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

Background

An agent bank appealed the substandard rating and nonaccrual treatment assigned to a revolving credit during the 2015 Shared National Credit (SNC) examination.

Discussion

The appeal asserted that there was sufficient senior secured repayment capacity of 164 percent in seven years and 32 percent projected total debt repayment. While total debt repayment of 32 percent is less than the 50 percent required for a pass rating, it was mitigated by sufficient senior secured debt repayment and the other positive considerations supporting a special mention rating.

The appeal stated that cash flow was sufficient to cover all interest and maintenance capital expenditures by a minimum of 1.4 times through the projection period. The “Interagency Guidance on Leveraged Lending,” dated March 2013, states that a pass rating can be sustained for a borrower that either demonstrates capacity to repay greater than 100 percent of senior secured debt or 50 percent of total debt. The appeal also asserted sufficient liquidity to accommodate the company’s growth plans through 2018.

The appeal stated that the company projects first lien revolver debt to reach $627 million at December 31, 2018. In this scenario, the company spends $742 million in growth capital expenditures (capex) above the amount of sustaining maintenance capex from 2016 through 2018. That no incremental capital raises are necessary to fund growth plans through 2018 is evidence of adequate liquidity.

The appeal further asserted that quarterly earnings before interest, taxes, depreciation, and amortization (EBITDA) is projected to grow 11 percent from first quarter 2015 to fourth quarter 2015 and annual EBITDA is projected to grow 45 percent from fiscal 2014 through fiscal 2018. EBITDA growth is accomplished despite the lower commodity price environment due to production growth funded with cash flow from operations, existing liquidity, and a significant hedging position entered into before fourth quarter 2014.

The appeal asserted, based on projections supported by the engineering analysis, that leverage was expected to decline by year-end 2017. This is based on improving EBITDA from an increase in production and New York Mercantile Exchange and West Texas Intermediate forward strip pricing as of January 16, 2015.

The appeal also asserted that the borrowing base analysis shows that the discounted proved reserves provide strong coverage of the first lien revolver of 2.1 times. This valuation utilizes the bank’s base pricing case, standard risk weightings of proved developed non-performing (PDNP) reserve categories, and limits the contribution from PDNP reserves to 25 percent of the total 1P value. The present value of future cash flows discounted at 10 percent (PV10) of the unproven reserves provides asset value to cover the first lien revolver and the second lien term loan by 1.6 times.

Conclusion

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

The appeals panel concluded that the bank’s repayment analysis did not consider term loan B, which is pari-passu in regards to repayment, when determining senior secured debt. There should be no differentiation between debt tranches that share priority in payments when determining senior secured debt. Additionally, although the “sustaining maintenance capex” showed 32 percent ability to repay senior secured debt over the borrower’s five year projection period, the appeal did not provide support for maintaining EBITDA at a static level annually.

The management base case is the most likely and shows overall negative free cash flow. Estimates indicate the borrower will require more liquidity than available on the balance sheet and under the existing line of credit. The base case shows the borrower will need to fund 2015 and 2016 combined cash flow shortfalls, which includes monetization of the remaining hedge positions.

The appeals panel noted that the amount advanced under the reserve based loan (RBL) as of March 31, 2015, indicates the excess availability under the borrowing base would be exhausted within two years. The appeal did not address how the remaining deficit cash flow would be funded. Even though revenues are projected to increase over the five-year period by 98 percent, the company is unable to generate positive free cash flow. Additionally, the borrower is using the RBL to service debt obligations and had refinanced prior advances under the revolving credit with a non-amortizing term loan B. This aggressive structure had rendered the RBL credit agreement provision of repaying the over-advanced portion within six months ineffective.

The appeals panel concluded that although the borrower was taking steps to increase EBITDA by developing additional wells through the use of existing liquidity, growth was accompanied by negative free cash flow with leverage remaining elevated in relation to the oil and gas sector. Additionally, the borrower requested and received relief with regard to its leverage covenants.

Regulatory agencies recognize that unique attributes of oil and gas RBLs result in risk inherent to the oil and gas industry requiring additional risk management practices and programs for oil and gas lending, including some controls that are similar to asset-based loans (ABL). For an ABL, however, the primary source of repayment is the conversion of working capital assets to cash, whereas for an RBL, the primary source of repayment is cash flow generated from the sale of oil and gas over the life of the reserves.

The appeals panel concluded that the controls in place for a traditional ABL are more stringent than those typically found in an RBL. ABL controls include a first lien on account receivables and inventory which is not shared with any other lending group, dominion of cash through a lock box arrangement or a springing covenant, regular field audits, and periodic collateral valuations.

The appeals panel concluded that the primary source of repayment for an RBL is the cash flow generated from the future sale of encumbered oil or natural gas once it has been extracted. RBLs often share the cash flow repayment “pari passu” with other debt, both secured and unsecured. In many cases, the other debt (term notes and bonds) requires no principal repayment until maturity. While the structures of RBLs may vary, the facilities generally do not self-liquidate. Disbursements of proceeds, while generally not restricted, are primarily used for capex pertaining to the exploration, acquisition, development, and maintenance of oil and gas reserve interests. Oil and gas reserve interests tend to be longer term, depleting assets as opposed to accounts receivable and inventory.

The regulatory agencies believe an RBL is subject to additional risks than a traditional ABL and should be evaluated and risk rated through cash flow analysis, although consideration is given to each facility’s structure, controls, and collateral. The primary determinant for the regulatory risk rating is the ability of the borrower to service all debt from operating cash flow, the primary source of repayment.