What Happens After a Default?

With the weak economy, we are seeing more companies breach covenants in their loan agreements. Such a default typically gives lenders these right:

1. Acceleration (i.e. "call the loan") - declare the principal of the loan to be immediately due and payable. This typically would result in the bankruptcy of the borrower since they do not have the cash on hand to repay the loan.
2. Foreclose on collateral - As with acceleration, this would result in the bankruptcy of the borrower.
3. Stop funding unused revolver commitments. Banks will typically continue to allow some revolver borrowings because cutting off the revolver would often result in a bankruptcy.

After a covenant default, banks typically do not exercise their rights - they do not call the loan or foreclose on collateral, and they often allow the borrower to continue to borrower under the revolver. Banks know that these actions would result in bankruptcy, and it is in everyone's interest to avoid bankruptcy.

So what really happens?

Most covenant defaults result in an amendment (or waiver) to the loan agreement. The financial covenants that were breached are loosened in order to get the borrower out of default. Ideally, the company and banks should see the covenant breach coming and work out an amendment before the default happens.

A good example of this is the recent amendment done by Actuant Corporation (ticker ATU), a diversified industrial company headquartered in Wisconsin. The company was forecasting deteriorating financial performance which could have breached covenants. Before the defaults happened, the company negotiated an amendment which increased its leverage covenant from 3.5x to 4.5x (with future step-downs) and reduced its fixed charge covenant covenant from 1.75x to 1.65x.

What do banks get in exchange?

In exchange for giving a borrower more room under its covenants, banks typically get one or more of the following:

1. Increased pricing and/or a one-time fee - to compensate them for the increased risk,
2. Additional collateral - to improve their loss in the event of a bankruptcy,
3. Reduced exposure - if the company is able to reduce unused amounts on the revolver or repay a portion of the term loan,
4. Additional covenants - to ensure that cash is used to repay debt (e.g. dividend and/or capex limitations) and to better monitor the company's performance.

In the Actuant example, the banks received:

• An amendment fee and increased pricing (spread went from L+250 to L+375; commitment fee went from 40 to 50bp),
• Faster term loan amortization (from $1.5 million per quarter to $10 million), and
• Additional collateral.