In loan agreements, lenders customarily require the borrower to make various financial covenants whereby the borrower promises to achieve certain financial metrics, often requiring the borrower to stay above or below certain thresholds based on its operations. Since financial covenants are based on past financial performance, breaches of financial covenants typically cannot be cured in the absence of some sort of cure provision. This is why the concept of an equity cure provision is an attractive option for borrowers. An equity cure provision allows a borrower’s shareholders to inject additional equity into the borrower in order to cure an existing breach of a financial covenant, so that the breach does not trigger an event of default. The issuance of additional equity creates a cash infusion enabling the borrower to increase its cash flow or EBITDA or reduce debt to meet the relevant financial covenants, such as a leverage ratio, operating cash flow ratio, or debt service coverage ratio. Essentially, an equity cure provision allows the borrower to go back in time to improve its financial metrics so that it is deemed to have been in compliance with the applicable covenant as of the measurement date. More and more, borrowers or their financial sponsors will request and lenders, in some cases, agree to the inclusion of an equity cure provision in the credit agreement. The borrower’s ability to utilize an equity cure to stave off a potential default is not unlimited, however. Typically, lenders will impose certain limitations on a borrower’s ability to use these provisions. When negotiating equity cure provisions, borrowers and lenders must consider a variety of factors to best serve their interests.
Frequency of Equity Cures
For borrowers, one of the most important aspects of an equity cure provision is how often the borrower can use the equity cure. Lenders prefer to limit the number of cures allowed throughout the term of the agreement and will often restrict the number of uses of the cure in consecutive periods. For example, a lender may limit a borrower’s exercise of an equity cure provision to no more than twice in one year and no more than three times over the term of the agreement. Such limitations enable the lender to prevent a scenario where the borrower could potentially use the equity cure as a cover-up for its continuing financial struggles. When negotiating an equity cure provision, borrowers should push to minimize the restrictions on their ability to use the cure, which will decrease the likelihood of defaulting on a financial covenant.
Along with the frequency of equity cures, the period of time during which a borrower can utilize the equity cure to remedy its potential breach of a financial covenant is an important consideration for both borrowers and lenders. Borrowers will certainly want to fight for a longer cure period to give their members or shareholders more time to inject the needed equity. Lenders, on the other hand, will prefer a shorter cure period to ensure that any breach of a financial covenant is cured in a timely manner. Oftentimes, the period during which the borrower can exercise the equity cure will match up with the applicable cure period for the delivery of borrower’s financial statements under the loan agreement, typically between 15 and 45 days.
Application of Proceeds
How the proceeds of an equity cure are applied is another frequent point of contention between borrowers and lenders. For instance, in the event of a breach of the leverage ratio, borrowers would prefer that any proceeds from the equity cure are applied to increase their EBITDA. Lenders, however, would rather not have the equity cure apply to EBITDA because this merely conceals, rather than fixes, the borrower’s underlying financial problems. For this reason, lenders will often require borrowers to use equity cure proceeds to reduce the amount of outstanding senior debt through a prepayment rather than applying it to EBITDA.
In addition to dictating how the proceeds of an equity cure will be applied, lenders will often attempt to limit the overall scope of an equity cure as well. Lenders typically prefer that equity cures only be used to cure specific financial covenants. Lenders with great bargaining power may even be able to limit the cure to only cash-flow related financial covenants, while borrowers usually want to be able to apply the equity cure proceeds for any purpose under the loan agreement. In order to limit the scope of an equity cure provision, a lender might include language that provides that all equity cure contributions will be disregarded in the calculation of consolidated EBITDA for all other purposes of the agreement, including calculating excess cash flow, and pricing and leverage provisions. This limits the scope of the cure to remedying a specific financial covenant. Borrowers, on the other hand, will frequently look to expand the scope by requesting that the injections of equity also apply to leverage ratios and other financial measures.
Another important consideration for lenders when negotiating an equity cure provision is the amount of equity proceeds allowed. The purpose of an equity cure provision is to allow the borrower to inject enough equity into the borrowing company in order to cure a breach of a financial covenant. Many borrowers, however, may want to inject even more equity than is actually needed to cure the relevant breach in order to avoid potential future breaches or otherwise boost their financial metrics. Equity cure provisions often apply the proceeds as an increase to cash flow and EBITDA. In such cases, the cure amount is treated as increased cash flow and EBITDA for all testing periods in the 12 months following the cure, so an “over-cure” might enable a borrower to cure the current breach of a financial covenant as well as any potential breaches in the future during that 12-month period. Lenders should try to limit the cure amount to allow only that amount needed to make the Borrower compliant with the relevant financial covenant for that particular period to avoid situations where an “over-cure” prevents the lender from exercising its rights related to future breaches of the financial covenants. Lenders should also consider placing an overall cap on equity cure amounts so that significant breaches of financial covenants cannot be cured through the injection of capital.
A potential trap that lenders should be mindful of when negotiating equity cure provisions is so-called “round-tripping.” Round-tripping occurs when the cure amount is provided by the borrower’s sponsor and then immediately paid back to the sponsor through dividends or repayment of subordinated debt. This scheme creates the artificial benefit of an equity cure to avoid an event of default without actually providing capital to the borrower permanently. Lenders can minimize the likelihood of round-tripping by requiring that the equity cure come from a person or entity outside of the loan party group so that there is an actual injection of funds into the borrower instead of book entries that do not improve the borrower’s financial position.
Equity cure provisions are important for borrowers and lenders to consider, but they must be carefully reviewed and negotiated. Borrowers should try to include these provisions in the credit agreement with as few restrictions as possible. If lenders agree to their inclusion, then they should try to limit the borrower’s ability to use the equity cure in the ways discussed above.