The German financing market was still in full swing at the start of 2020 with jumbo deals such as the financing for Advent's and Cinven's EUR17 billion acquisition of Thyssenkrupp's elevator business. All types of financing, including senior bank debt, unitranche financings by direct lenders and large institutional Term Loan B facilities, were available on loose documentary terms.
This bull market came to a sudden halt when Germany went into lockdown mode to combat the COVID-19 pandemic after a poignant speech given by Chancellor Angela Merkel on 18 March 2020. With an impact that in the views of many was even more drastic than the Lehman insolvency in September 2008, the financing markets shut down and switched to survival mode: pending deals were re-cut to ensure financing and any situation that was not close to the finish line was aborted or deferred indefinitely. Corporates and private equity firms alike focussed on protecting their businesses, setting the scene for a very different year.
Conscious of the drastic economic consequences and uncertainties the COVID-19 pandemic caused for businesses, the German legislator reacted quickly and, with retroactive effect as of 1 March 2020, comprehensively modified the German insolvency regime with a view to preventing insolvencies of companies which encountered financial difficulties as a result of the COVID-19 pandemic. In light of the fact that Germany has a very strict insolvency regime, this modification addressed nearly all insolvency-related obligations and restrictions which typically apply to insolvent companies, their directors and their creditors and which would usually frustrate the affected companies’ going concern status and their ability to continue trading.
Most importantly, the rules governing the obligation to file for insolvency were adjusted. From 28 March 2020 to 28 June 2020, insolvency filings by creditors were only permitted if the company was already insolvent on 1 March 2020. Directors’ obligation to file for insolvency was suspended until 30 September 2020, a breach of which normally entails criminal and personal liability. However, the suspension only applied to companies with prospects of overcoming existing illiquidity and whose insolvency was caused by the COVID-19 pandemic. The fulfilment of these requirements was presumed by statute if the company was not illiquid as of 31 December 2019, given the inherent uncertainty for directors in assessing them.
New financings and loans
Apart from the adjustment of the insolvency filing regime, restrictions for new financings were lifted with the aim to enable companies to access additional third party and shareholder financing to meet their liquidity needs. In any insolvency proceedings that will be filed on or before 30 September 2023, the equitable subordination regime for shareholder loans will not apply to any new shareholder loans which were extended during the suspension of directors’ obligation to file for insolvency. The lender liability regime which would otherwise apply in the context of distressed or turnaround financings by existing creditors does not apply to any new loans which were extended during the time the directors’ insolvency filing obligations were suspended and, as a consequence, such new loans can be granted without the need for a restructuring opinion. Any repayment of such shareholder or third-party financings until 30 September 2023 will not be subject to any claw-back. This also applies to any security granted during the suspension of directors’ insolvency filing obligations for such third-party financing whereas the existing claw-back regime continues to apply to any security granted for shareholder financings.
Loans extended under the loan programmes of state-owned bank KfW (on which see more below) are covered by the privileges outlined above, too. However, to facilitate the implementation of these government aid programmes, such loans benefit from these privileges irrespective of such loan being extended or collateralised during the period in which the insolvency filing obligations were suspended and irrespective of the repayment taking place on or before 30 September 2023.
These measures provided a significant relief for many companies which encountered financial difficulties as a result of the COVID-19 pandemic. Especially suspending insolvency filing obligations and lifting restrictions on new financings allowed companies to adjust their business activities to the current economic environment whilst seeking solutions with their trade and financial creditors and accessing additional financing sources, especially the loan programmes of the state-owned bank KfW.
Extension to the regime
The modification of the German insolvency regime was initially to expire on 30 September 2020. The Federal Ministry of Justice and Consumer Protection was authorised to extend it until 31 March 2021 if required due to ongoing demand for available public aid, ongoing financing obstacles or other circumstances. Following controversial discussions about the microeconomic and macroeconomic implications of such an extension, the German Parliament, on 17 September 2020, adopted an extension until 31 December 2020, but solely in relation to companies which are over-indebted without at the same time being illiquid.
Companies which became over-indebted as a consequence of the COVID-19 pandemic but are not illiquid should have the opportunity to exhaust all potential restructuring and refinancing options until the end of the year 2020 without being compelled to file for insolvency.
