Leveraged Lending
Adverse Risk Rating Examples
Example A of Adverse Risk Ratings
Borrower - United Publication Company, Inc. (United) Yourtown, USA
Business- Publisher of several monthly brand-name specialty magazines and provider of media production services.
Facility (Facilities) Description:
1. $50 million RC with maturity in one year. $20 million outstanding.
2. $50 million TL-A with current balance $45 million originating one year ago. Maturity in five years. Interest quarterly.
3. $200 million TL-B. Maturity in six years. Interest quarterly.
4. $400 million TL-C. Maturity in six years. Interest quarterly.
Credit agreement covering facilities has been amended three times, reducing annual principal repayment and financial covenant requirements. Total senior secured financing of $700 million shares its position in right of payment with additional high yield debt of $750 million.
Pricing: LIBOR + 200 BP.
Repayment:
TL-A amortizes $5 million annually with $30MM balance due at maturity.
TL-B amortizes $2 million annually with $190 million balance due at maturity.
TL-C is due at maturity.
Purpose: Debt refinancing and portfolio acquisitions.
Primary Repayment Source:
Operating cash flow.
Secondary Repayment Source:
Sale of individual operating units, publications, and trademarks.
Covenant Compliance:
Yes, as amended.
Collateral:
All business assets. No collateral valuation.
Financial Synopsis:
Financial condition is characterized by high leverage and negative tangible net worth. Working capital position is deficit and liquidity is provided by RC. Senior and total debt represent 6.5X and 7.5X EBITDA, respectively.
Principal assets are goodwill $1 billion and intangible assets $250 million.
Recent asset sales were used to prepay high yield debt resulting in the current balance above, but do support value of branded publications.
Earnings and performance levels are stable, but company has not realized growth plans that were basis for underwriting.
Current FYE fixed charge coverage (FCC) is projected to be 1.0X and benefits from the deferred amortization schedule of senior debt.
Current Status:
United’s current cash flow projections reflect capacity to meet contractual debt service requirements with little additional margin. Management will continue efforts to divest marginal units to reduce debt levels
Risk Rating Decision:
Substandard/Accrual
Weak financial position, characterized by high leverage, deficit working capital and negative tangible net worth.
Operating performance below projected levels.
Senior debt repayment restructure is liberal. Available operating cash flow provides for payment of interest, but only nominal reduction in company’s high debt level.
Sales of several underperforming units and the current performance levels of remaining units support the estimated value of remaining brand name units and exceed total senior debt.
Accrual status is supported by the stability and capacity of operating cash flow to provide interest payments.
Risk Rating Considerations:
Ability of the company to meet contractual debt service requirements does not mitigate its inability to provide reasonable level of debt reduction from operating cash flow.
Company management has been unable to increase revenues as planned and has resorted to secondary repayment sources (asset divestitures) to reduce debt.
Stability of earnings streams from remaining name brand units supports their estimated value.
Capacity of operating earnings to meet interest charges supports continued accrual status.
Example B of Adverse Risk Ratings
Borrower - Consolidated Equipment Company, Inc. (Consolidated)Anytown, USA
Business: Manufacturer of transportation equipment.
Facility Description:
$200 million RC with maturity due in three years. RC fully drawn. Outstanding balance recently permanently reduced $50 million by sale of three divisions.
Pricing:
LIBOR + 250 BP.
Repayment:
Interest due monthly, principal at maturity. Required step-down in commitment not met.
Purpose:
Debt restructure and merger-related expenses.
Primary Repayment Source:
Operating cash flow.
Secondary Repayment Source:
Sale of business assets or sale and refinance of company stock, or both.
Covenant Compliance:
No. Violated six covenants at last FYE. Covenants have subsequently been waived for this year in exchange for $15 million equity injection.
Collateral:
First lien on nine manufacturing plants recently independently appraised at $15 million, M&E appraised by third party using orderly liquidation value at $10 million, and AR with book value $10 million. Last field audit of company’s AR’s reflects significant delinquencies with no subsequent follow-up.
Enterprise Value: Estimated between $200 million and $250 million. Values have declined significantly with company’s deteriorating financial condition. The valuation relies on an increase in sales volume and margin beginning next year. Success of the plan is dependent on an industry turnaround and is hindered by the company’s current distressed condition.
Financial Synopsis:
Financial condition is characterized by high leverage and minimal tangible net worth.
Liquidity and working capital relief are only temporary in duration and provided by a recent $15 million, onetime equity infusion after the vendors refused to extend trade credit.
Total debt structure includes $75 million in subordinated debt.
Earnings and performance levels are poor. Expected synergies and improved sales projected from merger have not materialized. Sales levels have actually declined from pre-merger levels from a shift in customer preference and industry slowdown.
Last two FYE results show a breakeven EBITDA level and insufficient capacity to make interest payments. Proceeds of the recent sale of three divisions were used to reduce RC facility.
