PRIVILEGED AND CONFIDENTIAL — ATTORNEY WORK PRODUCT
MEMORANDUM
TO: Philip Hartmann, Esq. (Partner, Calderwood & Harkness LLP) Raymond Cho, Esq. (General Counsel, Crestline Packaging Solutions LLC)
FROM: Lisa Morrow and Marcus Leung, Calderwood & Harkness LLP
DATE: March 25, 2021
RE: Crestline Packaging Solutions LLC — $20,000,000 Mezzanine Financing with Ironwood Capital Finance LLC: Key Negotiation Issues and Recommended Borrower Positions
Matter No.: 1006-00001
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I. Executive Summary and Purpose of Memorandum
This memorandum summarizes the principal open negotiation issues arising from the non-binding term sheet (the "Term Sheet") executed between Crestline Packaging Solutions LLC ("Crestline" or the "Company") and Ironwood Capital Finance LLC ("Ironwood") on February 22, 2021, together with the related telephone discussions held between the parties and their respective counsel on March 3, 2021 and March 18, 2021. We are preparing this memorandum in advance of Calderwood & Harkness LLP's circulation of the initial draft Mezzanine Credit Agreement (the "MCA"), which is targeted for distribution to all parties on or before March 29, 2021.
The purpose of this memorandum is threefold. First, it identifies the key business and legal points on which the Term Sheet is either silent or presents terms that we believe warrant negotiation from the borrower's perspective. Second, it sets forth, for each such issue, Ironwood's proposed terms as reflected in the Term Sheet and the March discussions. Third, and most importantly, it recommends specific negotiating positions that Crestline should adopt with respect to each open issue, together with the rationale supporting those positions. We respectfully request that Philip Hartmann, Raymond Cho, and other relevant members of the Crestline team review this memorandum and provide feedback prior to our circulation of the initial draft on March 29, 2021, so that the draft can be prepared on a basis that reflects the Company's considered negotiating strategy.
Ironwood's counsel, Whitfield & Rao LLP (lead partner Naveen Rao; senior associate Juliana Cortez), is expected to return a markup of Calderwood & Harkness LLP's initial draft on or about April 5, 2021. This memorandum is designed to anticipate the issues most likely to arise in that markup and to ensure that Crestline's initial draft is drafted in a manner that frames those issues favorably for the borrower while remaining within the bounds of market practice for middle-market mezzanine transactions.
By way of background, Crestline Packaging Solutions LLC is an Ohio limited liability company headquartered at 4510 Harshman Road, Dayton, OH 45424. The Company is a portfolio company of Ridgeway Capital Partners Fund III, L.P. ("Ridgeway"), which holds approximately 78% of the fully diluted equity interests of Crestline, with the remaining approximately 22% held by members of management and the founding team. Crestline operates in the specialty packaging and industrial chemical coatings sector, with a particular focus on coatings and packaging solutions for the food and beverage industry. For fiscal year 2020, the Company reported revenue of approximately $87.3 million and EBITDA of approximately $14.1 million.
The proposed $20 million subordinated secured mezzanine term loan from Ironwood (the "Mezzanine Loan") will fund the Company's planned expansion of its Dayton, Ohio manufacturing facility (the "Dayton Plant Expansion" or the "Expansion Project"). The total estimated project cost for the Dayton Plant Expansion is $28.5 million, with the $8.5 million balance to be funded through an equity co-investment from Ridgeway. The Expansion Project encompasses a new 62,000 square foot coating line build-out, the acquisition and installation of packaging automation equipment, and working capital to support the ramp-up of the new capacity.
The Company's existing senior indebtedness consists of a $35 million revolving credit facility (of which $18.2 million is currently drawn) and a $25 million Term Loan A (of which $21.875 million remains outstanding), in each case under the Senior Credit Agreement with Pinnacle Commercial Bank, N.A. ("Pinnacle"), dated as of September 12, 2019 (the "Senior Credit Agreement"). Following the closing of the Mezzanine Loan, the Company's total funded debt will be approximately $60,075,000, resulting in total leverage of approximately 4.26x and senior leverage of approximately 2.84x, in each case based on 2020 EBITDA of $14.1 million.
We note that this is Calderwood & Harkness LLP's first financing engagement for Crestline. We have familiarized ourselves with the Company's organizational documents, the Senior Credit Agreement and related security documents, and the Term Sheet, and have conferred with Raymond Cho on the Company's operations, financial condition, and strategic objectives in connection with the Expansion Project. We have also reviewed the Pinnacle consent letter received on March 15, 2021 (the "Pinnacle Consent Letter"), which provides Pinnacle's preliminary consent to the incurrence of subordinated mezzanine indebtedness, subject to the negotiation and execution of an intercreditor agreement acceptable to Pinnacle.
II. Transaction Overview and Capital Structure Summary
A. Transaction Structure
The proposed transaction involves a $20,000,000 subordinated secured mezzanine term loan from Ironwood Capital Finance LLC, a Delaware limited liability company with offices at 600 Lexington Avenue, 22nd Floor, New York, NY 10022. Ironwood is a specialty finance firm focused on mezzanine lending and subordinated debt investments in middle-market companies across the industrial, manufacturing, and business services sectors.
The deal lead at Ironwood is Derek Calloway, Managing Director, who has principal responsibility for credit committee approval, final pricing, and overall transaction strategy. The day-to-day contact for document negotiation and diligence matters is Sarah Yun, Vice President, who has been responsive and professional in our interactions to date.
