Equity Cure Provisions in Commercial Loan Agreements
Banking and Business Monthly – November 2019 By Steven A. Migala
EQUITY CURE PROVISIONS IN COMMERCIAL LOAN AGREEMENTS
Commercial loan agreements frequently contain various financial covenants requiring the borrower to achieve certain performance metrics, such as a leverage ratio or debt service coverage ratio. Since these covenants are based on past financial performance, breaches of financial covenants cannot be cured absent a cure provision. The use of an equity cure provision is one way in which to prevent such a breach and a resulting event of default under the loan documents.
An equity cure provision allows a borrower’s equity owners to inject additional equity into the borrower in order to cure a breach of a financial covenant, thereby preventing it from becoming an event of default. The cash contributed in exchange for the additional equity is used by the borrower to increase its cash flow or EBITDA or reduce debt in order to satisfy the applicable financial covenant. The equity cure provision, in essence, allows the borrower to retroactively improve its financial performance so that it is deemed to be in compliance with the applicable financial covenant as of the measurement date. While an equity cure provision is obviously attractive to borrowers to prevent an event of default, lenders often impose certain limitations on a borrower’s ability to invoke an equity cure provision. What are some of these limitations? Below are some examples, all of which can be the subject of negotiation.
Length of Cure Period
The length of time during which the borrower can utilize an equity cure to remedy a financial covenant breach is important. Borrowers will want a longer cure period to give their owners more time to raise funds for the equity injection, whereas lenders desire a shorter cure period to ensure the breach is timely cured. A few approaches are to tie this cure period to other cure periods in the loan agreement, or to have it match the time within which a borrower must deliver required financial statements to the lender.
Number of Equity Cures
Borrowers will want the ability to use the equity cure frequently to avoid an event of default; however, lenders will want to limit the number of times the equity cure can be used throughout the term of the loan, and may also limit the number of uses in any given time period. For example, a lender may want to limit the use of the equity cure to no more than twice per year and not more than four times over the entire term. Doing so allows a lender to mitigate the ability of a borrower to mask poor financial performance.
Application of Cash Contributed
Borrowers and Lenders may negotiate how the cash contributed in exchange for equity is applied. For example, borrowers may want to use the cash to prop up EBITDA to cure a financial covenant breach, but lenders, fearing that doing so will not fix the underlying financial problems, may insist that any cash be used to prepay in part its loan and reduce the borrower’s debt (and risk) to the lender.
Specific or All Financial Covenants and Measures
Lenders may attempt to specify which financial covenants may be subject to an equity cure provision, such as only cash-flow related covenants, whereas borrowers typically want to be able to use an equity cure provision to cure any possible breach of the loan agreement that can be cured by a cash infusion. For example, lenders may require that all equity contributions be disregarded in calculating EBITDA for all other purposes of the loan agreement, including calculating excess cash flow, pricing (interest rate) and leverage ratios, thus limiting the scope of the cure to the particular financial covenant that is breached. Borrowers, on the other hand, will desire that equity injections apply to all financial covenants and measures.
Amount of Equity Injection
How much equity may be contributed? Lenders may believe that borrowers should only be permitted to receive an equity injection in an amount just sufficient to cure the breach of the financial covenant. Borrowers, however, may seek additional equity in order to prevent future, anticipated breaches or to improve their financial measures. If an equity cure provision allows the proceeds to be applied as an increase in cash flow and EBITDA, then this boost in cash flow and EBITDA will be taken into account in subsequent testing periods for the related financial covenants to the extent provided in the loan agreement, which typically can be up to twelve months. By contributing extra equity, borrowers may then prevent lenders from exercising their rights arising out of what otherwise would have been future breaches of financial covenants absent the extra equity injection. Lenders can seek to counteract such extra equity injections by seeking an overall cap on the total equity cure amount.
Prevention of Circular Cash Flows or “Round-Tripping”
Lenders should be aware of the potential abuse by borrowers of circular cash flows, or “round-tripping,” if they allow equity cure provisions. This occurs when the equity cure amount is provided by the owners and then soon paid back to them through dividends or repayment of subordinated debt. Doing so enables the borrower to cure the financial default without providing meaningful and lasting capital to the borrower. Lenders can mitigate this by restricting such dividends or repayments, or by requiring that additional capital come from third parties who are not already a party to the loan documents.
Equity cure provisions are useful to borrowers who want to prevent financial covenant breaches from leading to events of default under a commercial loan agreement, but lenders need to be wary of them. Borrowers will want as much freedom as possible to be able to use them, but lenders should want to mitigate their use to prevent potential abuses.
Steven A. Migala is a partner at Lavelle Law and possesses over 20 years of providing excellent representation to banks, businesses, and individuals in a variety of matters. He can be contacted at (847) 705-7555 and firstname.lastname@example.org.