affect the yield required on institutional and bank debt, as well as the stock price.

Boosting your ratings

How can you actually improve your ratings? Ratings can be improved when companies evaluate and change qualitative elements, quantitative factors and structural elements, and when they have a dedicated focus and communication strategy for credit rating analysts.

Quantitative factors may consist of issues beyond your control in the short term, such as scale of the business, EBITDA margins, leverage ratio, and cash flow metrics. Qualitative factors used in most ratings models include an analysis of the business profile, such as demand, brand value, competitive profile, prospects for growth, financial policies such as acquisition or shareholder-distribution policies, and other factors. Structural elements include an analysis of the debt capital structure, collateral package and relative recovery prospects for debtholders in a downside case.

Although some of these factors are difficult to improve in the short to medium term, changes to debt structure and improved understanding of the business profile can move the needle. For example:

1. Financial policy: communicating an increasing share of cash flow used to repay debt, reducing perceived risk.
2. Debt structure: the mix of secured and unsecured debt can improve ratings by influencing the potential recovery on debt in a default scenario. Recovery analysis is quite technical and requires a good amount of expertise and dialogue with the ratings counterparty.
3. Business profile: providing the right story and data to a ratings analyst can erase misperceptions. Many times the analyst simply does not want to do the hard work evaluating the business or does not want to ask questions.

Building a long-term strategy to improve your corporate credit rating

The proper communication strategy and capital structure can help to optimize and improve your rating, but this approach requires a tailor-made solution for your unique business and situation.

Redbridge has the expertise, deep knowledge of bank and rating agency processes and senior-level resources to help you improve your ratings for current needs and future strategic priorities. Ratings require a dedicated, long-term strategy, and the sooner the process starts, the sooner the ratings improve.