A senior credit agreement is a complicated document that can be daunting for even the most experienced club owners, especially smaller club owners who don't have a legal team. Considering these four provisions can make the process easier for everyone.
As the fitness industry grows, health club owners should position themselves to take advantage of opportunities to expand business. That often includes taking on senior credit in order to fund acquisitions and greenfield developments. A senior credit agreement is a complicated document that can be daunting for even the most experienced club owners.
For owners of national or regional fitness chains, the agreement may be as long as 100 pages and will be negotiated by a team of legal and financial professionals. For health club owners with fewer clubs, the agreement may be shorter, but it will contain many of the same provisions. The agreements for smaller club owners likely will not receive the same level of review due to the relative expense involved, but without appropriate tailoring, certain of these provisions can restrict the operation and growth of the business, can lead to unanticipated fees and expenses, and can make the club owner personally liable for the credit in an amount greater than necessary.
To avoid such issues, carefully consider four provisions:
1. Negative covenants. Negative covenants are actions that the borrower cannot take for as long as the credit agreement is in effect. They are typically drafted to prohibit an action in its entirety, such as a prohibition on incurring indebtedness, and then set forth a list of exceptions. The following are a few categories of negative covenants that can restrict the operation and growth of a club if appropriate exceptions are not negotiated:
- Indebtedness. If the business leases equipment, or intends to lease equipment in the future, an exception is needed to permit equipment leases up to an appropriate dollar threshold.
- Restricted payments. If the business distributes money to its owners in the form of dividends, which is often the case if the club is a pass-through entity and the dividends are used to pay taxes, an exception is needed to permit this.
- Acquisitions. If the business plans to grow by acquiring other clubs, an exception is needed to permit acquisitions up to an appropriate dollar threshold.
2. Financial covenants. Financial covenants are financial targets that a business must meet on a periodic basis. Failure to meet a target is an early warning sign that the club is not performing up to expectations and is an event of default under the credit agreement. A few typical examples of financial covenants are:
- Total leverage ratio. The ratio of (x) the clubs' total debt to (y) its consolidated EBITDA.
- Interest coverage ratio. The ratio of (x) the clubs' consolidated interest expense to (y) its consolidated EBITDA.
- Minimum EBITDA. The minimum amount of EBITDA that a club must generate (either on a club-by-club or consolidated basis).
Although failure to meet a target is a sign that the business is not meeting expectations, it does not necessarily mean that the borrower will be unable to repay the loan when it comes due. Lenders typically do not accelerate loans solely as a result of missing a financial target. However, they will often charge a default rate of interest and extract a forbearance fee for agreeing not to accelerate, which over time can make the club's cost of financing much higher than anticipated. To avoid this, club owners should carefully review financial targets to make sure that they contain appropriate cushions from the club's expected performance, which will allow the club to slightly underperform and remain in compliance.
3. Events of default. Events of default are events that give the lender the ability to cause all outstanding amounts under the credit agreement to become due and payable. A few typical events of default are:
- Failure to pay principal and interest when due
- Failure to comply with covenants
- A "cross default" to other indebtedness of the borrower
- Judgments against the borrower in a material amount
- Insolvency or the borrower or any guarantor
These events must contain appropriate cure periods, materiality thresholds and exceptions in ensure that they are only triggered by defaults that have a material effect on the business. As with financial covenants, the lender may charge a default rate of interest and seek a forbearance fee even though the lender will likely not accelerate the loan due to an immaterial event of default.
4. Personal guarantees. Although a personal guarantee from one or more of the club's owners is often unavoidable in a smaller credit facility, efforts should be taken to keep the guarantee as limited as possible. A few ways to limit guarantees are
- Limiting them to specifically identified assets of the guarantor
- Limiting them to a maximum dollar amount
- Making the guarantor a secondary source of recovery after actions have been taken against the borrower.
If successful, these limitations put less of the club owners' assets at risk.
To summarize, each provision of a credit agreement is important and should be reviewed carefully by both club owners and their counsel. Place particular focus on those discussed above to ensure the business is not unduly constrained, the cost of credit is not higher than expected, and the owner's personal assets are not put in harm's way.
James Stefanick is a member of Cole Schotz's Corporate, Finance & Business Transactions practice. Based in New York, Stefanick provides legal counsel on a broad range of corporate transaction matters with a particular focus on the fitness industry.