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A participant bank appealed the substandard ratings assigned to term and revolving credit facilities during the 2015 Shared National Credit (SNC) examination.
The appeal asserted that the facilities should be rated special mention due to improvement in financial performance. The company benefited from organic growth and decreasing leverage through the last 12 months ending the first quarter of 2015. The company also remained on track to achieve its updated projections for the year. In the first quarter of 2015, on a constant currency basis, revenues and earnings before interest, taxes, depreciation, and amortization (EBITDA) improved in all regions except China, the company’s smallest region.
The appeal acknowledged that the company underperformed in 2013 compared with the bank base case due to drought conditions, one of the drivers contributing to the bank’s special mention rating. In the past year, improved performance was noted with 2014 EBITDA only $7 million short of the bank’s base case. Given the strong levels of organic growth at the company, the bank projected the company to continue to perform closer to the original bank credit underwriting case going forward.
The appeal stated that the SNC write-up listed “substantial non-U.S. dollar operations” as a concern for future performance. The company’s revenues and expenses were well aligned by region and currency, and the company had deleveraged despite recent foreign currency headwinds. Foreign exchange (FX) rates had stabilized, and forward currency curves indicated likely strengthening against the U.S. dollar (USD). Based on the “Interagency Guidance on Leveraged Lending,” dated March 2013, 51.5 percent of the debt can be repaid within seven years without any benefit from this improvement.
The appeal noted that the company recently completed an acquisition, funded with nearly 50 percent equity. The sponsors injected significant equity in support of this acquisition. While the appeal acknowledged that a portion of the acquisition was funded with debt, it emphasized that the transaction was de-leveraging, with leverage approximately 0.4 times lower on a pro-forma basis, and would immediately add to earnings.
The appeal disagreed that the company’s elevated leverage provided an insufficient cushion to absorb underperformance to plan or a sufficient level of stress. While the company materially underperformed in 2013 with lower growth and higher leverage, liquidity was sufficient to provide a cushion and support any unplanned underperformance. As of the first quarter of 2015, the company had significant cash and availability under its credit facility that were more than adequate and not a well-defined weakness.
An interagency appeals panel of three senior credit examiners concurred with the SNC examination team’s originally assigned risk ratings of substandard.
The appeals panel determined the updated financial forecast continued to indicate that projected free cash flow was insufficient to appropriately de-leverage the balance sheet, amortizing 40.9 percent of total debt in seven years. Revenue was 3.6 percent short of base-case projections and 7.8 percent less than the company’s original forecast. Adjusted EBITDA was 5.9 percent less than the credit base-case projection, and 15.3 percent less than the borrower’s original forecast.
The appeals panel noted the company’s 2015 budget stated that recent acquisitions have lower profit margins than legacy operations, and significant additional acquisitions were contemplated for the coming year. For the company to perform to plan, it must improve production efficiency at the acquired units and achieve restructuring synergies. The company did not demonstrate in 2013 and 2014 that it can perform to plan. Although 2014 performance was closer to projections versus 2013, the company continued to underperform.
The company had chosen not to hedge FX risk; therefore, the impact of FX risk was appropriate to consider when evaluating capacity to amortize or refinance the USD-denominated debt. After the recent acquisition, a significant percent of first quarter 2015 EBITDA was generated overseas. With this level of foreign currency income, currency risk was a major component in determining the ability of the company to service its USD-denominated debt.
To help finance the acquisition, the company incurred significant additional debt through the use of incremental facilities. With the acquired company’s 2014 EBITDA, the company’s total leverage (consolidated pro forma) would be slightly lower. The decrease of 0.4 times mentioned in the appeal was pro forma based on 2015 projections. Minimal information was provided on the acquired company’s financial performance to help examiners determine the reliability of projections regarding acquisitions. Leverage is high if viewed as a standalone transaction.
The appeals panel noted that examiners reviewing the first lien loans calculated de-levering capacity of 41.0 percent for both senior and total debt within seven years. Total debt to adjusted EBITDA was projected to decline modestly over seven years. Based on the results and projections provided to them during the SNC review, the examiners reviewing the second lien loan calculated de-levering capacity of 32.4 percent of senior and total debt within seven years, with leverage declining a little over that time. In both cases, examiner calculated de-leveraging capacity and high leverage supported the substandard classification. Liquidity was considered satisfactory and not a reason for the substandard classification.