Workout: Restructuring a Loan Before Default

A workout is a loan restructured by agreement before any payment is missed. The trigger is usually a covenant breach. A breach gives the lender a right to a conversation rather than a loss to book. Terms are reset on both sides: the borrower's cash cost falls, the lender takes more security, a longer wait and a higher total rate. In Nilgiri Direct Lending Fund I, invented, that is what happened to position 3.

A workout begins with a distinction that is easy to state and constantly collapsed. A covenant breachA promise in the loan document broken at a scheduled test, while payments are still being made. is a promise about a ratio being broken while the money still arrives on time. A default is the money not arriving. The first is a tripwire the two sides put into the document on purpose, precisely so that somebody has to talk before the second one happens. A lender that reads a breach as a loss has spent that tripwire for nothing, and a reader who reads the two words as the same word will misread every restructuring they ever meet. Moyer, Distressed Debt Analysis, 2005, is the standard treatment of negotiating from that position.

Nilgiri Direct Lending Fund I, invented, is a private credit fund managed by Nilgiri Alternatives Advisors Private Limited, with Nilgiri Trusteeship Services Private Limited as its trustee. The fund is registered as an Alternative Investment Fund with the Securities and Exchange Board of India at sebi.gov.in. Its loan book has eight positions and cost Rs 2,40,00,00,000. Position 3 is mezzanine debt of Rs 30,00,00,000, being 12.5 per cent of that cost, carrying 11.0 per cent paid in cash and 5.0 per cent paid in more debt, with a second chargeA right over property that is paid only after a first charge over the same property is met.. Every rate quoted belongs to that one fund's own contract, and a different lender lending to a different borrower would have signed different numbers.

What actually happened at the Year 2 Q3 test?

Two things, and the order of them carries the whole subject. The borrower's net debt to earnings before interest, tax, depreciation and amortisation came out at 4.4 times, against a maintenance level of 3.75 times written into the document. And the coupon was paid, in full, on the day it was due. The breach and the payment sat in the same quarter and point in opposite directions. A ratio test exists to produce exactly that situation.

Consider a tenant in a let shop. The rent arrives on the first of every month, without fail, for two years. Then the landlord finds out the tenant has sublet half the floor to a cousin. The lease says plainly that subletting may not be done without written agreement. Nobody owes any money. Nothing is late. And yet a promise in the document has been broken, and the landlord now holds a right that did not exist last week: the right to sit the tenant down and renegotiate. A broken promise with the rent still arriving is a breach. If the rent had simply not arrived, that would be a different event with a different set of rights attached, and the conversation would be a very different one.

A workoutA loan restructured by agreement between borrower and lender before any payment is missed. is what happens when the two sides use that right to rewrite the deal rather than to end it. Nothing about it is automatic and nothing about it is a rescue. Both parties are acting in their own interest, and what each of them handed over can be named precisely once the reset terms are laid out. A workout is not a judgement about the borrower. Whether the business could pay is a separate discipline covered separately, and two different companies holding the same document would produce the same reset arithmetic.

Why does a lender write a ratio test into the document at all?

Because a promise to repay in five years says nothing for four years and eleven months. A maintenance covenantA ratio the borrower must stay inside, tested on a fixed timetable rather than only when it borrows. is a ratio the borrower has to stay inside, measured on a timetable somebody wrote down in advance. On position 3 the leverage test runs every quarter. Nobody has to suspect anything, nobody has to ask for the numbers as a favour, and nobody has to wait for a payment to be late. The date arrives, the ratio is computed, and it either sits inside the level or it does not.

Compare two ways of looking after a person's health. One is to see a doctor when something hurts. The other is to have a check-up booked for the same week every year whether anything hurts or not. The second one does not make anybody healthier by itself. The booked check-up forces a conversation onto a date, at a point where there is still something to talk about. A maintenance covenant buys the lender a date, and a date is the only thing that reliably turns a slow problem into a discussion rather than a surprise.

The words "at the Year 2 Q3 test" matter more than the number 4.4. The level itself is arithmetic: 4.4 divided by 3.75 is 1.173, so the borrower sat 17.3 per cent above the level it had promised to stay inside. To come back to 3.75 times on unchanged net debt, its earnings would have to rise by that same 17.3 per cent. Because 3.75 divided by 4.4 is 0.852, its net debt on unchanged earnings would have to fall by 14.8 per cent. Neither of those two figures needs any input about the borrower that this record has not fixed. How that ratio is built, and what a lender is doing when it sizes a loan against it, is covered separately under the leverage ratio.

There is one more thing the document usually carries alongside the test, and it is worth naming because readers reach for it in the wrong place. A cureFixing a breach or a missed payment within the period the document allows. is the chance to put a breach right inside a period the document allows. The existence of a cure period is one of the things that makes a breach and a default different animals in practice as well as in principle. For position 3 the document fixes no cure period, no notice period and no timetable.

