Sleepless Nights Over Unrestricted Subs?
I am not the only one losing sleep over the potential misuse of Unrestricted Subsidiaries – J. Crew may have been the first borrower to demonstrate the dangers of these entities not subject to the covenants, but Intralot and others have shown that it is most certainly not the last.
Unrestricted Subsidiaries did not always strike fear in the hearts of lenders. I explain in the first chapter of the Leveraged Finance Covenant Training course that back in my baby lawyer days these entities were fairly benign from a lender-perspective – indeed, they might even bode well for investors.
Why? Well, once upon a time, investments Unrestricted Subsidiaries were viewed as “fun money” for the borrower. Perhaps management wished to try a new jurisdiction or product line, requiring experimentation in a manner that covenant provisions might not allow, and the amounts available for such forays was limited. If the gamble worked to the borrower’s advantage, it could accrue value to the business to the benefit of lenders as well.
This is now ancient history – today, Unrestricted Subsidiaries (like Permitted Liens and non-guarantor debt incurrence) are seen as liability management tools, and investment capacity for such entities has skyrocketed over the past decade.
Bear in mind as well that borrowers can use any Restricted Payments capacity for investments in Unrestricted Subsidiaries, so the potential figure taking this into account is likely much higher.
What happens when assets are transferred to an Unrestricted Subsidiary? They are out of reach of lenders, and not protected by the covenants. When borrowers use investments capacity and comply with the requirements of designating an Unrestricted Subsidiary, credit support can be released as well.
In short – you can kiss those assets goodbye.
And the clever lender will have potential third-party or savvy members of the existing syndicate waiting in the wings to lend against those juicy assets. At that point, if you’re not one of the savvy syndicate, you are s*** out of luck (the legalese term for this is “primed”).
So, we are not surprised that lenders are focused on Unrestricted Subsidiaries. Our Leveraged Finance Covenant Training course goes into detail about how to think about them, how to calculate capacity of the borrower to invest valuable assets in them, and how to think about which assets might be used (hint: it’s not just IP that borrowers can transfer, making your J. Crew Blocker an incomplete inoculation against the risk).
The only way to avoid losing sleep about what bumps in the night is to turn on the light and shine it directly on the potential risk. We show our clients how to find the light switch.
By Sabrina Fox - FLT Founder