A question of timing: The applicable test date in leveraged finance

Where is the relevant drafting generally found?

Near the front of the facilities agreement, in the definitions and interpretation and construction section.

In summary, the agreement will state that the company is permitted (in its sole discretion) to determine compliance with any ratio or incurrence-based test in relation to any relevant transaction calculated by reference to the "Applicable Test Date".

This drafting allows the business to elect to rely on the fact that the action in question was permitted, and the relevant test was satisfied, either at the time that the action or liability in question was taken or incurred, or (as the case may be) earlier, when the relevant action or liability was originally committed to by the business.

Compliance with the relevant financial test for this purpose is generally determined on a pro forma basis after giving effect to the relevant transaction or liability and as if the relevant transaction had occurred at the beginning of the Relevant period (being the previous 12 months) ending on the chosen reporting date.

It is important for the parties to check that there are no inconsistencies between any related construction provisions and the drafting in the impacted operative clauses in the facilities agreement.

Which financial tests are covered?

Typically, the sponsor’s starting place is often for this term to capture any financial covenant, ratio or incurrence-based permission, test or basket in the finance documents, including any components of financial definitions such as EBITDA, Adjusted Leverage or whether a Default or an Event to Default is continuing. Any such test is often defined as an “Applicable Metric”.

Lenders will typically look to clarify that any maintenance financial covenant is expressly excluded from this construct. They may also argue that the rationale for the Applicable Test Date is driven by transactions where the group must commit to a third party in advance, such as acquisitions or financings agreed on “certain funds” terms. In those situations, allowing the borrower to demonstrate compliance at the point of commitment provides commercial certainty and reduces execution risk for the borrower. Extending the concept to internal permissions like Permitted payments is less persuasive to lenders, who are usually reluctant to allow cash to leave the business without a recent leverage test being satisfied.

Similar care is required when considering whether, and to what extent, the Applicable Metric definition should apply to the assessment of all Defaults and Events of Default. While sponsors may view it as logical that the absence of a Default or Event of Default should be tested at the point a transaction is committed to, particularly where the transaction is binding and externally driven, lenders will typically be wary of outcomes that dilute traditional draw‑stop protections. This is especially relevant when determining whether a certain funds “Major Default” has occurred, which as a sub-set of the Events of Default, are limited to the most fundamental breaches under the financing documentation. For example, lenders may argue that if an insolvency event has occurred at the point of completion of the relevant transaction, this should operate as a drawstop notwithstanding the fact that there was no such default continuing at the time the group committed to the relevant transaction.

When is the Applicable Test Date?

This is the definition which allows the business to elect whether to rely on satisfying the Applicable Metric either:

• when the business has committed to the relevant action (for instance to set up the Incremental Facility, or to make an acquisition or a disposal, or to give a guarantee) (commitment stage); or
• when the relevant transaction is consummated or facility drawn down (completion stage).

The typical formulation provides that if the company elects to satisfy an Applicable Metric at commitment stage, it then does not need to test compliance again at completion stage. On some transactions the borrower may go further and ask for additional flexibility to be able to re-test the Applicable Metric at any point in time between commitment stage and completion stage for a proposed transaction. In this way, should the group’s financial performance have improved (or its debt reduced) since the initial test was calculated at commitment stage, then the group would be able to increase the size of the relevant transaction without being in breach.

To mitigate the risk of credit deterioration, lenders often push to cap the amount of time which can elapse for the purposes of this construct between the commitment being incurred by the business and the transaction later being completed. In practice, the parties may agree to match this period of time to any certain funds period which has been agreed in the context of future bolt-on acquisitions.

Paper trail

It will be important for the group’s financial reporting to be clear about:

• how and when they have tested compliance for a particular transaction or liability to be incurred; and
• when available headroom at any point in time has been used on a pro forma basis for a planned transaction (or the incurrence of a liability) which has been committed to but not yet completed (or incurred).

Lenders will want to ensure that the Applicable Test Date construct takes into account for future tests any transactions which have been permitted but not yet completed. Otherwise, a theoretical gap exists in the interim period which could, for example, leave them exposed to substantial debt incurrence in excess of the agreed leverage tests.

Which accounts must be used?

Often the company is given the flexibility to run the financial test either:

• as at the most recent quarter date (or, if more recent, the end of a month) for which financial statements have been delivered; or
• for the last date of the most recently completed Relevant Period for which the business has sufficient available information to be able to determine that Applicable Metric. Some documents go further and allow the borrower to test ‘as at such other date’ on which the business has sufficient available information for the purpose of the relevant test.

In each case, any test will be pro forma for the relevant transaction and any related debt incurrence.

Clearly lenders will want to ensure that if the second option is chosen, the company must provide that financial information to them and to know that it will be of a sufficiently detailed and accurate nature so as to be reliable. They should also pay attention to drafting which permits the company to pick and choose between older and more recent financial statements, and therefore obtain greater flexibility that may not be justified by current levels of debt or performance.

It’s a balancing act…

The use of the Applicable Test Date construct has become ubiquitous within the European leveraged finance market. It is another illustration of the balance that the parties need to strike between giving the borrower’s business sufficient flexibility whilst retaining sufficient credit rigour for its lender creditors.