Baskets, Carve-outs, and Restricted Payments

What this topic is

Negative covenants in a credit agreement or indenture prohibit categories of action: incurring debt, granting liens, making restricted payments, making investments, selling assets, transacting with affiliates. Each prohibition is followed by a long list of exceptions, called baskets and carve-outs, that permit the action anyway, either up to a fixed amount, up to an amount that grows with earnings or assets, or without limit if a financial ratio is met.

Why it matters

Nobody breaches a negative covenant. Transactions are structured to fit within the exceptions, which means the exceptions are the covenant. A borrower with $340M of aggregate basket capacity across investments, restricted payments and debt has $340M of freedom that no financial covenant will constrain, and the largest liability management transactions of the last decade were executed entirely inside permitted capacity. Reading the prohibition tells you almost nothing. Adding up the exceptions tells you everything.

Who should learn it

Credit investors and direct lenders doing document diligence, sponsors and CFOs planning dividends, acquisitions or restructurings, and advisers who need to know what a document actually permits before advising anyone.

What you will understand

• The anatomy of a restricted payments covenant and how the builder basket accumulates
• How grower baskets compound with an EBITDA definition the borrower substantially controls
• How unrestricted subsidiary designation moves assets outside the credit group, and what a blocker does
• How to build a capacity model that adds up everything a borrower may do without asking anyone

Prerequisites

• When not to Raise
• SBA Loans

Common misconception

"The restricted payments covenant caps dividends at 50% of net income, so the sponsor cannot take much out." That describes one component of one basket. The full picture typically includes a starter basket available on day one, the cumulative builder, 100% of the proceeds of any equity contribution, a general restricted payments basket sized as the greater of a fixed amount and a percentage of EBITDA, an unlimited ratio-based basket available whenever leverage is below a stated level, a management equity repurchase allowance, capacity to make investments that can later be converted, and the ability to reclassify prior usage to free up room. Adding those up frequently produces a number several times the size of the builder alone.