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Appeal of Shared National Credit (SNC)—(Fourth Quarter 2015)

Background

An agent bank appealed the special mention ratings assigned to a senior secured facility during the 2015 Shared National Credit (SNC) examination.

Discussion

The appeal asserted that a pass rating was appropriate due to mitigating factors for each of the ascribed potential weaknesses. With respect to continued financial deterioration and performance significantly below plan, the appeal acknowledged that the company’s financial performance declined throughout the first half of 2015, with the weaker performance leading to an amendment to increase covenant flexibility. Revised projections showed company leverage remaining at a moderate level, however, with projected cost reductions offsetting pricing weaknesses and currency headwinds.

The appeal further argued that the capital structure put in place at origination, including a moderate leverage profile, reflected the cyclical and commodity nature of the company’s business and the strict covenant package. It noted that in return for granting covenant relief, the lenders negotiated a large reduction in the restricted payments basket preventing future outflow of free cash flow.

The appeal indicated the company’s contingent liability process is manageable, as the company is contesting allegations from lawsuits. The bank, however, considers that any potential cash flow requirements will not be realized until sometime in the future. Based on revised projections, the company’s strong free cash flows in the later years are available to deal with cash payments stemming from this contingent liability.

The bank believes the technical shortfall in earnings before interest, taxes, depreciation, and amortization (EBITDA) meeting satisfactory fixed charge coverage levels was driven by capital expenditures (capex) in connection with expansion projects.

Conclusion

An interagency appeals panel of three senior credit examiners concurred with the SNC examination team’s originally assigned risk rating of special mention due to potential weaknesses that include continued financial deterioration of the borrower, performance significantly below plan, and covenant relief necessitated shortly after origination. Although cost savings measures have been implemented to improve EBITDA, those potential savings are not expected to be realized until 2017.

The appeals panel acknowledged that the company presented revised projections, in part due to the company’s need to show improved EBITDA within days of the spinoff from another company. The company significantly missed initial projections, however, for the first reporting period after loan origination. The deteriorated financial performance and below plan performance so shortly after origination are potential weaknesses that if left uncorrected, may result in further deterioration. The company also faces challenges, including the potential that projections again fall short in future reporting periods. Consideration was given to the causes of the missed projections, and the appeals team evaluated the revised projections, including a reduced dividend, when arriving at the risk-rating determination. These positive factors mitigated a more severe rating, but did not eliminate or offset the potential weaknesses noted.

The appeals panel further noted that the company sought covenant relief before the first covenant reporting date, shortly after the loan origination. Pursuant to the covenant relief, the EBITDA definition was amended to include all expected cost savings reasonably expected to be realized within 365 days. The use of “expected” in the EBITDA definition provides a one-year window of time for the saving to materialize. If the savings do not materialize, or materialize but not to the extent expected, this would result in further deterioration of the company’s repayment prospects. A delay of one year also hampers the lender’s ability to take timely corrective actions before this covenant would be breached.

The appeals panel also noted that the company is subject to ongoing litigation risk associated with the upcoming trials, which could further stress the company’s financial performance. There were several lawsuits and the first lawsuit decided was against the company.

The appeals panel noted that the actual EBITDA shortfall cited in the write-up illustrates the stress on cash flow. Capex related to expansion was a cash expense, was not a one-time charge, and was not discretionary. As such, the original voting team used actual capex for the fixed charge coverage calculation. The insufficient amount of EBITDA to cover fixed charges was not the primary factor supporting the special mention rating, but does underscore the potential weaknesses evident from the deteriorating financial performance.