In light of the recent news that a well-known telco borrower is using assets transferred to an Unrestricted Subsidiary as leverage for lenders to participate in discounted debt buybacks, we thought it was a good time to highlight potential sources of Unrestricted Subsidiary investments capacity in the average leveraged finance deal.*
The first important point to note is that in atypical HYB (and any TLB using HYB incurrence covenants), any Restricted Payments capacity can be used for investments in Unrestricted Subsidiaries. Said another way, borrowers have far more capacity to invest in these entities, which are outside of the purview of the covenant restrictions, than what’s present in the dedicated Permitted Investment basket.
A second key point is that analysing capacity for investments in Unrestricted Subsidiaries requires an analysis of the Restricted Payments covenant and the Permitted Investments definition, which is in the Certain Definitions section.
With those points out of the way, let’s dive into the analysis!
Step one: start with the Restricted Payments covenant builder basket and gather the following information:
How does it build?
o 50% Consolidated Net Income less 100% of losses, or 100% EBITDA less 1.4x Interest Expense?
- The latter formulation is more common in telecoms deals, and typically accrues faster
o Is there a zero-floor provision (preventing the builder from decreasing below zero, or in some deals, from decreasing at all, from losses)
When does it build from?
o Back-dated builder baskets can cause nasty surprises
o In some cases, for repeat issuers this can be back-dated by a decade or more
What conditions must be met to use capacity in the builder?
o No default / Event of Default
- Compliance with the ratio test (note that this is not required for Restricted Investments in some deals)
Step two: aggregate applicable Permitted Payments capacity. For the typical deal, this will include:
o General Restricted Payments Basket
o Leveraged-based Restricted Payments Basket
Step three: aggregate applicable Permitted Investments capacity. For the typical deal, this will include:
o General Permitted Investments Basket
o Leverage-based Permitted Investments Basket
o Investments in Unrestricted Subsidiaries Basket
o Investments in Similar Businesses Basket
Note that calculation mechanics may work in such a way that the leveraged-based permissions contain more capacity than it might appear after a black of the envelope calculation using financial statement figures. For example, the EBITDA figure itself will no doubt be subject to many adjustments, and the debt figure might back out significant categories of debt, including revolving credit facilities and working capital facilities.
Students of FLT’s Leveraged Finance Covenant Training have a strong understanding of these concepts and know exactly whereto look to calculate capacity for investments in Unrestricted Subsidiaries.
To equip your team with these skills, get in touch to find out more about our first-of-its-kind online covenant education platform.
*Note that modern vintage TLBs often incorporate HYB-style incurrence covenants, particularly if there are bonds in the same capital structure. However, traditionally TLBs would contain a separate Investments covenant, in contrast to the HYB approach, which includes in the Restricted Payments definition any Restricted Investment (including investments in Unrestricted Subsidiaries). Regardless, the builder basket concept is present in both TLB Investment covenants and HYB Restricted Payments covenants.