The Modern Twist on Traditional Covenants: Lessons from the Somacis Deal

October 29, 2024

In today's leveraged finance market, understanding how covenants work is crucial for lenders. The Somacis €550 million senior secured floating rate notes deal provides an excellent case study on how modern covenant provisions can pose potential risks to lenders.

Guarantor Coverage: A Key Starting Point

Guarantor coverage reveals some risk of future structural subordination:

Revenue coverage: 69%

EBITDA coverage: 66%

Asset coverage: 77%

While day-one non-guarantor debt sits at just €12 million, the structure contains provisions that could significantly alter this picture over time.

Debt Capacity: Top-Tier Flexibility

The Debt baskets include standard aspects, like the Ratio Debt Baskets set at 5.75x Consolidated Net Leverage Ratio and 2x Fixed Charge Coverage Ratio. In addition, the Permitted Debt baskets include the standard Credit Facilities basket, Capital Lease Obligations / Purchase Money Debt basket, General Debt basket, and others.

However, the presence of an Available RP Capacity Amount basket (Clause 17) suggests flexibility at the wider end of the borrower-friendly spectrum, as it allows the borrower to convert Restricted Payments capacity into debt capacity.

While there's a non-guarantor debt cap (greater of €124 million or 100% of Consolidated EBITDA), this limitation only applies to the Ratio Debt Baskets and the ratio-based Credit Facilities baskets. Multiple other carveouts remain available for non-guarantors to incur additional debt, so there is little protection against future structural subordination.

Restricted Payments: The Evolution of Borrower Freedom

Modern covenant packages have significantly relaxed traditional restrictions, which were designed to protect lenders. This deal show cases several borrower-friendly features:

Builder Basket Innovation

  • No fixed charge coverage ratio requirement (this is unusual)
  • Restricted investments (including in Unrestricted Subsidiaries) permitted even during material defaults
  • 50% CNI basket with zero floor mechanism that:
    • Increases with positive consolidated income
    • Never decreases with losses

The "Super Grower" Phenomenon

A particularly noteworthy feature of this deal is its financial calculations framework:

Key Elements

  • Forward-looking synergies (purchase, sales, and group initiatives)
  • The "super grower" provision which:
    • Allows fixed amounts to increase with grower amounts
    • Does not require subsequent reductions

This creates a potential disconnect between performance and covenant flexibility.

Risk Implications for Lenders

This structure raises several important considerations:

  • Risk of increasing structural subordination
  • Potential for covenant flexibility to outpace actual performance

These provisions of the Somacis deal demonstrate how modern financing structures have evolved to favor borrower flexibility. While this may be the current market standard, lenders must be aware of these provisions to understand their potential long-term implications.

This evolution in covenant structures underscores the importance of detailed analysis in credit assessment. As these provisions become more complex, and more prevalent, the ability to identify and understand their implications becomes increasingly crucial for effective risk management.

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