The Mezzanine Loan will be structurally and contractually subordinated to the Company's existing senior secured credit facility with Pinnacle. In terms of lien priority, Ironwood will hold a second-priority security interest in substantially all of the assets of Crestline and its subsidiary, Crestline Coatings Inc., with Pinnacle retaining its first-priority security interest under the Senior Credit Agreement. The relationship between the senior and mezzanine lenders, including priority of payment, standstill provisions, and remedy limitations, will be governed by an intercreditor agreement to be negotiated among the parties and their respective counsel (discussed in detail as Issue 5 below).
All transaction documents for the Mezzanine Loan will be governed by the laws of the State of New York, as specified in the Term Sheet.
B. Use of Proceeds
The Term Sheet specifies that 100% of the proceeds of the Mezzanine Loan are to be applied to capital expenditures related to the Dayton Plant Expansion. The estimated allocation of the Mezzanine Loan proceeds, together with the Ridgeway equity co-investment, is as follows:
• New 62,000 sq. ft. coating line build-out: Approximately $12.8 million, encompassing design, construction, and commissioning of a new high-capacity coating line at the Dayton facility, including site preparation, structural work, HVAC, and clean room specifications required for food-grade coatings.
• Packaging automation equipment: Approximately $5.7 million, covering the acquisition and installation of automated packaging lines designed to increase throughput and reduce per-unit packaging costs.
• Working capital for ramp-up: Approximately $1.5 million, to fund the incremental working capital requirements associated with bringing the new capacity online, including raw material inventory build, staffing and training costs, and initial marketing and customer qualification expenditures.
The total project cost of the Dayton Plant Expansion is estimated at $28.5 million, to be funded with $20.0 million from the Mezzanine Loan and $8.5 million from an equity co-investment by Ridgeway. We understand from Raymond Cho that Ridgeway's equity co-investment has been approved by the Fund III investment committee and is expected to be funded concurrently with or shortly after the closing of the Mezzanine Loan. Jonathan Hale (Managing Partner, Ridgeway Capital Partners) and Annika Westergaard (Principal, Ridgeway Capital Partners, and Crestline board observer) are the relevant Ridgeway contacts for the equity co-investment and related governance matters.
C. Post-Closing Capital Structure
The following table summarizes the Company's anticipated capital structure immediately following the closing of the Mezzanine Loan:
Key Post-Closing Credit Metrics:
• Total Funded Debt: $60,075,000 ($18,200,000 + $21,875,000 + $20,000,000)
• Total Leverage Ratio: 4.26x ($60,075,000 ÷ $14,100,000 EBITDA)
• Senior Leverage Ratio: 2.84x ($40,075,000 ÷ $14,100,000 EBITDA)
We note that total leverage of 4.26x places the Company at the higher end of the typical range for borrowers seeking mezzanine financing (generally 3.5x to 5.0x total leverage), but the ratio is not atypical for a growth-stage transaction involving a significant capital expansion program. The senior leverage ratio of 2.84x provides meaningful structural protection for Ironwood as a second-lien lender. We expect Ironwood to focus closely on the deleveraging trajectory as the Expansion Project begins generating incremental EBITDA in fiscal years 2022 and 2023.
It is important to note that the PIK component of the Mezzanine Loan interest (discussed in detail in Issue 1 below) will cause total funded debt to increase modestly each quarter, which will have the effect of gradually increasing the total leverage ratio absent corresponding growth in EBITDA. This dynamic should inform the Company's negotiating position on financial covenant levels and EBITDA definitions.
III. Key Negotiation Issues
The following sections address, in order of priority, the principal open negotiation issues that we have identified based on our review of the Term Sheet, the March 3 and March 18 discussions, and our assessment of market practice for comparable middle-market mezzanine transactions. For each issue, we describe: (A) Ironwood's proposed terms, (B) the key concerns from Crestline's perspective, and (C) our recommended negotiating position.
Issue 1: Interest Rate Structure — Cash Pay / PIK Split
A. Ironwood's Proposed Terms
The Term Sheet provides for a total interest rate on the Mezzanine Loan of 10.50% per annum (1,050 basis points), fixed for the entire term of the loan. The proposed allocation between cash pay interest and payment-in-kind ("PIK") interest is as follows:
• Cash Pay Component: 8.00% per annum (800 basis points), payable quarterly in arrears on the last business day of each fiscal quarter.
• PIK Component: 2.50% per annum (250 basis points), compounding quarterly and added to the outstanding principal balance of the Mezzanine Loan at the end of each fiscal quarter.
Based on the initial $20.0 million principal balance, the quarterly cash interest obligation would be $400,000 ($20,000,000 × 8.00% ÷ 4), and the initial quarterly PIK accrual would be $125,000 ($20,000,000 × 2.50% ÷ 4). Total initial quarterly interest would therefore be $525,000, and the annualized total interest obligation in Year 1 would be approximately $2,100,000.
Because the PIK interest compounds quarterly and is added to the outstanding principal balance, the effective principal balance of the Mezzanine Loan will increase over the life of the loan. Assuming no prepayments, by maturity on May 7, 2026 (approximately five years from closing), the compounded PIK interest will have increased the outstanding principal balance to a figure meaningfully in excess of the original $20.0 million. This compounding effect also increases the absolute dollar amount of both cash pay interest and PIK interest in subsequent quarters.
B. Key Concerns for Crestline
Several concerns arise from the proposed interest rate structure:
Near-term cash burden. The cash interest component of $1,600,000 per year (8.00% × $20.0 million) must be serviced in addition to the Company's existing senior debt service obligations under the Pinnacle facilities. During the 18 to 24-month construction and ramp-up period for the Dayton Plant Expansion, the Company will not yet be generating incremental revenue from the new capacity, but will bear the full cash interest burden of the Mezzanine Loan. The Expansion Project is expected to begin generating meaningful revenue contribution in the second half of fiscal year 2022, with full run-rate contribution not anticipated until mid-2023. During the interim period, the combined cash debt service obligations may place meaningful pressure on the Company's liquidity and fixed charge coverage.
