As much of the business world seeks to bounce back from the COVID pandemic, new macroeconomic challenges are presenting themselves that may make refinancing more challenging for sponsoring employers. In his latest blog, David Fairs considers the risks of refinancing to the employer covenant and the actions trustees and sponsoring employers should take to ensure member benefits are protected.
As the UK responded to the COVID-19 pandemic, many sponsoring employers sought to bolster their liquidity, typically turning to their existing — and generally supportive — lenders to both draw down and extend their facilities.
While many employers face continued pandemic-related challenges, the return of a more normalised business environment is likely to also see a return of refinancing in its more traditional sense, being the agreement of new facilities (or extension of existing ones) for the primary purpose of meeting debts that are falling due. For example, an employer has a £20m term loan from Bank A maturing in six months’ time, so it borrows £20m from Bank B to pay it off; corporate debt remains unchanged at £20m and the employer’s current funding requirement is secured for another five years.
Of course, it isn’t that simple. Even in such a basic example, there are several things we expect sponsoring employers and trustees to consider when refinancing, any, or all of which could have a material impact on the employer covenant.
- Interest costs and fees: changes in the cost of debt (interest and fees) could impact the employer’s free cash flow and consequently its ability to meet pension contributions. Trustees should understand the impact of any such changes on the employer covenant.
- Debt structure: debt comes in a variety of common forms, including bonds, term loans, revolving facilities and asset-backed facilities. When replacing one type of debt with another (eg a term loan with an asset-backed facility) trustees should ensure they have a good understanding of any impact. For example, an asset-backed facility fluctuates over time and may allow a higher overall debt-burden.
- Security / guarantees: lenders will often seek to take security over assets as collateral for lending they consider to be riskier, or to allow them to offer a more competitive price. Such security would typically result in the trustees’ claims ranking behind lenders debt, reducing the scheme’s outcome in the event of insolvency. Cross guarantees are another tool used by lenders, allowing them to claim their debts from multiple entities, also potentially reducing the recovery for pension schemes. Trustees should ensure they understand the implications of any changes to claim priority on their potential insolvency outcome.
- Financial covenants: financial covenants are typically measures of company financial performance that, once breached, allow debt holders to take action such as call in their debt, charge a fee, take security or otherwise make commercial improvements to their terms. An example covenant would be a ‘leverage ratio’ where the total debt must not exceed a multiple of the company’s profit. Changes to such covenants could represent a power shift between trustees and lenders in the event of financial stress.
- Restrictive covenants: in addition to financial covenants, lending documents may include clauses that restrict the ability of the employer to undertake certain activity — for example its ability to increase deficit reduction contributions to the scheme or to grant security to a pension scheme. Trustees should be mindful of such clauses, which may restrict their ability to agree appropriate funding plans or protections for the scheme.
- Counterparty: refinancing can take place with the same lender or with a new lender. Where a new lender is preferred, it is more likely that changes will take place in the areas listed above. Trustees should be mindful that different lenders may have different risk appetites and objectives. A change in lender may also facilitate engagement with trustees as a key stakeholder.
Whilst none of the above are new areas for trustees and employers to consider, a challenging and inflationary financial climate makes changes in these areas potentially more likely. Despite continued buoyancy in some markets (eg asset backed lending), credit conditions are tightening and larger refinancings have become more challenging, impacted by lender concerns around certain sectors, costs associated with climate change and ensuring adequate returns on their investment. These conditions are likely to be reflected in higher interest rates and tighter covenants, with potentially more onerous security requirements and greater restrictions on use of funds.
Although the rise of alternative lenders including hedge funds and private equity, alongside newer retail banks (also known as ‘challenger banks’), may help to ensure that liquidity remains available to sponsoring employers, the risks associated with such new market entrants may extend beyond those listed above. Such risks could include lender objectives such as ‘loan to own’, or even challenges to the lenders’ own financial stability.
Our expectations of sponsoring employers and trustees in the context of refinancing are simple. It is critical to understand the implications of any refinancing on the pension scheme and the employer covenant, and to mitigate — to the extent possible — any detriment caused.
This understanding should extend beyond the basic quantum of debt to consider the areas highlighted above, and any other factors considered relevant. If, for example, new money is being introduced beyond that required to meet existing debt, trustees should ensure they have a clear understanding of the purpose of the additional debt and any associated risks to covenant. Trustees should also be cognisant in their analysis of the risks that could arise in the event debt is not refinanced, such as any need to sell assets to meet financial obligations.
Whilst not strictly a ‘refinancing’, we also expect trustees to be mindful of debt transactions, where control over existing lending passes from one counterparty to another, as this could precipitate a change in lending strategy (including changes to how the lender might approach a covenant breach) or highlight potential risks facing an employer. Where trustees become aware of such a transaction, we would expect them to proactively work with the employer and new lender to assess any change in the circumstances of the employer or the lending strategy, and any consequent impact on the trustee’s assessment of covenant.
To support this approach, trustees should engage with management well ahead of any potential refinancing to ensure they have a strong understanding of the employer’s current debt structure (including relevant legal clauses / restrictions) and, also consider debt covenants and refinancing within their monitoring, information sharing and contingency planning frameworks. To facilitate this, employers should be prepared to share relevant information with trustees, including financing documents.
Similarly, we expect employers to provide meaningful and timely information on debt and refinancing proposals, including debt transactions, to trustees. In addition to the legal documents, this could include forecasts, scenario analysis and other information provided to the lender as part of the process, that trustees may find helpful as part of their analysis and monitoring.
Trustees are the first line of defence in the assessment and mitigation of corporate events that impact covenant, including refinancing. As set out in our guidance on corporate transactions and clearance, it is critical that trustees and sponsoring employers engage effectively to assess the extent to which a corporate event is detrimental to covenant and agree adequate mitigation.
By David Fairs, Executive Director of Regulatory Policy, Analysis and Advice