What did the lender give up when it agreed to a reset?

Cash today, and time. Cash today and time are both real losses to the party handing them over, whatever else the deal did.

Cash today is the simpler of the two. Before the reset the fund received 11.0 per cent of Rs 30,00,00,000 in cash each year, being Rs 3,30,00,000. After it, the cash coupon is 8.0 per cent of the same original Rs 30,00,00,000, being Rs 2,40,00,000. One convention holds throughout: the cash coupon is computed on the original Rs 30,00,00,000 of principal and does not accrete, so only the part paid in more debt grows the balance. Rs 90,00,000 a year that used to reach the fund's bank account now does not.

Time is the harder one to feel, and it is the thing an amend and extendChanging terms and pushing the repayment date out rather than enforcing. is named after. The maturity of position 3 moved out by two years. Two more years is two more years in which nothing can be redeployed, two more years of the loan sitting on the books, and two more years during which anything at all can happen to the borrower. Money that comes back later is not the same money, and a lender agreeing to wait has conceded something it cannot get back by writing a higher rate.

The date that did not move matters as much. The Year 2 Q3 test date did not move: it had been written into the document on the day the loan was made and it arrived on schedule. The far end of the loan moved and the near end did not. Almost every restructuring has that shape.

What did the lender take in exchange?

Three things, and only one of them is a rate. The total contracted rate on position 3 rose from 16.0 per cent to 17.0 per cent. Adding up, 11.0 plus 5.0 is 16.0 and 8.0 plus 9.0 is 17.0. The fund took an additional charge over the shares in a subsidiary of the borrower, on top of the second charge it already had. And the owner standing behind the borrower put Rs 8,00,00,000 of new money into the business, ranking behind everything the fund holds.

The second of those three is the one readers skip past, so slow down on it. A second charge over the borrower's assets and a charge over the shares in a subsidiary are not two versions of the same thing. One reaches property the borrower already pledged, behind somebody else. The other reaches a different property altogether: the shares in a company, rather than the machines and receivables inside that company. Adding a charge over a new property widens what the lender can claim. Improving where the lender stands in what it could already claim is a different move. Which of those two a security document does, and what each of them actually reaches when it is tested, is covered separately under the security package. Where a company's registered charges live as a public record is a matter for the Ministry of Corporate Affairs at mca.gov.in.

What did the five changed lines actually say?

A workout is not a mood, an accommodation or a show of goodwill. A workout is a specific number of specific edits to specific lines of one document, and on position 3 there were five of them.

The pairing of the last row with the first row is the entire lesson, so read the two together. The cash the borrower must find each year fell by Rs 90,00,000, from Rs 3,30,00,000 to Rs 2,40,00,000. The total contracted rate rose by one point. Both of those sentences are true about the same document on the same day, and a reader who holds only one of them has the deal backwards.

Why can cutting the cash coupon be the lender's own move rather than a concession?

Start with a shopkeeper. A regular customer, good for the money over ten years, hits a bad stretch and cannot clear the monthly bill. The shopkeeper has two obvious choices and one less obvious one. Stop supplying, and recover whatever is on the ledger from somebody with no reason left to co-operate. Carry on as before, and watch the ledger drift. Or say: pay less each month for now, and the rest goes on the tab with a charge for carrying it. The third choice takes less cash from the customer this month and leaves the shopkeeper with a larger amount owed at the end. The shopkeeper is not doing a favour. The tab is a different deal.

The reset on position 3 has exactly that shape. The borrower's difficulty was a cash difficulty: it had to find Rs 3,30,00,000 every year while a ratio in its document said its debt had grown too large relative to its earnings. Cutting the cash coupon to 8.0 per cent takes Rs 90,00,000 a year of that pressure off. Raising the rate paid in more debt from 5.0 to 9.0 per cent puts four points back on, in a form the borrower does not have to find cash for. The lender did not give three points away; it moved three points from one column to another and charged an extra point for making the move.

What does the lender's income look like after the reset?

The trade becomes visible in rupees rather than in points once the two years after the reset are worked out. Payment in kindInterest settled by adding to the amount owed instead of paying cash. means interest settled by adding to the amount owed instead of handing over cash. The fund still recognises the interest as income. The cash never arrives.

Work the two years after the reset, on that same convention: the 9.0 per cent paid in kind compounds on the balance as it accretes, and the 8.0 per cent cash coupon is charged on the original Rs 30,00,00,000 and does not. Year one, the balance goes from Rs 30,00,00,000 to Rs 32,70,00,000, so Rs 2,70,00,000 was added. Year two, Rs 32,70,00,000 becomes Rs 35,64,30,000, so Rs 2,94,30,000 was added. The cash is Rs 2,40,00,000 in both years, charged on the original principal throughout. Income recognised comes to Rs 5,10,00,000 in year one and Rs 5,34,30,000 in year two.