PIK compounding and principal accretion. The PIK component, while preserving near-term cash flow, compounds quarterly and results in principal accretion that increases total funded debt over the life of the loan. This has two adverse effects: (i) it increases the ultimate repayment obligation at maturity, and (ii) it gradually compresses the Company's total leverage ratio cushion under the financial covenants (discussed in Issue 4 below), even if EBITDA remains flat.
Market comparability. We have reviewed comparable middle-market mezzanine transactions in the industrial and manufacturing sector for companies with total leverage in the 4.0x to 4.5x range. The 10.50% blended rate is within the market range (which we estimate at 9.50% to 12.00% for credits of this quality), although the allocation between cash pay and PIK is somewhat aggressive relative to comparables, which have typically featured a larger PIK component (3.00% to 4.00%) and correspondingly lower cash pay.
C. Recommended Borrower Position
We recommend the following negotiating position on the interest rate structure:
Accept the 10.50% total rate. The blended rate of 10.50% is within the range of market for middle-market mezzanine financing at the Company's leverage level and credit profile. Attempting to negotiate the total rate below 10.50% is unlikely to be productive given Ironwood's credit committee pricing parameters and the Company's leverage profile, and could create an adversarial dynamic early in the negotiation.
Negotiate for a more favorable cash/PIK split. We recommend proposing one of the following alternative structures:
• Option A (Preferred): 7.00% cash pay / 3.50% PIK. This would reduce the quarterly cash interest obligation from $400,000 to $350,000 and the annual cash interest burden from $1,600,000 to $1,400,000, a savings of $200,000 per year that would meaningfully improve the Company's cash flow position during the ramp-up period.
• Option B (Fallback): 7.50% cash pay / 3.00% PIK. This represents a more modest shift and may be more palatable to Ironwood, while still reducing the annual cash interest burden by $100,000 (from $1,600,000 to $1,500,000).
Alternatively, propose an interest-only holiday. If Ironwood resists any change to the ongoing cash/PIK split, we recommend proposing a six-month interest-only holiday during which all interest would be paid in kind. Specifically, for the first two quarters following closing, the entire 10.50% rate would accrue as PIK interest, with the 8.00%/2.50% cash/PIK split commencing in the third quarter. This approach would preserve approximately $800,000 in cash during the most capital-intensive phase of the Expansion Project.
Emphasize the alignment of interests. The core argument to Ironwood is that reducing the near-term cash burden supports the Company's ability to maintain compliance with the fixed charge coverage ratio covenant and reduces the likelihood of a covenant default during the critical expansion period. A covenant default during expansion would not serve Ironwood's interests, particularly given the standstill provisions that would delay Ironwood's ability to exercise remedies. Additionally, a higher PIK component marginally increases Ironwood's return at maturity through the compounding effect, partially offsetting the reduced current yield.
Issue 2: Prepayment Premium Schedule
A. Ironwood's Proposed Terms
The Term Sheet sets forth the following prepayment premium schedule applicable to voluntary prepayments of the Mezzanine Loan:
The Term Sheet does not expressly distinguish between voluntary and mandatory prepayments in the context of the premium schedule, and is silent on the treatment of prepayments made in connection with a change of control.
B. Key Concerns for Crestline
Sponsor exit flexibility. Ridgeway Capital Partners Fund III, L.P. is a private equity fund with a finite investment horizon. Based on our understanding of the Fund III timeline, Ridgeway may seek to exit its investment in Crestline through a sale of the Company or a refinancing during Years 1 through 3 of the Mezzanine Loan. The prepayment premium schedule creates a meaningful economic friction for such a transaction. A 3% prepayment premium on the full $20.0 million principal amount equals $600,000 in Year 1, declining to $400,000 in Year 2 and $200,000 in Year 3. While these amounts are not prohibitive in the context of a sale transaction, they represent an unnecessary drag on sponsor economics that should be minimized where possible.
Application to mandatory prepayments. If the premium schedule applies to mandatory prepayments — for example, prepayments required from asset sale proceeds, excess cash flow sweeps, or insurance or condemnation proceeds — it could create perverse outcomes. For instance, if the Dayton facility were damaged by a casualty event and the Company were required to apply insurance proceeds to prepay the Mezzanine Loan, the imposition of a prepayment premium on such proceeds would effectively reduce the Company's recovery from the casualty.
Scheduled amortization. If the final MCA includes any scheduled amortization of the Mezzanine Loan (which is not contemplated by the Term Sheet but may be proposed during negotiations), it must be clear that scheduled amortization payments are not subject to the prepayment premium.
C. Recommended Borrower Position
Accept the premium schedule for voluntary prepayments. The 103/102/101/par declining premium structure is standard market practice for mezzanine transactions and is not an issue on which we believe significant negotiating capital should be expended with respect to voluntary prepayments. The schedule is consistent with the majority of comparable transactions we have reviewed.
Exclude mandatory prepayments from the premium schedule. We recommend pushing hard to ensure that mandatory prepayments triggered by insurance or condemnation proceeds and, if applicable, by asset sale proceeds or excess cash flow sweeps, are excluded from the premium schedule entirely or, at minimum, are subject to a reduced premium. The strongest argument applies to insurance and condemnation proceeds, where the prepayment is involuntary from the borrower's perspective and arises from a casualty or government action that impairs the collateral securing the loan.
Negotiate a change of control exception. We recommend proposing that any prepayment made in connection with a change of control of the Company be subject to a maximum premium of 101 (1%), regardless of when during the loan term the change of control occurs. This provides Ironwood with some economic protection while facilitating Ridgeway's exit flexibility. Alternatively, if Ironwood resists this formulation, we could propose that the prepayment premium in a change of control scenario be capped at the lesser of (i) the otherwise applicable premium under the schedule and (ii) 101.
