Guarantor Coverage Test: a Worked Example

A lender to a holding company is, without guarantees, a creditor of a company whose main assets are shares in its subsidiaries. The subsidiaries' own suppliers, employees, landlords and lenders are paid from the subsidiaries' assets first, and only what is left reaches the parent. That is structural subordination. A guarantee from a subsidiary lets the lender claim against that subsidiary directly, alongside its other creditors rather than behind them.

Taking a guarantee from every subsidiary is the simplest answer and, for a small group of locally incorporated, wholly owned companies, often the practical one. In a larger or international group it can be costly or unavailable. A foreign subsidiary may face local limits on guaranteeing its parent's debt, a part-owned company has other shareholders to consider, and dormant or tiny entities are not worth the paperwork. Each market also has its own rules on when a company may guarantee another's debt. In New Zealand, section 131 of the Companies Act 1993 lets a director of a wholly owned subsidiary act in the holding company's best interests if the subsidiary's constitution expressly permits it. Australia's section 187 of the Corporations Act 2001 is similar but adds a condition: the subsidiary must not be insolvent when the director acts, or become insolvent because of the act. UK company law has no such provision, so a subsidiary's directors must be satisfied that the guarantee serves the subsidiary itself. The coverage test is the compromise: the lender takes the bulk of the group and lets the rest go.

The detail is in how each guarantor's figure is measured. Agreements commonly take it on an unconsolidated basis, excluding intra-group balances and investments in subsidiaries, so that a parent does not count its subsidiaries' earnings or assets a second time through its shareholdings. Many treat a guarantor's negative EBITDA as zero, so that one loss-making guarantor does not drag the total down, and some cap how much negative EBITDA can be ignored. Group EBITDA is the covenant definition, not necessarily the reported figure.

The test is usually run on the annual accounts and certified with them. If it fails, the group must bring in further subsidiaries as guarantors within a set period, each signing an accession deed and often granting security. Many agreements add a separate rule that any single subsidiary above a stated share of group EBITDA must accede regardless of the total.

A horticultural packaging group, constructed for this page, borrows through its New Zealand holding company. Its agreement requires guarantors to hold at least 85% of group EBITDA and 75% of group gross assets, both levels being the example's. During the year it bought a recycling business in Australia, which has not yet acceded. Figures are US$m, guarantor figures unconsolidated and net of intra-group items:

The asset test passes and the earnings test fails, because the business bought this year earns well on a modest asset base. The group needs guarantor EBITDA of at least US$20.4m (85% of 24.0), US$1.9m more than it has.

Only the acquired business fixes it, which is what the lender would want: that is where the new earnings sit. If the recycling business cannot accede quickly, for instance because its own debt is being refinanced or, if the group's facility paid for it, because its guarantee would be financial assistance under Australia's Corporations Act and may need shareholder approval first, the group asks for time, and the lender's question is how long its guarantees will reach less of the group than agreed.

A cross-guarantee is a document: each company in a defined group guarantees the debts of the others, so all of them stand behind the borrowing. The coverage test is a measure of how much of the group those documents reach, and a rule for what happens when the answer falls short. A lender can rely on both, with the cross-guarantee signed by the guaranteeing group and the coverage test deciding who must join it.

The test also says nothing about what each guarantee is worth. In most drafting a guarantor counts in full whatever its own debts, and a guarantee limited in amount, whether by agreement or by local law, still counts its company's full EBITDA. A lender reads the coverage figure as the reach of its guarantees and reads each upstream guarantee for its value.

DEFINED IN ONE PARAGRAPH → · THE UPSTREAM GUARANTEE → · CORPORATE BENEFIT →

The test bites when a group changes shape. An acquisition brings in earnings outside the guarantor group until the target accedes, which is why acquisition approvals often make accession a condition. A disposal of a guarantor removes its earnings from the numerator. A reorganisation can move contracts, staff or intellectual property from a guarantor into a company that is not one, and coverage falls with no change in the group's results.

Because the test usually runs on annual accounts, a slide can go unseen for most of a year. A lender that receives management accounts by entity, rather than only consolidated, can watch the guarantor share between tests and raise accession before the certificate is due. When the test fails, the lender's reading is less about the percentage than about where the earnings went and whether they are coming back.

WHAT YOUR BANK HOLDS AS SECURITY → · THE COMPLIANCE CERTIFICATE →