The German government was also quick to respond to the liquidity needs of the economy and offered COVID-affected businesses, inter alia, subsidised loans through state-owned bank KfW. Two main programmes were used: first, the entrepreneurial loan programme (Unternehmerkredit) with the programme No 037, a long-standing loan programme by KfW which was extended to cover COVID-affected businesses. Second, the programme for direct participation in syndicated financing facilities (Direktbeteiligung für Konsortialfinanzierung) with No 855. This new programme was specifically designed to support larger companies with new syndicated loan facilities or an additional tranche in existing syndicated loan facilities.
The main difference between the two programmes is that in case of an entrepreneurial loan, KfW will only provide back-to-back financing to the banks who will act as sole lenders to the borrower. In other words, KfW provides funding for the loans to the banks and the banks pass the funds through to the borrower. Up to 80% of the credit risk is borne by KfW so that in case of an insolvency of the borrower, the banks will only have to return 20% of the funds received from KfW.
Given KfW neither becomes a direct lender to the borrowing company nor is a party to the credit agreement, the execution of an entrepreneurial loan can be very straightforward. Its standardised pricing is at around 2% fixed interest per annum and its term varies between two and six years. This makes the entrepreneurial loan the instrument of choice for many corporates, in particular where no secured financing is part of the financing structure so that the KfW-backed loan sits pari passu with existing financing arrangements of the company. But even where secured financings are in place, the entrepreneurial loan is available on an unsecured basis (though recently, a cap of EUR100 million was introduced), as long as KfW and its exposure under the 80% risk assumption is treated equally with the fronting banks' 20% own risk-piece.
Direct participation in syndicated facilities
The No 855-programme for direct participation in syndicated facilities is considerably more complex. As with the entrepreneurial loan programme, KfW requires that at least 20% of the credit risk is borne by non-state lenders so that, alongside KfW, there are commercial banks providing new funds to the borrower. Very often, such banks are incumbent lenders to the borrower so that there is an intrinsic conflict of interest between those lenders with old money commitments and KfW. The latter only provides new funds and thus indirectly protects the existing old money commitments.
Under the No 855-programme, KfW is a lender of record and as such party to the facilities agreement and the related finance documents. Therefore, KfW's involvement in the documentation process is much higher. There are detailed drafting guidelines for syndicated facilities agreements with KfW involvement which affect all areas of the loan agreement. This includes pivotal clauses such as the Majority Lender-definition, mandatory prepayments and an individual right for KfW to accelerate its participation in the facilities under certain circumstances.
For a borrower, KfW's requirements for tight restrictions on dividend and similar upstream payments are very demanding and a topic of intense negotiations, particularly where family or other private shareholders are involved who might themselves have their own financing needs and might be dependent on a certain minimum of distributions from the company. From an incumbent lender's perspective, the "last in, first out"-principle puts the most stress on the structure, with KfW demanding that the new KfW-backed facility is repaid before any other material financing facilities of the borrower.
It was a major task for all market participants to follow all practice guidelines issued by KfW for its loan programmes as they evolved over time and were adjusted to the COVID-crisis. Often, there were changes to the documentary and other requirements during a current documentation process, resulting in lengthy negotiations and complex documentation. Most elements of the programmes seem settled now and, though further KfW-backed loans are expected in the coming months, it is also expected that structuring and documenting the facilities becomes simpler on the basis of the practice established during the past months.
With the lockdown measures taking their toll on public and economic life, the operating performance of German businesses has been adversely impacted with only very few exceptions. EBITDA (earnings before interest, tax, depreciation and amortisation), as the key metric for measuring operating performance and testing financial covenants, went down considerably, in particular in industries depending on travel, leisure and public life in general. Thereby, net leverage, the most common financial covenant in corporate and leveraged lending, was sent skyward.
The first few weeks of March affected by COVID-19 gave a bitter foretaste of what was to come in the second and third quarter. Businesses with maintenance financial covenants, tested mostly on a quarterly, sometimes half-yearly basis, started negotiating for covenant relaxations in various forms. In less severe cases, lenders were simply asked to raise the prescribed leverage levels to create a buffer for the borrower group.
