More and more private-equity sponsored deals are including provisions that allow the sponsor to inject equity to boost EBITDA if the company is not going to meet its covenants. Known as an equity cure right, the provision allows the private equity groups to bypass lenders and add equity without an amendment.
While the idea of equity cure rights may have existed for a few years, previously only the top-tier sponsors would be allowed to have it written into its contract. Now, some say it is almost a given that a private equity group will ask for that language to be included. The provision has also been seen in more amendments. Most recently the November commitment letter for John Maneely Co., a Carlyle Group portfolio company, included an equity cure right.
The idea is that if a leveraged borrower at the end of a quarter is not in compliance with covenants, the equity sponsor can add additional equity into a deal that will count as EBITDA. The private equity sponsor does not need an amendment or even a discussion with its banks or investors. However, the injected equity does not need to be used to pay down debt. Rather, theoretically, it could be used for cap ex or even put towards paying out a dividend.
"I think the concern you have as a lender, to the extent you have a concern, is that this is a company not meeting its plan and not hitting covenants and it may be delaying the inevitable, which may not be favorable to a lender," explained Eric Goodison, partner at Paul, Weiss, Rifkind, Wharton & Garrison. "It might be better to get to the table and have discussions...this just delays that dialogue. I think that is the concern."
Investors agreed that if there is an issue of underperformance, they want the borrower to come and talk to them, so they can make a decision about what should be done. "Covenants let lenders exercise control and give them some leverage at the negotiation table," a portfolio manager said. "Allowing the sponsor to put in additional money deprives that right. We might have a different opinion [of how the company is doing] than the sponsor." Spokesmen for various private equity groups either declined comment or did not return calls.
Much like concerns investors have with covenant-lite deals, equity cure right provisions can allow problems to go unchecked until the situation is very serious. From an investor's point of view, an amendment signifies a discussion to increase pricing, as they reason increased risk needs to mean increased compensation. Without that meeting, pricing may not increase commensurately with the increased risk. "A covenant defaults, the banks reprice a deal," another portfolio manager said. However, a third portfolio manager said he would rather have an equity cure right written into an agreement than a covenant lite deal. "There are worse things than equity cures, like no covenants," he said. "At least they are putting in some equity. I would say in the scheme of things, it's not preferable, but there are a lot worse trends than that."
One commitment letter that included an equity cure filed with the Securities and Exchange Commission stated that if any of the financial covenants are violated, the company has five business days to "cure such breach by procuring that the proceeds of any new entity be contributed into the bank group." It says that equity can be applied toward the prepayment of the term loans or added back to the calculation of consolidated operating cash flow and by doing such, the covenant test would therefore have been satisfied.
In this specific instance, qualifications are given such that an equity cure right may not be used on more than three occasions during the facility; in the case of an add-back it can not exceed £100 million; and it can not be used for two consecutive quarters.
