Ask any corporate what the defining feature of the onset of the Covid-19 crisis was for their business and the answer will be the same: shock at the speed with which all business activity – and therefore cashflow – halted.
Although concern about the virus had been growing in China since late 2019, many firms were blindsided when lockdowns started to hit Europe and the US in early March.
The sudden cessation of all cashflow is something that is just not supposed to happen.
“No equity valuation model could have seen this coming,” one investor points out in April. “Earnings over the coming year are always the biggest weight in any valuation model. What is happening now will necessitate ripping up all the models that we have and starting again.”
When a stop of this nature happens, the obvious first port of call for any corporate is its short-term working capital and revolving credit lines. These were tapped in their droves as soon as the enormity of what was unfolding became apparent.
As we highlight in our US bank earnings feature, the large US banks saw huge volumes of credit line drawdowns in March, with many clients quickly tapping the full limit of their available funding.
Boeing’s spectacular drawdown of the full $13.8 billion available to it was an early signal of the extent to which firms would tap credit lines to weather the storm.
Already beset with problems associated with the flawed 737 Max aircraft, Boeing had signed a Citi-led 18-month delayed draw term loan in February, just before the Covid-19 crisis hit.
Other large US firms to tap their revolving credit facilities (RCFs) in their entirety included Kraft Heinz, which took the whole $4 billion available to it. In Europe, Air France/KLM drew down on €1.765 billion RCF funding led by BNP Paribas, CM-CIC, Crédit Agricole, Deutsche Bank, HSBC, Natixis and Societe Generale.
Tapping your revolver as soon as trouble strikes is a sensible thing for any firm to do. It gives access to liquidity that can be used either to meet immediate costs, such as paying suppliers, covering payroll or even covering commercial paper (CP) or refinancing bond issuance.
Tapping more than you might immediately need means that funds can also be re-deposited as a rainy-day fund for problems ahead.
The only snag is that revolvers are never really meant to be used in this way. Indeed, they are structured to encourage the opposite outcome.
The onset of Covid-19 lockdowns was so sudden that many firms were forced to tap their RCFs in their entirety – and will have incurred often harsh utilization fees as a consequence
When corporates and their banks agree the terms of their revolving credit lines, there is a clear understanding that the full amount will not be tapped. RCFs are usually only drawn up to around 20% to 30% of their full amount.
For just this reason, they are structured with explicit utilization fees, which kick in when the facility is tapped above a certain agreed level. The severity of the utilization fee imposed reflects the degree of conviction with which the bank does not want the facility to be drawn over and above this.
Many corporates will happily agree to very high utilization fees of this nature because they never expect to reach the point at which they kick in. They agree to such terms safe in the knowledge that should this level be approached, other facilities will be put in place and the situation remedied.
However, the onset of Covid-19 lockdowns was so sudden that many firms were forced to tap their RCFs in their entirety – and will have incurred often harsh utilization fees as a consequence.
Another trap for the unwary borrower forced to tap their entire RCF is the springing covenant. Most documentation for such lending states that when aggregate outstanding utilizations exceed a certain amount, a springing covenant will be tripped. This could see the borrower hit with higher charges, reduced flexibility and perhaps mandated deleveraging.
Again, this is probably something that many borrowers pay little heed to when they agree the RCF, given that they would never expect to tap it over a certain limit in the normal course of business.
But this is not the normal course of business: even a 12-month trailing leverage covenant on a revolver is likely to be eventually breached in the current environment.
Many borrowers are, or will soon be, tripping springing covenants on their borrowing and it remains to be seen how aggressively lenders decide to deal with this. And while the banks will have underwritten the credit lines, these loans will have been syndicated widely.
This could have interesting repercussions in the sub-investment grade lending market.
As covenants have rapidly evaporated throughout leveraged lending in recent years, many have fretted that there will be nothing to bring borrowers to the table in a crisis until firms completely run out of cash.
That prospect is looking alarmingly real at many private equity portfolio companies, many of which have been encouraged to tap revolvers to their fullest extent by their sponsors.
Springing covenants buried in an RCF could, in many cases, be one of the only meaningful triggers left in the debt stack at these firms. This is something that has not escaped the notice of many credit opportunities funds, which are now eyeing up the RCFs of firms that are good but are facing a short-term cash squeeze due to lockdowns.
Most outstanding leveraged loans are now covenant-lite, but these funds can buy into the RCFs of such corporates, enforce the springing covenant when it is tripped and get them to the table.
They are not called credit opportunities funds for nothing.