Clarify treatment of scheduled amortization. The MCA should explicitly provide that any scheduled principal amortization payments are not subject to the prepayment premium.
Issue 3: Warrant Coverage
A. Ironwood's Proposed Terms
The Term Sheet provides that, as a condition to closing, Crestline will issue to Ironwood detachable warrants (the "Warrants") exercisable for 2.5% of the fully diluted equity interests of Crestline Packaging Solutions LLC. The key terms of the Warrant as set forth in the Term Sheet are as follows:
• Exercise Price: $1.00 per unit (nominal).
• Anti-Dilution Protections: Customary weighted-average anti-dilution adjustments for stock splits, dividends, and below-market issuances.
• Transfer Restrictions: The Warrants will be subject to customary transfer restrictions, including a right of first refusal in favor of the Company and/or Ridgeway.
• Put/Call Mechanics: Ironwood will have the right to put the Warrants (or the equity interests issued upon exercise) to the Company or Ridgeway upon certain liquidity events, and the Company and/or Ridgeway will have the right to call the Warrants upon repayment of the Mezzanine Loan. Specific put and call pricing and triggering events are to be negotiated.
• Registration/Information Rights: Piggyback registration rights (to the extent applicable) and customary information rights.
B. Key Concerns for Crestline
Dilution impact. The issuance of Warrants for 2.5% of the Company's fully diluted equity will dilute both Ridgeway and management/founders. On a pro forma basis, Ridgeway's ownership would decline from approximately 78.0% to approximately 76.05%, and management/founders' ownership would decline from approximately 22.0% to approximately 21.45%. While the absolute percentage dilution is modest, the aggregate implied value of the warrant position is significant. Based on the Company's 2020 EBITDA of $14.1 million and an assumed enterprise value multiple of 7.0x (consistent with recent comparable transactions in the packaging sector), the implied enterprise value of the Company is approximately $98.7 million and the implied equity value is approximately $38.6 million ($98.7 million less $60.1 million of total funded debt). A 2.5% warrant position would therefore have an implied value of approximately $966,000. The $1.00 per unit nominal exercise price means that this value is effectively granted to Ironwood at closing for minimal consideration.
Authorization requirements. The issuance of new equity interests in Crestline requires analysis under both the Crestline Operating Agreement and the Ridgeway Fund III Limited Partnership Agreement. We need to confirm whether the issuance of Warrants (and the underlying equity interests upon exercise) requires the consent of existing members or the Ridgeway LP advisory committee. Raymond Cho should coordinate with Ridgeway to confirm the necessary authorization requirements and ensure that all required consents can be obtained prior to closing.
Governance implications. The Warrant will create a new class of equity interest holders in Crestline. Ironwood (or any subsequent holder of the Warrants or the underlying equity interests) would acquire certain governance rights under the Operating Agreement, including potentially the right to receive financial information, attend member meetings, and participate in distributions. The governance implications should be carefully assessed and, to the extent possible, limited in the Warrant Agreement and any corresponding amendments to the Operating Agreement.
Put/call mechanics. Ironwood will likely seek a put right exercisable upon a change of control of the Company and potentially at or after the maturity of the Mezzanine Loan. A put right creates a contingent cash obligation for the Company or Ridgeway to purchase the Warrant (or the underlying equity interests) at a price reflecting fair market value, which could be material depending on the Company's performance. A put right at maturity is particularly problematic, as it creates a potential cash obligation at the same time as the bullet maturity of the Mezzanine Loan.
C. Recommended Borrower Position
Reduce warrant coverage. We recommend opening negotiations by proposing warrant coverage of 1.5% of fully diluted equity, with a fallback position of 2.0%. The argument to Ironwood is that the 10.50% coupon (with a significant cash pay component) already provides adequate yield, and that excessive equity dilution is inconsistent with Ridgeway's fund economics and management's incentive structure. We note that warrant coverage in the range of 1.0% to 3.0% is typical for middle-market mezzanine transactions, so a request for 1.5% to 2.0% is well within market range.
Negotiate a higher exercise price. If Ironwood insists on 2.5% warrant coverage, we recommend proposing a higher exercise price that reduces the immediate dilutive effect. Specifically, we would propose an exercise price based on the implied equity value per unit at closing, calculated by reference to a mutually agreed enterprise value methodology (e.g., a multiple of trailing twelve-month EBITDA). Even a modest exercise price — for example, calculated to represent 50% of the implied per-unit equity value — would meaningfully reduce the present-value cost of the Warrant to the existing equity holders.
Co-sale and drag-along rights. The Warrant (and any equity interests issued upon exercise) must be subject to co-sale (tag-along) and drag-along rights consistent with the terms of the Crestline Operating Agreement. This ensures that Ironwood's equity position does not create an impediment to a future sale or other liquidity event initiated by Ridgeway.
Sunset provision. We recommend negotiating a provision under which the Warrants expire unexercised if the Mezzanine Loan is repaid in full prior to its stated maturity date. This provides Ironwood with an incentive to allow the Warrants to serve their intended purpose — as additional yield in the event that the Company does not prepay the Mezzanine Loan early — while rewarding the Company for early repayment. As a fallback, we could propose that the Warrants expire if the Mezzanine Loan is repaid in full within 24 months of closing.
Limit the put right. We recommend limiting Ironwood's put right to a change of control of the Company only, and not permitting a put at or after the maturity of the Mezzanine Loan. The put price should be determined by reference to fair market value as determined by an independent appraiser selected by mutual agreement (or, if the parties cannot agree, by each party selecting an appraiser and the two appraisers selecting a third). The put right should be exercisable only within a limited window following the change of control (e.g., 90 days).
