Restricted Group: Who the Covenants Bind and Count

A borrower's group can be divided three ways, and a lender reads all three. The consolidated group is every company in the accounts. The restricted group is the parent and the subsidiaries the agreement binds: usually all of them, less any the borrower has designated as unrestricted. The obligor group is the companies that have signed as borrower or guarantor, usually giving security as well. Each circle normally sits inside the one before.

The circles answer different questions. The restricted group answers whose conduct is controlled and whose figures are counted. Its members are limited in what they borrow, what security they grant, what they pay to shareholders, what they invest and what they sell, and the leverage and cover ratios are calculated on their combined earnings and debt. The obligor group answers whom the lender can sue and whose assets it holds. A restricted subsidiary that gives no guarantee is counted and controlled, but the lender has no direct claim on it.

The concept comes from US high-yield bonds. It has spread into leveraged loans in the US and Europe, the UK included, and into some sponsor-backed financings of Australian businesses that use those markets' documents. Definitions differ deal by deal, but three features recur.

Ratios are calculated on the restricted group, so the earnings of unrestricted subsidiaries are left out, in many documents except for cash they actually pay up to the restricted group. Non-guarantor restricted subsidiaries are limited separately: in how much they may borrow, because their own creditors rank ahead of the lenders on their assets, which is structural subordination, and in how much the guarantors may invest in them. And a guarantor coverage test can require the guarantors to account for a set share of the restricted group's earnings or assets, so the counted circle and the liable circle cannot drift far apart.

A bank facility for a mid-sized New Zealand or Australian business more often defines one group, the consolidated group or a named guaranteeing group, and tests its covenants on that. What is usually missing is the label, and the borrower's right to move a company outside the covenants by designating it.

A fire-protection services group owned by a private equity fund, constructed for this page like every figure in it, borrows a US$90m term loan at its parent. It has four subsidiaries: Australian and New Zealand servicing companies, which guarantee the loan and give security; a UK installation company, which is restricted but gives no guarantee and has a local overdraft of US$3m; and a monitoring-software start-up, designated unrestricted, which lost US$1.5m this year and has US$2m of debt of its own. EBITDA by company, in US$m:

The covenant reads 3.88 times, and two things in that figure deserve a second look. The start-up's losses sit outside it, which improves the ratio by about a third of a turn against the consolidated 4.22 times; that is the designation working as written, but the owners are still funding those losses from somewhere. And US$4m of the counted earnings come from a company that owes the term lenders nothing. If the UK business failed, its overdraft bank would be paid from its assets first, and the term lenders would reach only what was left, through the parent's shareholding.

Now suppose the agreement lets guarantors invest freely in restricted subsidiaries, and the Australian company moves a maintenance contract book earning US$3m to the UK company. The tested leverage does not move, because both companies are inside the restricted group. The guarantors' share falls to 17 ÷ 24, or 71%, and the lenders' direct claim has lost a contract book. A coverage test set above 71% would catch the move; without one, the first sign may be next year's security schedule.

The space between the restricted group and the obligor group matters most as a route. Leveraged agreements often allow investment in non-guarantor restricted subsidiaries more freely than in unrestricted ones, on the reasoning that the value stays inside the covenants. But a non-guarantor restricted subsidiary may be allowed to invest onward, including in an unrestricted subsidiary, and in some documents what it receives from a guarantor can pass straight through. Market commentary calls this a trapdoor: value moves from the obligor group to the restricted group, and from there out of the covenants altogether.

Lenders answer by narrowing the route rather than the destination. Protections seen in many agreements include a cap on investment in non-guarantor subsidiaries, a rule that value passed through them still counts against the basket for unrestricted subsidiaries, a guarantor coverage test, and a requirement that any restricted subsidiary above a set size become a guarantor. Which of them a deal carries is negotiated.

DEFINED IN ONE PARAGRAPH → · GUARANTOR COVERAGE TEST → · PERMITTED BASKETS →

At approval, the lender reads the tested ratio and the consolidated ratio side by side and asks for the difference to be explained company by company. A restricted group that leaves out loss-making companies tests better than the business performs. One that counts non-guarantor earnings tests better than the lender's claim. Neither is wrong, but both need to be visible in the credit paper.

In the documents, the restricted group is fixed in the definitions and moved by the baskets. A lender who agrees a tight leverage covenant and loose investment baskets has protected the ratio and left the assets mobile. In a mid-market bank facility the same question takes a simpler form: which companies are in the group the covenants test, which of them guarantee, and what may pass between them.

UNRESTRICTED SUBSIDIARY → · COVENANT-LITE LOANS →