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4.3.3. Covenants between lending banks and PE firms with the target company: loan agreements
The covenants in the loan agreements we studied were primarily promises that HCA made about its continuing financial condition. Those covenants include maintaining the target company's assets, restrictions on fundamental changes in the company, dividend payments, transactions with affiliates, and incurring additional indebtedness. To a certain degree, lenders can monitor their loans by verifying compliance with these covenants.
Jasper Arnold (1982) suggested that loan lenders are most concerned about borrowers’ earning power, cash flow generation, and business risks. To make sure a
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borrower will pay down its borrowings, banks often use several types of restrictions to control it. The types of restrictions include cash flow control, strategy control, the default trigger, balance sheet maintenance, and asset preservation. Cash flow control permits bankers to monitor borrowers’ cash flow and limits borrowers from doing excessive dividends and stock repurchases. Bankers normally monitor EBIT to monitor a borrower’s cash flow. Strategy control occurs if a borrower’s resources are ill-matched with its opportunities and risks. In such cases, bankers normally reduce investments in certain products or technology by limiting capital expenditures and acquisitions or writing in a debt-to-equity test. Default trigger means the lender’s rights to call back the loans or ask for corrective actions. Lenders seldom use default triggers, and this mechanism is mainly to protect lenders from losses or borrowers’
misbehavior. Lenders keep an eye on the strength of the balance sheet and the degree of business risk. Balance sheet maintenance is to ascertain that a borrower does not harm its balance sheet by excessive leveraging or by financing fixed assets with short-term loans, which reduce the borrower’s net working capital. To reach the goals, lenders impose a current ratio, a net working-capital minimum, and a debt-to-equity ratio. Assets are deemed the ultimate source of repayment by lenders, and hence, they do not want to see assets sold or pledged to other creditors. Preserving assets is also very important to lenders. After understanding what loan lenders care about borrowers, the research could use it as a basic covenant framework to discover what interests and concerns beyond banks or other institutional lenders while designing loan facilities and covenants with private equity firms together with the target company in a buyout deal. The following summarizes the covenant analytical framework. In Table 3, the objectivities and approaches for loan covenants are summarized.
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To complete the HCA buyout, several banks committed to make loans to PE firms withHCA and its subsidiaries as guarantors. The debt commitments included senior secured credit facilities and senior secured second lien loans under a bridge facility.
For the senior secured credit facilities, Bank of America (BOA), JPMorgan Chase Bank (JPMCB), Citigroup Global Markets Inc. (CGMI), and Merrill Lynch Capital Corporation (MLCC) committed to provide (each committing to 25%) to HCA and its European subsidiaries up to $16.80 billion of senior secured credit facilities. The purpose of these facilities was to finance the buyout, refinance certain existing indebtedness of HCA and its subsidiaries, pay transaction fees for this buyout, and provide ongoing working capital. When the merger was completed, HCA made only
$14,365 million of loans including facilities of asset-based revolving credit, revolving credit, term loan A, term loan B, and European term loan. As for the senior secured second lien loans under a bridge loan, Citigroup Global Markets Inc., Bank of America Bridge, JPMorgan Chase Bank (JPMCB), and Merrill Lynch Capital Corporation committed to provide (each committing to 25%) to HCA up to
$5.70 billion of senior secured second lien loans under a bridge facility. This bridge facility would be made only if the offering of secured second lien notes by HCA was not completed substantially concurrently with the buyout. The purpose of the bridge facility was similar to the senior secured credit facilities except for the working capital.
The interest rate for the senior secured credit facilities should be an applicable margin plus either London Interbank Offered Rate (LIBOR) or the higher of the prime rate of Bank of America and the federal funds rate (FFR) plus 0.50%. As for the bridge facility, it had a floating interest rate equal to LIBOR plus a spread that increased over time, up to $1.5 billion, by issuing additional loans or exchange notes.
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The debt guarantors of senior secured credit facilities except the European term facilities were each existing and future direct and indirect, wholly-owned material domestic subsidiaries of HCA and the European term facility, which would be guaranteed by each existing and future wholly-owned European subsidiary of HCA.