Coordinate with Ridgeway. Prior to finalizing the Company's position on warrant coverage, we strongly recommend that Raymond Cho consult with Jonathan Hale and Annika Westergaard at Ridgeway to confirm that the proposed warrant structure (whether at 2.5% or a reduced percentage) is acceptable from the sponsor's perspective and that any required LP consents can be obtained. The warrant discussion is likely to be a point of significant interest to Ridgeway, and the Company's negotiating position should be aligned with the sponsor's preferences.
Issue 4: Financial Covenants
A. Ironwood's Proposed Terms
The Term Sheet provides for the following financial covenants, each tested quarterly on a trailing twelve-month basis:
(i) Total Leverage Ratio. The Company's Total Leverage Ratio, defined as Total Funded Debt divided by Trailing Twelve Month EBITDA, shall not exceed 4.75x as of the last day of any fiscal quarter.
(ii) Fixed Charge Coverage Ratio. The Company's Fixed Charge Coverage Ratio ("FCCR"), defined as Trailing Twelve Month EBITDA divided by Fixed Charges, shall not be less than 1.15x as of the last day of any fiscal quarter.
(iii) Minimum EBITDA. The Company's Trailing Twelve Month EBITDA shall not be less than $12,500,000 as of the last day of any fiscal quarter.
B. Key Concerns for Crestline
The financial covenant package raises several significant concerns, each of which we discuss below:
Total Leverage Ratio cushion. The Company's post-closing total leverage ratio will be approximately 4.26x against a covenant maximum of 4.75x. This provides a cushion of only 0.49x, which translates to approximately $6.9 million of EBITDA headroom (i.e., EBITDA could decline by approximately $6.9 million, from $14.1 million to approximately $7.2 million, before the 4.75x maximum would be breached, holding total funded debt constant). On a percentage basis, this represents approximately 10.3% cushion, which is below the 15% to 20% cushion that is generally considered adequate for a company undertaking a significant capital expansion project.
Moreover, because the PIK interest component adds to the outstanding principal balance each quarter, the total funded debt numerator of the leverage ratio will gradually increase over time. Based on our preliminary estimates, assuming no prepayments and a constant 2.50% PIK rate, total funded debt will increase by approximately $500,000 in Year 1 and by increasing amounts in subsequent years as the PIK compounds. This will further compress the leverage ratio cushion absent corresponding EBITDA growth.
Expansion period EBITDA risk. During the Dayton Plant Expansion (fiscal years 2021 and 2022), the Company's EBITDA may be adversely affected by several factors, including start-up costs associated with the new coating line, employee training and hiring expenses, temporary production disruptions at the existing facility, and the ramp-up inefficiencies inherent in bringing new manufacturing capacity online. The Company's financial projections (as prepared by Patricia Gallagher, CFO) indicate that EBITDA could dip modestly in fiscal year 2021 and the first two quarters of fiscal year 2022 before the new capacity begins generating incremental revenue contribution. A 10.3% cushion in the total leverage ratio may not be sufficient to absorb these temporary EBITDA pressures.
Minimum EBITDA cushion. The proposed minimum EBITDA covenant of $12,500,000 compares to 2020 actual EBITDA of $14,100,000. This provides a cushion of $1,600,000, or approximately 11.3%. While the absolute cushion may appear adequate, the minimum EBITDA covenant is a particularly blunt instrument during an expansion period because it does not adjust for the temporary dip in EBITDA that may result from expansion-related disruptions. Unlike the leverage ratio, the minimum EBITDA covenant is not affected by changes in the debt balance; however, it is directly exposed to any downward pressure on EBITDA.
Fixed Charge Coverage Ratio. The FCCR covenant of 1.15x is tight by market standards for mezzanine financings, where 1.10x to 1.25x is typical. More importantly, the definition of "Fixed Charges" in the denominator of the FCCR is critical. If "Fixed Charges" is defined to include capital expenditures funded from Mezzanine Loan proceeds (i.e., the Permitted Expansion CapEx), the FCCR could be severely impaired during the construction period. Similarly, if PIK interest (which is non-cash) is included in "Fixed Charges," the covenant will be more restrictive than the economic substance warrants.
EBITDA definition. The definition of "EBITDA" (or "Adjusted EBITDA" or "Consolidated EBITDA") in the MCA will be one of the most heavily negotiated provisions. The Term Sheet does not specify the EBITDA definition in detail. For a company in the specialty chemical coatings industry undertaking a major expansion project, the EBITDA definition must include appropriate add-backs for non-cash charges, non-recurring items, transaction expenses, and expansion-related costs. Additionally, the ability to include pro forma cost savings from the Expansion Project on a forward-looking basis (subject to appropriate limitations) will be important for maintaining covenant compliance during the period before the new capacity reaches run-rate contribution.
C. Recommended Borrower Position
We recommend the following positions on the financial covenant package:
Total Leverage Ratio — step-down structure. We propose a step-down structure under which the maximum total leverage ratio is set at 5.00x for the first eight fiscal quarters following closing (covering the expansion period through approximately mid-2023), stepping down to 4.75x for all fiscal quarters thereafter. This provides the Company with approximately $6.0 million of additional EBITDA headroom during the critical expansion period (i.e., cushion of approximately 17.5% at 5.00x versus 10.3% at 4.75x, based on current EBITDA). In the alternative, if Ironwood resists a higher initial leverage cap, we should negotiate for EBITDA add-backs specifically targeted at expansion-related costs (discussed below), which would effectively increase the cushion without raising the headline covenant level.
