As we emerge from the economic downturn and with more "new money" investment finance deals being done, lenders and borrowers frequently ask for our view on what is market practice in relation to equity cure rights (the rights of shareholders to cure a financial covenant default by injecting further equity funding). Before the credit crisis hit, equity cures were prevalent in real estate financings and a key focus of negotiation on financial covenant provisions. But have they survived the credit crisis and if so, what does the market standard cure right look like?
In a nutshell, the answer is cure rights have survived but it's probably too early in the new world to say with any confidence what market practice is.
Without doubt lenders are more reluctant than in 2006 to relinquish their right to accelerate loans as a consequence of a borrower’s non-compliance with financial covenants. Of the investment transactions that the Eversheds real estate finance team has advised on since November 2009, 50% of transactions contained no rights at all for sponsors to cure a financial covenant breach. This approach is hardly surprising in the current climate - in granting the borrower a cure right lenders are effectively depriving themselves the opportunity to seize the upper hand in working out potential problems or recalibrating the terms of a deal to reflect any deterioration on the credit quality of the Borrower. Much will depend on the specifics of the transaction and the track record of the sponsors.
Covenant cures are certainly not a thing of the past, however. 50% of deals enabled the sponsor to cure a loan to value breach. However, cures for interest cover covenants are less prevalent , featuring in only 30% of the deals in our survey.
How do cure rights operate? Typically investors will be permitted a certain window within which to provide additional equity to remedy a breach, anything up to around 30 days following the date of breach. During this period the Lender agrees that it will not take action to accelerate the loan and enforce its security.
In the case of loan to value cures, it will usually be the case that the breach can be remedied by way of a prepayment of the loan in order to bring down the outstanding debt sufficiently to ensure covenant compliance. Alternatively (although less common) funds may be deposited into a "rectification" or "cure" account charged in favour of the lender such that if such funds deposited were applied in reduction of the loan, the loan to value covenant would be complied with. The monies held are usually capable of being released to the Borrower when the LTV has been at compliant levels (without taking into account the deposited monies) for a certain period of time, usually 2 quarters. In our survey 55% of those facilities that incorporated LTV cures included the rectification account mechanic. The final option enables the sponsor to bring additional assets within the lender's security net to boost " value". This appears to be the least common approach (only 30% of facilities containing LTV cure rights included this option).
Cures of interest cover breaches are conceptually more problematic for lenders. The perception is that such cures can often only temporarily mask underlying profitability issues: cash infusions may be modest and may not materially improve the borrower's financial condition where actual or projected rental income is weak as against interest payments. Interest cover cures take various forms. The loan can be prepaid to bring interest accruing down to a level that can be serviced from the rental stream. This was offered by lenders in 100% of transactions that included an interest cover cure. Lenders sometimes offer the sponsors the option of placing monies into a rectification account, such amounts being treated as a notional reduction in the loan. The lender has unfettered access to the account to apply against interest shortfalls. Alternatively in some cases the sponsors are required to deposit an amount of cash into a charged account such that the interest accruing on that amount, when treated as “rental income” on each interest payment date, is sufficient to ensure compliance.
Often lenders impose a limit on the number of times an equity cure right can be exercised in consecutive periods (approximately 50% of facilities in our survey containing no restriction, the other 50% containing a maximum of 2 consecutive interest periods). It is also common to see an overall cap on the number of times the equity cure rights can be exercised during the life of the deal. Perhaps surprisingly our survey showed that in approximately 40% of cases, no maximum cap was applied, the other cases having a range of between a maximum of 2 and 6 times.
So in summary we would conclude that cure rights are not a thing of the past but, where permitted, are likely to come with greater restrictions than pre credit crunch.
Simon Mead
Simon Mead is a partner in the Real Estate Finance team at Eversheds LLP