Two arithmetic notes before the picture. The 68.8 per cent is Rs 3,30,00,000 over Rs 4,80,00,000. The division gives exactly 68.75 per cent, and 68.8 is the same figure rounded to one decimal place. And the compounding is doing real work. Two years of 9.0 per cent charged on the original Rs 30,00,00,000 would give Rs 35,40,00,000. Compounding on the accreting balance gives Rs 35,64,30,000 instead, a difference of Rs 24,30,000. Income recognised rose in both years while cash received fell by Rs 90,00,000. A reader who cannot say that sentence out loud has the reset the wrong way round. How that balance keeps compounding beyond year two, and what a lender with a lot of it on its books is actually holding, is covered separately under payment in kind.

What does Rs 8,00,00,000 of fresh equity do that a covenant amendment cannot?

Fresh equity changes where the first rupee of loss lands. The size of the cheque has almost nothing to do with the answer.

Consider a cousin who has borrowed from a bank to open a small workshop. Then the cousin's parents put their own savings into the workshop as shares, not as a loan. Nothing about the bank's document changed. No rate moved and no security was added. But there is now a layer of somebody else's money underneath the bank's, and that layer has to be entirely wiped out before the bank is short by a single rupee. The parents did not make the workshop better. The parents changed the order in which money is lost.

The sponsorThe owner standing behind the borrower, whose money ranks behind every lender. of position 3's borrower put in Rs 8,00,00,000 of fresh equity as part of the reset. Against the Rs 30,00,00,000 loan that is 26.7 per cent of it, and it ranks behind every claim the fund holds. Money that ranks behind a lender is worth something to that lender because of where it sits, not because of how much it is, and Rs 8,00,00,000 sitting behind is worth more to the fund than Rs 8,00,00,000 sitting alongside would be. There is a second thing it does, quieter but real: somebody who has just written a new cheque has reasons to keep paying attention that somebody who has not written one does not. Where the money ranks is fixed by the document. The position's final worth depends on a recovery nobody can observe yet.

How would anyone tell whether the workout worked?

Honestly, it cannot be told. The record states one fact and stops. Position 3 is performing at the record date, and that is the whole of what the record says about how it turned out.

The record date is the single date everything in this invented set of accounts is stated as at, being the end of Nilgiri Growth Partners Fund II's Year 9 Quarter 2. Nothing after it exists here. There is no later quarter, no repayment, no second breach and no verdict. The record was drawn up at one moment and stops there. Calling the workout a success would mean making up the part after the full stop.

"Performing" is a narrow word doing precise work, so naming what it does and does not mean is worth a moment. Performing means the payments contracted for are being made. Performing does not mean the borrower is healthy, does not mean the loan will be repaid in full, does not mean the ratio has come back inside its level, and does not mean the two sides made good decisions. The word is a statement about money arriving on dates, and nothing else. A reader who upgrades it into a judgement has made the very error the opening distinction warned against, in the opposite direction.

Both parties, incidentally, acted in their own interest here and neither did the other a kindness. The borrower wanted the annual cash cost down and got Rs 90,00,000 a year of it. The lender wanted a higher total rate, more property inside its security and new money ranking behind it, and got all three. Each side handed something over: the borrower a point of total rate, a widened charge and dilution of its owner's position by fresh equity; the lender Rs 90,00,000 a year of cash and two years of waiting. The exchange is a trade, not a rescue.

Where does a reader most often get this exactly backwards?

What happens if the two sides cannot agree?

A failure to agree is where the workout ends and something else begins. A workout exists because both sides preferred a rewritten document to the alternative, and the alternative is not a vague threat: it is the set of rights the lender already holds, exercised. The reach of those rights, and the order in which anybody gets paid out of a borrower's realisation, is decided by the security package and by rank, and both are covered separately.

The two events named at the outset finally separate for good at that point. Position 3 breached a covenant, reset its terms and is performing. Position 5 of the same invented loan book did the other thing: it was subordinated unsecured debt of Rs 20,00,00,000, its borrower missed a coupon and did not put it right, and the position was written down to 40 paise in the rupee. Two positions in one loan book, one breach and one default, and the arithmetic of what a default costs is covered separately, under the security package and under senior debt. The security package and senior debt carry the subject on from there.

Where an agreement cannot be reached at all, a formal insolvency process exists, and in India that process sits with the Insolvency and Bankruptcy Board of India at ibbi.gov.in. Its steps, timetables and thresholds are set there and belong to a separate subject. A workout is one of the things two parties may do instead of going there, and naming what it avoids is not the same as saying it is better than going there. Whether reaching an agreement or exercising rights is the right course in any actual situation turns on one specific document, one specific borrower and advice taken on both.