An “equity cure” is a type of legal provision often found in credit agreements governing loans that finance acquisitions by private equity sponsors. In an alignment of interests between lenders, private equity sponsors, and their portfolio company borrowers, these provisions allow sponsors to retroactively cure their portfolio companies’ financial covenant defaults by making a cash equity contribution typically treated as a dollar-for-dollar increase to the company’s adjusted EBITDA in the amount necessary to cause compliance with the company’s financial covenants for the applicable measurement period. Equity cure provisions benefit all parties involved by providing a clear protocol for navigating economic downturns or other periods of financial difficulty in a manner that prioritizes de-risking the lender’s credit exposure while protecting the company’s viability and sustaining the sponsor’s commitment to the success of the business.
This article summarizes common market practice for equity cure provisions in middle-market, sponsor-backed credit agreements.
The vast majority of secured credit agreements with sponsor-backed borrowers will contain one or more financial ratio covenants. For example, a leverage ratio covenant requires that, as of the end of each calendar quarter, the ratio of the borrower’s funded debt to the borrower’s adjusted EBITDA for the trailing four-quarter period must not exceed a specified level. If the borrower’s adjusted EBITDA for the measurement period is insufficient to keep the leverage ratio under the specified maximum level, an automatic event of default will result, entitling the lender to exercise all legal remedies available to a secured creditor, including accelerating the loans and foreclosing on the borrower’s assets. A fixed charge coverage ratio is another common financial ratio covenant that uses adjusted EBITDA in the numerator of the ratio and is, therefore, susceptible to cure through a retroactive deemed increase to adjusted EBITDA.
A typical equity cure provision will provide that, concurrently with the delivery of the borrower’s quarterly financial statements and compliance certificate demonstrating the applicable financial covenant breach under the credit agreement, the sponsor may deliver to the lender a written notice indicating the intent to exercise an equity cure. The notice would need to calculate the applicable cure amount – i.e., the amount that, when retroactively added to the borrower’s adjusted EBITDA for the default quarter, would result in pro forma compliance with the applicable breached financial covenant(s). The cure amount would then be due from the sponsor within a short period of time (e.g., 10 business days) after the delivery of the notice.
Especially in middle-market deals, once the borrower receives the cure amount, it is often required to be immediately applied to repay the outstanding loans under the credit agreement, thereby reducing the lender’s credit exposure. Borrowers and sponsors want to ensure that such amounts are exempted from prepayment penalties that may otherwise apply to early principal payments. In certain contexts, borrowers and sponsors may be able to negotiate for the ability to retain the cure amount as cash on the borrower’s balance sheet in lieu of a paydown or for a hybrid approach that, e.g., delays the first mandatory prepayment from cure proceeds until the second exercise of an equity cure during the loan term.
The credit agreement will typically specify that the cure amount is treated as a dollar-for-dollar increase to the borrower’s adjusted EBITDA for the default quarter, not only for purposes of the initial quarter-end measurement date associated with the applicable financial covenant breach, but also for purposes of each of the ensuing three-quarter end measurement dates that also include the default quarter in their respective trailing four-quarter measurements of adjusted EBITDA.
On the lender-friendly end of the spectrum of market practice, some equity cure provisions will provide that the debt reduction resulting from the application of cure proceeds to the repayment of the outstanding loans is disregarded for so long as the cure proceeds are treated as an artificial increase to adjusted EBITDA, although this formulation is not very common in the market.
From the lender’s perspective, an equity cure provision should include language specifying that the cure amount is only deemed to constitute adjusted EBITDA for curing the applicable breached financial ratio covenant(s). It should not, for example, for purposes of any leverage-based pricing grid, leverage-based incurrence test in a negative covenant basket, or other credit agreement provision (beyond the applicable breached financial ratio covenant) that may separately involve a measurement of adjusted EBITDA. This limitation could also conceivably benefit the borrower – for example, in a credit agreement that does not require a mandatory paydown from equity cure proceeds but otherwise contains an excess cash flow sweep that starts its excess cash flow measurement from adjusted EBITDA.
Virtually all equity cure provisions limit the frequency with which they can be exercised and the total number of times they can be exercised. The details of these limits vary considerably from deal to deal. A fairly typical formulation might prohibit the exercise of more than two consecutive cures or more than two cures in any period of four consecutive quarters and contain an overall limit of four total cures in the span of a five-year loan term.
While most credit agreement provisions are designed to benefit the lender and to protect the likelihood of the loans being repaid (subject to limited carve-outs and exceptions designed to provide the borrower with the flexibility to operate its business), equity cure provisions are fairly unique in that they provide significant benefits to all three of the major parties involved (the lender, the borrower, and the sponsor). When a typical equity cure is exercised, the lender benefits from an immediate paydown of a portion of the outstanding loans in the amount necessary to bring the borrower’s financial ratios within the range that the lender had deemed appropriate during its underwriting process.
Needless to say, the lender also benefits from the preservation of future interest payments from the surviving borrower on the remaining loan amount. The borrower avoids enforcement and benefits from a reduced debt burden. Finally, the sponsor benefits from the opportunity to keep its portfolio company in business (and thus capable of yielding future profits) at the price of only a partial paydown of the loans, avoiding the need to hastily arrange a refinancing of the entire loan amount or otherwise engage in costly forbearance negotiations.
Having the equity cure protocol hardwired into the credit agreement at closing, in advance of any distress, makes it easier for the parties to capture the aforementioned benefits more efficiently and with less risk of a breakdown in a constructive lending relationship.
Taylor Smith is a partner at Davis Graham & Stubbs, LLP, specializing in Finance & Acquisitions, Corporate Finance and Private Equity. He can be reached at 303-892-7435.
