Operating Under Terms of an Amended Credit Agreement

After months of steady increases, the Federal Reserve has paused raising interest rates. But even if the rates start to decrease by a few basis points in 2024, interest rates will still be high relative to the past few years. As cost of capital remains high, borrowers and lenders are looking for flexibility in their business operations. Credit agreement amendments can be the inflection point that offers an increase in flexibility and allows the agreement to stay in place. 

How Today’s Business Landscape Impacts Credit Agreements

With high interest rates, ongoing supply chain issues, and contraction in corporate spending, today’s business climate presents various challenges for borrowers. As borrowers navigate these economic pressures, they become more likely to run out of liquidity or breach a covenant related to debt-EBITDA ratio or EBITDA interest. 

In these cases, a stressed borrower might seek a credit amendment. In the interest of hedging their credit investment, lenders often want borrowers to be able to work their way out of a difficult financial situation. For these reasons, covenant breaches, and by extension, credit amendments, are going to continue through 2024 and into 2025.

Wondering what to do when a company in your portfolio breaches its covenant? Read our insight:

Common Credit Agreement Amendments

When a loan is originated, the lender’s origination team manages it from the outset. But once an amendment is created, the loan might move to portfolio management or the special assets group. This relocation brings new oversight, as a different team is now responsible for handling the account, its financial information, and the due diligence. This leadership transition can create an opportunity for both lenders and borrowers to reassess the prior agreement and work together to establish amendments to the credit agreement.

Depending on when a loan matures, it can be beneficial to add a few quarters, a year, or perhaps a year and a half to the loan’s tenure. These loan extensions, also known as amend and extend agreements, are especially common in today’s environment, reaching a reported $14.7B in October 2023. 

As borrowers seek out flexibility to pay off their debt and navigate today’s tight economic environment, lenders are also increasingly offering amendments to maintenance covenants. Common maintenance amendments include debt-EBIDTA ratio relief, interest coverage (EBIDTA to interest coverage relief), and principal and interest payment relief. These amendments bring benefits to both borrowers and lenders, as borrowers receive needed leniency and lenders avoid having to seize or sell the assets. Additional amendments can include a default fee and a default rate of interest, which both increase income for lenders. This income can take the form of supplemental cash interest, as is the case with a default fee, or with interest above the standard rate, as is the case with a default rate of interest. 

What Lenders Can Expect from a Newly Amended Credit Agreement

Amended credit agreements present lenders with the opportunity to implement additional requirements for borrowers. For instance, consider a borrower that is a restaurant chain. The lender might mandate the restaurant to close its less profitable locations. Alternatively, that restaurant might be required to liquidate those assets by selling less profitable locations or other real estate holdings.

A lender could also audit a borrower’s operations and expenses. That same restaurant may need to provide additional information on leases and common area maintenance (CAM) charges at various locations within the portfolio. The lender could even bring an external advisor to examine the borrower’s financial forecast as an added layer of review.

Lenders can also request live Q&A sessions with the borrower to better assess the updated financials and operating statistics. While this level of transparency might have previously only been necessary for management or a private equity sponsor at periodic intervals, a lender may choose to increase transparency as part of the amended credit agreement terms. With these possibilities, lenders can ultimately facilitate adjusted credit agreements in a more confident and transparent manner.

Amended Credit Agreements Come with Lender Scrutiny

Borrowers are likely to face a range of new financial implications under the terms of an amended credit agreement. Specifically, they might need to make higher interest rate payments while also meeting tighter payment due dates. They could also adhere to an adjusted debt payment structure if the lender requested that more principal be paid alongside increased interest.

To account for these changes, it will be critical for lenders to closely monitor these changes and reporting requirements at the borrower level. Lenders should consider implementing new reporting expectations that request borrowers to update their financial forecasts, budgets, and projections. For example, a restaurant that previously only needed to forecast for the next quarter might now need to provide revised monthly budgeting for the following fiscal year.

Lenders are also able to request new KPIs from the borrower that provide deeper visibility into the borrower’s financial and operational processes or health. Thinking again of the restaurant chain, they might need to provide revenue details by menu item or by location. 

If the amended credit agreement also introduces new compliance requirements to demonstrate a borrower’s legal standing, borrowers may need to create new reporting mechanisms that prove the company is not violating any compliance requirements that may impact financial standing or its ability to meet financial obligations. 

Common internal process adjustments lenders may institute can include:

• Compliance: Borrowers may need to prove their ability to uphold an amended credit agreement, demonstrating new controls and reporting mechanisms that foster compliance and legal good standing.  
• Forecasting: As financial forecasting becomes more complicated, borrowers may need new internal processes. Both borrowers and lenders will want to communicate the best way to update and deliver accurate forecasting under the new terms of agreement.
• Cash flow analysis: As part of their reporting requirements, borrowers can request a more detailed cash flow analysis. It’s very likely that a distressed borrower would be required to develop a 13-week cash flow analysis.

For borrowers who don’t already have these systems in place, creating them can consume significant time and resources internally. However, these procedures are critical. Lenders may agree to credit amendments that increase flexibility for borrowers, but they will expect borrowers to enhance compliance with transparent reporting, forecasting, and communications.

The Benefits for Both Borrowers and Lenders

As borrowers and lenders navigate negotiations, there are a range of benefits and risks for both parties.  Many amendments, like loan extensions and maintenance covenants adjustments, offer the necessary space and flexibility for borrowers to make operational improvements. To keep the flexibility within reason, lenders will increase reporting requirements to prevent overspending and further breaches.

Lenders know that borrowers could be at risk of breach or even default if they continue to underperform and fail to cut costs. But it is a careful balancing act for lenders: while scrutinizing borrower’s business operations and financials is necessary to protect the lender, they won’t want to make requirements so onerous that they need to take over the business and foreclose on assets. 

For borrowers in distressed situations or for lenders navigating breaches of covenant, a third-party advisor may provide valuable support. When amending credit agreements, both borrowers and lenders will be dependent on accurate financial forecasting and enhanced internal controls and reporting. BDO can support borrowers and lenders in this situation and a myriad of other turnaround, recovery, restructuring, or bankruptcy scenarios. 

BDO professionals can help clients with financial modeling and viability assessments, evaluate credit risk, transform financial reporting, and work with organizations to verify the strength of internal controls and processes. Borrowers and lenders who leverage BDO’s services may enhance resiliency amid today's volatile economic landscape.

Want to learn more? Reach out to us today.

Turnaround and restructuring services as well as operational value creation services within the United States are offered through BDO Consulting Group, LLC, a separate legal entity and affiliated company of BDO USA, P.C., a Virginia professional corporation. Certain turnaround and restructuring services may not be available to attest clients of BDO USA under the rules and regulations of public accounting.