Current Status: Consolidated has incurred large operating losses since the merger of the two predecessor companies. The company experienced a significant decline in equipment orders and industry outlook is unfavorable for the near future. Current cash flow projections do not reflect capacity to meet contractual debt service requirements with questionable liquidity sources.
Risk Rating Decision: Split rating – Substandard/Doubtful. Interest on Nonaccrual
Weak financial position, characterized by high leverage, deficit working capital and minimal tangible net worth.
Liquidity level continues to pose an immediate threat to the company with limited sources.
Operating performance is poor and not expected to improve significantly in near future.
Cash flow is incapable of providing for company’s liquidity needs and supporting ongoing capital needs, debt repayment, and interest costs.
Appraised value of hard assets (RE and M&E) supported by current, independent appraisals classified substandard ($25 million). Remainder of debt collateralized by questionable value of delinquent AR and secondary support provided by enterprise value classified doubtful ($125 million). Portion of RC permanently reduced by sale of three divisions not classified ($50 million).
Borrower’s questionable ability to repay principal and interest requires the nonaccrual of interest.
Risk Rating Considerations:
The level of secondary support provided by the company’s enterprise value is suspect due to the company’s severely distressed condition, immediate liquidity concerns, insufficient cash flow, and poor industry conditions.
Example C of Adverse Risk Ratings
Borrower: Many Promotional Items, Inc. (Many) Mytown, USA
Business: Supplier of promotional products.
Facility Description:
$300 million aggregate balance recently restructured into three TL tranches all maturing in five years. TL-A $150 million, TL-B $100 million, and TL-C $50 million.
Pricing: TL-A: LIBOR + 250. TL-B: 8 percent PIK. TL-C: No interest, convertible into 25 percent of common stock at lender’s option.
Repayment: TL-A: Interest monthly plus $1 million quarterly principal payments. Semi-annual cash flow recapture per formula. TL-B: PIK interest due annually. Principal due at maturity. TL-C: No interest. Principal due at maturity.
Purpose: Restructuring of outstanding debts originally used for acquisition financing and working capital.
Primary Repayment Source:
Operating cash flow, sale of business, or refinance.
Secondary Repayment Source:
Sale of business or refinance, or both.
Covenant Compliance: Not in compliance before recent restructuring, violating EBITDA, leverage and interest coverage covenants. All violations waived as part of restructure. Following restructure, all covenants are in compliance.
Collateral: TL-A: All company assets and stock of subsidiaries and borrower. TL-B and TL-C: Second lien on all company assets and stock of subsidiaries and borrower. Facilities are defaulted. AR and INV are subordinated to another lender. Collateral not audited or formally monitored. Estimated value of FA $50 million. Estimated equity net of first lien in AR and INV is $50 million.
Enterprise Value: Independently estimated between $150 million and $180 million.
Financial Synopsis:
Financial position reflects significant deterioration over the past three years with severe leverage, negative tangible net worth, excessive operating losses and inadequate CF.
Financial stress is a result of Many’s leveraged acquisition strategy initiated two years ago and failure to effectively integrate acquired entities to achieve projected results.
Last FYE operating statement reflects the erosion of revenues by 10 percent from the prior year, and trailing management projections by 20 percent.
The year produced a FCC of only .43X, leverage increasing with funded debt/EBITDA at 10X, and intangibles representing 30 percent of total assets.
Current Status:
A new management team has been put into place and has reduced operating costs but not yet demonstrated success to restore company stability.
Current interim financial results reflect results in line with reduced expectations, but success is dependent on ability to achieve a moderate revenue turnaround and controlling overhead over a sustained fiscal time period.
Projections for the next two years reflect a stable level of free cash flow consistent with current performance at $20 million. Projected CF ramp ups after year three are suspect due to company’s lack of demonstrated ability to achieve shorter-term projections and economic uncertainties.
Risk Rating Decision: Split rating – Substandard/Doubtful/Loss. Interest on Nonaccrual
Weak financial position, characterized by high leverage and negative tangible worth.
Operating losses continue to inhibit cash flow and jeopardize full and orderly liquidation of debt.
Portion of TL-A supported by the reasonable repayment capacity of the current level of sustainable free cash flow is classified substandard ($100 million).
Portion of TL-A supported by the more speculative nature of the EntV dependent upon significant cash flow ramp-ups after the first two years is classified doubtful ($50 million).
TL-B and C are not supported by past or near term financial performance of the company or available secondary sources, and are classified loss ($150 million).
Borrower’s inability to repay principal and interest requires the nonaccrual of interest.
Risk Rating Considerations:
The level of secondary support provided by the company’s EntV is suspect due to the company’s poor performance to date, but risk of loss is much higher on that portion supported by long-term projected improvement in cash flow.
Previous: Appendix A: Appendix A
Next: Appendix B: Appendix B