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How to Read a Credit AgreementHard

Two loans at the same margin are not the same loan. The difference is in the definitions, and the definitions are read first.

5 min read · 874 words

Read it in the wrong order and you learn nothing

The instinct is to turn to the covenants. A leverage test of four times sounds tight or loose and everybody has a view.

It is unreadable on its own. A four-times test is four times something, and that something is a defined term. So is the word "debt". So is "restricted subsidiary", which decides what parts of the group any of it applies to.

The order that works is: definitions, then baskets, then amendment provisions, then the financial covenants. By the time you reach the covenants you already know what they mean, and frequently that they mean less than they appear to.

The transactions this document governs are the buyout and the Term Loan B that funds it.

1. The definition of earnings

Everything is a multiple of it. Read the add-backs one by one:

  • Exceptional and non-recurring items — and whether there is a cap on them.
  • Run-rate cost savings, expected but not yet achieved. Check the cap, the look-forward period, and whether they need to be certified by anybody.
  • Pro forma effect of acquisitions — counting a full year of a business owned for three months.
  • Synergies from transactions not yet completed.

Each may be defensible. The direction of all of them together is the tell. A covenant set at a level that sounds tight, measured on a figure adjusted upwards by a third, is not tight — and both halves of that sentence are in the document.

2. The definition of debt

What counts. Leases, receivables facilities, preferred instruments, guarantees, earn-outs, and any borrowing at entities the covenants do not reach. A leverage ratio that excludes categories of borrowing is measuring something narrower than it sounds, and the exclusions are listed rather than hidden.

3. Restricted and unrestricted subsidiaries

The most consequential definition in the modern agreement. Restricted subsidiaries are inside the covenant perimeter. Unrestricted ones are outside it entirely: their earnings do not count, their debt does not count, and — the point — assets moved to them are beyond the lenders' reach.

Read who can be designated as unrestricted, on what test, and whether material assets or intellectual property are carved out from what may be transferred. This is the clause behind drop-down transactions, and it was agreed years before anybody used it that way.

4. The baskets

Permissions, each with a number, and they add up:

  • Debt incurrence — a fixed amount plus an amount available if a ratio is met, plus a general basket, plus an incremental facility, plus refinancing capacity.
  • Restricted payments — what may be paid to shareholders. This is the clause that permits a dividend recapitalisation.
  • Permitted investments — what may be moved where, including into unrestricted subsidiaries.
  • Permitted liens — what may be pledged to somebody else, which decides whether these lenders stay where they think they are in the queue.
  • Asset sales — whether proceeds must repay debt or may be reinvested, and how long the reinvestment window is.

Add the baskets up. The total is how much can happen without anybody asking, and it is routinely far larger than any single clause suggests.

5. The amendment provisions

Who can change what. Traditionally, altering a payment date, an amount or a rate needed every affected lender — the sacred rights — and everything else needed a majority.

Those boundaries have moved. Read specifically whether a majority can consent to new debt ranking ahead of the existing loans, and whether pro-rata sharing is a sacred right. If it is not, a majority of lenders and the borrower can improve their own position at the expense of the rest — see uptiering.

This is now one of the first things a professional lender checks, and it is a change in practice within the last few years.

6. The financial covenants, at last

  • Maintenance — tested every quarter regardless of what the borrower does. Miss it and you are in default.
  • Incurrence — tested only when the borrower wants to do something.

Covenant-lite means maintenance tests are absent, or apply only to the revolving facility and only when it is drawn beyond a threshold. It does not mean covenant-free. The practical consequence is that lenders no longer get an early seat at the table when performance slips; they wait for a missed payment.

7. The mechanics that decide a bad year

  • Equity cure — the sponsor's right to fix a breach by injecting equity, and how often it may be used.
  • Cash sweep — how much surplus cash must repay debt, which drives the whole deleveraging case.
  • Change of control — what happens if the owner changes.
  • Guarantor coverage — what proportion of the group actually guarantees the loan, and the test that keeps it there.

The four questions to leave with

  1. What is earnings, after every add-back, and how far is that from the accounts?
  2. Where can the assets go, and who has to agree?
  3. What can a majority of lenders do to me?
  4. What ranks ahead of me today, and what could rank ahead of me tomorrow?

None of those is answered by the margin, and all four decide what the loan is worth if anything goes wrong.