The asset-based revolving credit facility was secured by a first-priority lien on all present and future accounts receivable (AR) of the guarantors. Other senior secured credit facilities were secured by a second-priority lien on accounts receivable, a first-priority lien on capital stocks, and substantially all present and future assets of guarantors. However, the debt guarantors of senior secured second lien facilities were HCA and its domestic subsidiaries. The debts were secured by a second-priority lien on the non-accounts-receivable and by a third-priority lien on certain of the accounts receivable.
The senior secured credit facilities contained several affirmative and negative covenants. The covenants included restrictions on indebtedness, investments, sales of assets, and mergers, meeting the restriction of strategy control and asset preservation.
A minimum interest coverage ratio was also included and reached the restriction of cash flow control. The maximum total leverage ratio represented the restriction of the balance sheet balance. The covenant of customary events of defaults referred to the default trigger. As a result, the covenants of this loan agreement contained all the loan restrictions suggested by Jasper Arnold (1982). The bridge facility was required to pay in full on or before the first anniversary of the merger. If not, the bridge facility would have converted into term loans maturing on the 10th year of the merger. The covenants of the bridge loans restricted HCA to incur or repay certain debts, to make dividends, distributions or redemptions, and to incur liens. The covenants mainly represented a restriction of balance sheet maintenance. In Table 4, two debt facilities provided by banks are compared.
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Table 1. The sources of the funds from the indebtedness Unit: $ Million Sources of Funds
Senior secured credit facilities -- Asset-based revolving credit facility 1,535 Revolving credit facility --
Term loan A facility 2,750
Term loan B facility 8,800
European term loan facility 1,279
Outstanding notes 5,700
Retained existing secured indebtedness 230
Retained existing unsecured
indebtedness 7,519
Other sources 5,157
Total sources of funds 32,970
Source: Adapted from the S-4 prospectus filed on September 25, 2007.
Table 2. HCA’s incentive program and its implications in 2007 Post Buyout Implications Base salary The same as
before
Compensation is not based on an increase in base salary but on short- and long-term
Cash flow generation abilities are more important than I/S performance.
The vesting period is shorter and in consistent with PE’s holding period.
PE firms focus more on cash generation with EBITDA as a performance criterion.
Source: Adapted from the 2007 annual report and adjusted for this study.
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Table 3. The objectivities and approaches for loan covenants
Restrictions Objectivities Approaches
Cash flow control Secure debt and interest payment
EBIT
Strategy control Prevent from ill-matched strategies
limiting capital expenditures and acquisitions
debt-to-equity test Default trigger Provide rights to call the
loan or ask for correction
healthy balance sheet
controllable business risks Balance sheet
maintenance
Prevent from excessive leveraging or financing fixed assets wi
th short-term loans
current ratio, net working capital minimum, D/E limit, no additional borrowings
Asset preservation Prevent from significant assets sold or pledged to other creditors.
Negative pledge clause
Source: Adapted from Jasper, A. H. (1982) and adjusted for this study.
Table 4. The comparisons of two facilities
Senior secured credit facilities Senior secured second lien loans
Lending banks ♦ BOA, JPMCB, CGMI, and MLCC ♦ CGMI, Banc of America
Bridge, JPMCB, and MLCC
Interest rate ♦ LIBOR or higher of BOA prime rate and FFR+0.5%
♦ LIBOR plus a increasing spread
Loan Amounts ♦ $16.8 billion ♦ $5.7 billion
Loan Objectivities ♦ Financing the buyout, refinancing certain existing indebtedness, paying transaction fees, and providing ongoing working capital
♦ Financing the buyout, refinancing certain existing indebtedness, and paying transaction fees
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Guarantors ♦ All except European term facilities: HCA and its domestic subsidiaries
♦ European term loans: HCA’s European subsidiaries
♦ HCA and its domestic subsidiaries
Guarantees ♦ Asset-based revolving credit facility:
Secured by a first-priority lien on all present and future AR
♦ Others: Secured by a second-priority lien on AR, a first-priority lien on capital stocks, and all present and future assets
♦ Second-priority lien on the non-AR and a third-priority lien on certain AR
Covenants ♦ Restrictions of cash flow control, strategy control, default trigger, balance sheet maintenance, and asset preservation.
♦ Restrictions of balance sheet maintenance
Source: This research