Fixed Charge Coverage Ratio — favorable definition. We recommend accepting the 1.15x FCCR level but negotiating a favorable definition of "Fixed Charges" that:
(a) Excludes Permitted Expansion CapEx from the definition of "Fixed Charges," so that capital expenditures funded from Mezzanine Loan proceeds and the Ridgeway equity co-investment do not reduce the coverage ratio;
(b) Excludes any voluntary prepayments of debt from "Fixed Charges," so that the Company is not penalized for elective debt reduction;
(c) Excludes PIK interest from "Fixed Charges," on the basis that PIK interest is a non-cash charge and its inclusion would distort the coverage ratio. Only cash interest payments (and scheduled principal payments, if any) should be included in "Fixed Charges"; and
(d) Ensures that maintenance CapEx is included in "Fixed Charges" only to the extent of actual cash expenditures (not accruals).
Minimum EBITDA — step-up structure. We propose that the minimum EBITDA covenant be set at $11,500,000 for the first four fiscal quarters following closing (covering the anticipated period of greatest expansion disruption), stepping up to $12,500,000 for all fiscal quarters thereafter. The $11,500,000 level provides a cushion of approximately $2,600,000 (18.4%) relative to 2020 EBITDA, which we believe is adequate to absorb the temporary EBITDA impact of the expansion-related disruptions without triggering a covenant default. If Ironwood resists the step-up structure, we should as a fallback negotiate for a broader set of EBITDA add-backs that effectively increase the cushion.
EBITDA definition — customary add-backs. We recommend insisting on an EBITDA definition that includes the following customary add-backs:
(a) Non-cash charges, losses, and expenses (including non-cash compensation expense, depreciation, and amortization);
(b) Transaction expenses incurred in connection with the closing of the Mezzanine Loan and the Expansion Project, including legal, accounting, and advisory fees;
(c) Expansion project costs, including pre-opening costs, training expenses, relocation costs, and other one-time costs directly attributable to the Dayton Plant Expansion, subject to an aggregate cap to be negotiated (we recommend proposing a cap of $2,500,000 over the life of the loan);
(d) Non-recurring items, including restructuring charges, litigation settlements, and other extraordinary items, subject to an annual cap equal to 10% of trailing twelve-month EBITDA;
(e) Pro forma cost savings, operating efficiencies, and revenue enhancements projected to result from the Expansion Project, calculated on a run-rate basis as if such savings had been achieved at the beginning of the relevant measurement period, subject to (i) a requirement that such savings be reasonably identifiable, factually supportable, and expected to be realized within 12 to 18 months, and (ii) an aggregate cap equal to 20% of trailing twelve-month EBITDA before giving effect to such add-backs; and
(f) Losses or charges attributable to force majeure events, casualty losses, and similar extraordinary events, to the extent covered by insurance and for which a claim has been submitted.
Equity Cure Right. We strongly recommend negotiating the right for Ridgeway (or any other existing equity holder) to cure financial covenant defaults by contributing additional equity capital to the Company. The contributed equity would be counted as EBITDA for purposes of recalculating the relevant financial covenant ratio for the test period in which the cure contribution is made. We recommend the following parameters for the equity cure right:
(a) Maximum of two equity cures in any rolling twelve-month period, and a maximum of five equity cures over the life of the Mezzanine Loan;
(b) Each equity cure must be in the form of a cash contribution to the equity capital of the Company (no in-kind contributions or forgiveness of intercompany payables);
(c) The cure contribution must be made within ten business days following the date on which the applicable compliance certificate is delivered (or required to be delivered);
(d) The equity cure right is available only for financial covenant defaults, not for other events of default; and
(e) The amount of any equity cure contribution counted as EBITDA shall not exceed the amount necessary to cure the relevant covenant default (i.e., no "over-curing" that creates artificial cushion for future periods).
The equity cure right is an important safety valve that protects both the Company and Ironwood. It ensures that temporary EBITDA shortfalls during the expansion period do not trigger a default and enforcement cycle that would be value-destructive for all stakeholders. From Ironwood's perspective, the equity cure right provides additional downside protection by requiring the sponsor to invest additional capital in support of the Company.
Issue 5: Intercreditor Agreement — Standstill Period and Payment blockage
A. Ironwood's Proposed Terms (per Term Sheet)
The Term Sheet contemplates that the respective rights and priorities of Pinnacle (as senior lender) and Ironwood (as mezzanine lender) will be governed by an intercreditor agreement (the "Intercreditor Agreement") to be entered into among Pinnacle, Ironwood, and the Company at or prior to the closing of the Mezzanine Loan. The Term Sheet outlines the following key intercreditor terms:
• Standstill Period: 180 calendar days following the occurrence of a default under the Senior Credit Agreement, during which Ironwood may not exercise any remedies against the collateral (including foreclosure, the exercise of lien rights, or the commencement of enforcement proceedings).
• Payment blockage: Pinnacle will have the right to deliver a "payment blockage notice" to the Company and Ironwood upon the occurrence of a payment default or bankruptcy default under the Senior Credit Agreement, following which no cash interest payments may be made on the Mezzanine Loan for the duration of the blockage period.
• Lien Subordination: Ironwood's second-priority security interest in all collateral will be expressly subordinated to Pinnacle's first-priority security interest. Ironwood will not contest, challenge, or take any action inconsistent with Pinnacle's lien priority.
• Turnover Provisions: If Ironwood receives any proceeds from the collateral in contravention of the intercreditor waterfall, Ironwood will be required to turn over such proceeds to Pinnacle.