Lenders were often willing to grant such waivers even without fee payments or increased margin levels given the consensus that none of the parties involved was in any way to blame for the situation. Where the leverage trajectory was forecast to be steeper, the leverage covenant was suspended for a few quarters, mostly until early or mid-2021. From then on leverage testing will apply again, at original or at reset levels or in some cases at levels which remain to be agreed in 2021, when visibility is expected to be higher. Where the leverage covenant was suspended, lenders typically insisted on a minimum liquidity covenant as a replacement. This covenant tests the minimum liquidity (cash and available credit lines) typically on a monthly basis, with some discussions around trapped cash in cross-border deals.
The minimum liquidity covenant is often combined with a rolling liquidity forecast and additional cure rights in sponsor deals. During the leverage covenant suspension period, the margin grid is commonly adjusted or replaced by a stepped-up margin, compensating the lenders for the leverage covenant waiver and the increased risk profile. It remains to be seen how these liquidity covenants will phase out and how deals find their way back to traditional leverage-based covenants and pricing grids.
A major focus was on adjustments, or more traditionally "add-backs", to the consolidated EBITDA of borrowing groups. Already in the quarterly financial statements for the first quarter, sponsors and corporates started making COVID-19-related adjustments to their quarterly results. This was met with scrutiny by lenders, and the proper construction of the financial definitions in facilities agreements became a point of intense discussion. Almost all modern facilities agreements with an EBITDA-definition include the concept of so-called Exceptional Items. It allows certain items of an "exceptional, one off, unusual, non-recurring or extraordinary" nature not to be taken into account when calculating EBITDA.
Sometimes this effect is capped at a certain maximum amount of adjustments for exceptional items, expressed as a percentage of consolidated EBITDA in any last twelve months-period. The immediate question that springs to mind is: "Would anyone doubt that the COVID-19 pandemic is exceptional?" But matters are, of course, much more complex than that. There seems to be a broad consensus that the effects of the pandemic can be exceptional in nature.
It would also seem commonly accepted that extraordinary costs caused by the pandemic are indeed items that can be added-back in the calculation of EBITDA, such as costs for increased hygiene at the workplace, additional hardware for employees' home offices, etc. However, the crucial question really is: can lost revenues be "normalised"? For instance, can a hospitality business which had to close its restaurants add revenues to its topline which it expected but which did not materialise due to the lockdown?
Views and the future of covenant protection
The views on this could not be more controversial. On the one hand, some sponsors take the view that the effects of the pandemic are clearly exceptional and can, as such, be normalised in any EBITDA calculation. On the other hand, concerned lenders fear nothing less than the end of their covenant protection if businesses badly hit by the COVID-19 crisis still sail through any covenant testing.
As is often the case, the answer to this conundrum, if there is one, cannot be given universally and will lie in the granular detail of the accounting principles applied by the borrower, the nature of its business and the exact wording of the financial definitions in the facilities agreement. The battle over the COVID-19-adjustments will likely be fought in autumn, with Q2 financial statements having been submitted to lenders in August in most deals, and it will be interesting to see which turn the market will take on this issue.
New Deals – Outlook
Despite the continuing COVID-19 crisis, new deal activity is on the rise in the second half of 2020, both in general lending and in acquisition finance. Whilst pricing has been adjusted upwards, in some cases considerably, documentary terms remain accommodating and borrower-friendly, mainly driven by an intense competition of many lenders for fewer deals.
Unsurprisingly, a focal point of the current negotiations is to what extent exceptional effects resulting from the current COVID-19 pandemic can be normalised in EBITDA and, even further-reaching, any exceptional effects from future pandemics and similar events. Given the countless types of exceptional events and their effects, and the potential for never ending disagreement on what may and may not be adjusted in EBITDA, it may well be that lenders offer to be generous on the adjustments as such, as long as their aggregate amount is subject to an absolute cap (percentage of LTM EBITDA).
This basket approach would be less than perfect, but it is a tried and tested route for the more elusive components of an EBITDA calculation and would likely avoid bitter disputes over exceptional events in the future. Again, market practice is far from being settled, and it remains to be seen how future finance documentation will address disruptive events like a global pandemic.
More generally, given current activity levels, one can be optimistic for the remainder of the year 2020. The German economy shows early signs of recovery which should soon translate into a healthy number of new money deals.