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Appeal of Shared National Credit (SNC) (Third Quarter 2015)

Background

An agent bank appealed the substandard ratings assigned to a revolving credit and term loan during the 2015 Shared National Credit (SNC) examination.

Discussion

The appeal asserted that the facilities should be rated special mention because while the borrower faced issues requiring close attention, the borrower maintained sufficient cash flow to service debt.

The borrower operated a company producing a ready-to-eat (RTE) product that was one of the highest-margin products sold in the consumer packaging goods industry. Over the past several years, however, the category had experienced above average revenue declines. The appeal stated that the borrower’s diversification strategy was viewed as a long-term credit enhancement despite the margin decline. The strategy seeks to diversify into faster-growing categories that will drive long-term revenue and earnings before interest, taxes, depreciation, and amortization (EBITDA) growth to offset continuing declines in the RTE product business.

The appeal stated that leverage was high based on pro forma fiscal year 2015 EBITDA, which was inclusive of the recently acquired brands. The appeal further stated that food companies generally exhibit more stability than other industries, however, and can therefore operate with higher leverage than more cyclical/volatile industries.

The appeal asserted that base-case assumptions were realistic with top line growth of 2 percent to 3 percent per annum. The base case, incorporating the acquired brands acquisition and related senior secured debt, demonstrated an ability to repay 111 percent of funded senior secured debt within seven years, which satisfies the “Interagency Guidance on Leveraged Lending,” dated March 2013 (guidance). While the base case demonstrated an ability to repay 38 percent of total debt within seven years, the appeal argued that this was not a “nominal” amount, an illustration of a lack of sound worth, an inability to satisfy its obligations, or an indication that an event of default is probable.

Conclusion

An interagency appeals panel of three senior credit examiners concurred with the SNC examination team’s originally assigned risk rating of substandard.

The appeals panel concluded that the company had been highly active with acquisitions and had high and increasing leverage. Company management had not demonstrated an ability to accurately project manufacturing inputs costs, leading to EBITDA and margin projection misses. Despite bank management’s assertion of acquisitions being long-term credit enhancements, performance to plan had been weak, which raised uncertainty regarding the company’s ability to achieve projections. EBITDA and margins for fiscal year 2013 and 2014 were lower than the bank’s base case projections for both years. Variances to plan had become more pronounced as the company ramped up acquisition activity. One acquisition introduced significant exposure to commodity price volatility, which contributed to management’s inability to accurately project manufacturing costs.

The appeals panel concluded that comparable companies showed significantly lower leverage than the borrower. The appeals panel acknowledged that 111 percent of senior secured debt repayment met one key aspect of the repayment hurdles outlined in the guidance. The 50 percent threshold for total debt is, however, more applicable to companies with the borrower’s debt structure. The majority of the company’s debt was in senior unsecured notes. Projected total debt repayment capacity was 39 percent in seven years, significantly below the guidance. Given the company’s capital structure, examiners considered total debt repayment capacity the pertinent factor when determining risk ratings.

Additionally, the appeals panel stated that cash flow projections were back-loaded, with 53 percent of cumulative free cash flow (FCF) generated in the final three years of the projection period. Using pro-forma fiscal 2015 or fiscal 2016 FCF, projections indicated the ability to amortize only 63 percent of senior secured debt and 22 percent of total debt in seven years. Furthermore, the borrower’s ability to fully amortize senior secured debt was dependent upon its ability to meet projections, which it had failed to do in recent years.