B. Key Concerns for Crestline
Standstill period duration. The 180-day standstill period is at the longer end of the market range for intercreditor agreements in senior/mezzanine structures. Typical standstill periods range from 120 to 180 days. From Crestline's perspective, a longer standstill period is generally beneficial because it provides an extended period during which Ironwood cannot foreclose on the collateral or take other enforcement actions, allowing the Company and its senior lender to work toward a resolution of any senior default without the additional pressure of a second-lien enforcement action. However, Ironwood may push for a shorter standstill period (e.g., 120 or 150 days) in the markup, and we should be prepared for that discussion.
Payment blockage duration and triggers. The Term Sheet does not specify the precise duration of the payment blockage period or the specific triggers. Market practice is for the payment blockage to be limited to 179 consecutive days in any 360-day period, with a mandatory "unblock" period of at least 181 days following the expiration of any blockage period before a new blockage notice may be delivered. This prevents Pinnacle from indefinitely blocking payments on the Mezzanine Loan through sequential blockage notices. We need to ensure that the payment blockage triggers are limited to payment defaults and bankruptcy defaults under the Senior Credit Agreement, and are not triggered by financial covenant defaults or other non-payment events of default.
Intercreditor agreement form and timing. The Intercreditor Agreement must be agreed among three law firms: Calderwood & Harkness LLP (on behalf of Crestline), Whitfield & Rao LLP (on behalf of Ironwood), and Tavrenis & Lennox LLP (on behalf of Pinnacle, led by partner Margaret Lennox). The target date for agreement on the Intercreditor Agreement form is April 12, 2021. This is an aggressive timeline, and the intercreditor negotiation is often the most time-consuming aspect of a senior/mezzanine financing.
Pinnacle consent letter. The Pinnacle Consent Letter received on March 15, 2021 provides Pinnacle's preliminary consent to the incurrence of subordinated mezzanine indebtedness, but the consent is conditioned on the execution of an Intercreditor Agreement in form and substance satisfactory to Pinnacle. We need to confirm that the Consent Letter does not contain conditions on the intercreditor terms that are more onerous than what the Company anticipates or that would conflict with the terms Ironwood is likely to accept. We are reviewing the Consent Letter in detail and will circulate our analysis separately.
Pinnacle expectations. Todd Brennan, Pinnacle's relationship manager for the Crestline account, has indicated informally in telephone conversations with Raymond Cho that Pinnacle will seek a "no-action" clause in the Intercreditor Agreement prohibiting Ironwood from challenging, contesting, or seeking to prime Pinnacle's liens in any bankruptcy or insolvency proceeding. This is a customary provision from the senior lender's perspective, and we do not anticipate that it will be controversial.
C. Recommended Borrower Position
Accept the 180-day standstill. We recommend accepting the 180-day standstill period as proposed in the Term Sheet. The longer standstill period benefits Crestline by providing maximum time to negotiate with Pinnacle in the event of a senior default, without the risk of a premature second-lien foreclosure. If Ironwood pushes for a shorter period in the markup, we should resist and argue that the 180-day period was agreed in the Term Sheet.
Payment blockage limitations. We recommend the following positions on the payment blockage mechanics:
(a) Payment blockage should be triggered only by payment defaults and bankruptcy defaults under the Senior Credit Agreement. Financial covenant defaults, reporting covenant defaults, and other non-payment events of default under the Senior Credit Agreement should not give rise to a payment blockage right;
(b) The payment blockage period should be limited to 179 consecutive days in any 360-day period;
(c) Following the expiration of any payment blockage period, there must be a mandatory unblock period of at least 181 days before a new payment blockage notice may be delivered;
(d) PIK interest should continue to accrue and be added to the outstanding principal balance of the Mezzanine Loan during any payment blockage period. Only cash interest payments should be subject to blockage. This is critical because Ironwood's return depends in part on PIK accrual, and any restriction on PIK accrual during a blockage period would effectively reduce Ironwood's economic recovery; and
(e) Absent the delivery of a valid payment blockage notice, the Company should be permitted to make all scheduled cash interest and principal payments on the Mezzanine Loan without restriction.
Qualified transferee provision. We recommend negotiating a provision in the Intercreditor Agreement that permits Ironwood to assign its mezzanine position to creditworthy transferees (meeting specified criteria, such as minimum assets under management or institutional investor status) without requiring Pinnacle's consent. This provides Ironwood with liquidity while ensuring that any transferee is a responsible institutional investor.
Coordination with Tavrenis & Lennox. Lisa Morrow will coordinate with Margaret Lennox at Tavrenis & Lennox LLP on the Intercreditor Agreement form. We recommend that Calderwood & Harkness LLP prepare the initial draft of the Intercreditor Agreement (rather than leaving the first draft to Pinnacle's counsel), which will allow us to frame the terms in a borrower-friendly manner from the outset.
Issue 6: Capital Expenditure Limitation
A. Ironwood's Proposed Terms
The Term Sheet provides for the following capital expenditure limitations:
• Annual General CapEx Limit: $8,000,000 per fiscal year for all capital expenditures other than Permitted Expansion CapEx.
• Permitted Expansion CapEx: Capital expenditures of up to $28,500,000 in aggregate during fiscal years 2021 and 2022, limited to expenditures directly related to the Dayton Plant Expansion project.
The Term Sheet does not address carryover of unused CapEx capacity from one fiscal year to the next, the treatment of CapEx funded from insurance proceeds, or the treatment of CapEx funded from equity contributions.
B. Key Concerns for Crestline
Adequacy of the general CapEx limit. The $8.0 million annual general CapEx limit may be restrictive for a company of Crestline's size and in Crestline's industry. With 2020 revenue of $87.3 million, the Company's maintenance CapEx requirements are estimated at 3% to 4% of revenue, or approximately $2.6 million to $3.5 million annually. This leaves only $4.5 million to $5.4 million of the general CapEx basket available for non-expansion growth capital expenditures. Given the dynamic nature of the specialty packaging and coatings industry, the Company may need to invest in equipment upgrades, technology improvements, or facility modifications outside the scope of the Dayton Plant Expansion. An $8.0 million cap could constrain the Company's operational flexibility.
