As the world begins to evaluate the short- and long-term effects of the COVID-19 coronavirus on the global economy and financial markets, private credit funds are assessing the pandemic's effect on their current portfolios. Many funds may discover significant impacts to the credit facilities financing their existing portfolios in addition to the outbreak's negative impact on the underlying loans themselves.
Many private credit funds rely on so-called "warehouse" credit facilities from banks or insurance funds as a source of financing to provide liquidity for their loan portfolio. Often, the lenders' commitments under these secured, asset-level facilities are tied to a "borrowing base" calculated by applying an advance rate to the carrying value of the loans being financed as recorded in accordance with generally accepted accounting principles in the United States ("GAAP"). Although the GAAP rules can be complex, private credit funds generally "mark to market" their portfolio of existing loans on a periodic basis. In times of economic distress (including in the wake of the coronavirus pandemic), these funds may experience significant write-downs in the value of the existing portfolios.1 The value of the loans may also be reduced by lenders' discretion to haircut the loans, or if certain trigger events occur with respect to the underlying loan borrowers. These adjustments become more likely to occur in challenging economic times, such as that produced by the COVID-19 pandemic. Some funds may find that the outstanding amount under their warehouse facilities exceed the amounts permitted under the related facility documents (sometimes called a "borrowing base deficiency") as a result of these adjustments.
The occurrence of a borrowing base deficiency can lead to severe adverse consequences. The existence of a borrowing base deficiency, for example, may prevent the applicable borrower from borrowing under the credit facility or consummating other transactions, may alter the required application of proceeds under the credit facility, may result in an event of default under the credit facility if not remedied within the applicable grace period and may trigger cross-default provisions in other financing agreements. Given these consequences, the lenders typically seek to "cure" the borrowing base deficiency. The options to do so will ultimately depend on the terms of the underlying credit facility documentation, but typically include (1) contributing funds to the applicable borrower, which would then be used to repay the amount of the deficiency, (2) repaying the outstanding loan amounts under the credit facility in an amount sufficient to repay the amount of the deficiency, (3) contributing additional collateral meeting the eligibility criteria under the credit facility documentation and (4) selling a portion of the existing collateral under the credit facility, the proceeds of which would then be used to repay the amount of the deficiency.2
The impact of COVID-19 will vary across the market (both for private credit funds and their respective borrowers), as will the treatment of COVID-19 under the applicable credit facility and underlying loan documentation. Accordingly, we recommend considering the available options to cure any borrowing base deficiencies in light of specific circumstances of each lender and a careful review of the related documentation.
For additional perspectives regarding COVID-19's impact on private credit funds and leveraged lending transactions, please see our Coronavirus COVID-19 webpage. Our team of experienced lending lawyers is continuing to monitor ongoing developments with respect to COVID-19 and expects to provide additional updates as they arise.
1. Please note, however, that the extent and impact of such write-downs may be mitigated by actions taken by the Financial Accounting Standards Board ("FASB") in response to the COVID-19 outbreak. See Board of Governors of the Federal Reserve System, et al., Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus (Mar. 22, 2020), https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200322a1.pdf.
2. Funds may wish to consider alternatives to open market sales of assets. Mayer Brown lawyers would be happy to discuss solutions that may be available to funds facing a borrowing base deficiency.
March 25 2020
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