Permitted Expansion CapEx definition. The Permitted Expansion CapEx basket must be defined with sufficient specificity to cover the full scope of the Dayton Plant Expansion, while also providing a reasonable cushion for cost overruns. Construction projects of this magnitude frequently experience cost overruns in the range of 5% to 15%. A basket limited to exactly $28.5 million could require Crestline to seek Ironwood's consent for any expenditure above the original budget, even if the overrun is modest and fully funded from available sources.
Carryover. The absence of a carryover provision means that any unused CapEx capacity in a given fiscal year is forfeited. This penalizes the Company for prudent capital management and creates an artificial incentive to spend up to the cap in each year.
Insurance proceeds. If the Company's equipment or facilities are damaged and insurance proceeds are received to fund replacement or repair capital expenditures, such expenditures should not count against the general CapEx limit. The Company is effectively restoring the asset base to its pre-casualty condition, not making a new investment.
C. Recommended Borrower Position
Propose a higher general CapEx limit. We recommend proposing an annual general CapEx limit of $10.0 million, which provides adequate headroom for maintenance CapEx ($2.6 million to $3.5 million), routine growth CapEx, and the flexibility to respond to market opportunities or regulatory requirements. We would argue that the higher limit is consistent with the Company's revenue base and industry norms.
Carryover provision. If Ironwood resists a higher annual limit, we should negotiate a carryover provision allowing up to 50% of unused CapEx capacity from one fiscal year to be carried forward to the immediately succeeding fiscal year. For example, if the Company spends only $6.0 million against an $8.0 million cap in one year, $1.0 million (50% of the $2.0 million unused capacity) would be added to the following year's basket, creating a $9.0 million limit for that year. The carryover should not be further carried forward beyond one year.
Permitted Expansion CapEx — breadth and cushion. The Permitted Expansion CapEx basket should be defined broadly to encompass the full scope of the Dayton Plant Expansion, specifically including the coating line build-out, packaging automation equipment, and working capital ramp-up costs. We recommend proposing a basket equal to 110% of the estimated project cost, or $31,350,000, to provide a reasonable cushion for cost overruns. This approach is preferable to requiring the Company to seek a waiver or consent for every incremental dollar above the original $28.5 million budget.
Exclusions from the CapEx limitation. The following categories of capital expenditures should be excluded from both the general CapEx limit and the Permitted Expansion CapEx basket:
(a) Capital expenditures funded from insurance proceeds received in connection with a casualty event;
(b) Capital expenditures funded from equity contributions made by Ridgeway or other equity holders;
(c) Leasehold improvements required by applicable law, regulation, or governmental order; and
(d) Capital expenditures required to comply with environmental, health, or safety regulations, to the extent such expenditures are mandated by applicable regulatory authorities.
Issue 7: Collateral and Security Package
A. Ironwood's Proposed Terms
The Term Sheet provides that the Mezzanine Loan will be secured by a second-priority lien on substantially all assets of the Company and its wholly-owned subsidiary, Crestline Coatings Inc. ("CCI"), including the following:
• All equipment, inventory, and accounts receivable of the Company and CCI;
• All intellectual property of the Company and CCI, including trademarks and trade secrets related to coating formulations (the "IP Collateral");
• A second-priority real property mortgage on the Company's Dayton facility located at 4510 Harshman Road, Dayton, OH 45424, subordinate to Pinnacle's existing first-priority mortgage;
• A pledge of 100% of the membership interests in CCI (Ohio corporation, Ohio Secretary of State Filing No. 4389201, EIN 31-2093417); and
• UCC-1 financing statement filings with the Ohio Secretary of State, and recordation of the second mortgage with the Montgomery County, Ohio Recorder's Office.
B. Key Concerns for Crestline
intellectual property collateral. The Company's coating formulation trade secrets are among its most valuable assets and are core to its competitive position in the food and beverage coatings market. The granting of a security interest in the IP Collateral raises several concerns. First, to the extent that the security agreement requires the Company to describe its trade secrets in a collateral schedule, there is a risk that such disclosure could impair the trade secret status of the information under Ohio law (Ohio Revised Code § 1333.61 et seq.) or the federal Defend Trade Secrets Act (18 U.S.C. § 1836). The collateral schedule should describe the trade secrets in general terms sufficient to identify the category of intellectual property without disclosing specific formulations or other confidential technical information. Second, in an enforcement scenario, if Ironwood were to foreclose on the IP Collateral and transfer it to a third party, there is a risk that the acquirer could fail to maintain adequate trade secret protections, resulting in the loss of trade secret status and the competitive advantage it confers.
CCI pledge. The pledge of 100% of the membership interests in CCI creates a potential pathway for Ironwood to gain control of CCI through an enforcement action. While the second-lien position and the Intercreditor Agreement standstill provisions mitigate this risk, the Company should ensure that the pledge is expressly subordinated to Pinnacle's rights and that any enforcement of the pledge is subject to the standstill and other provisions of the Intercreditor Agreement.
Pinnacle consent. The Senior Credit Agreement with Pinnacle may contain negative covenants restricting the Company's ability to grant liens on its assets to third parties. The March 15, 2021 Pinnacle Consent Letter should address this issue, but we need to confirm that the consent is not limited or conditional in a manner that could create complications. Specifically, we need to confirm that Pinnacle's consent permits the granting of second-priority liens on all categories of collateral contemplated by the Term Sheet, including the real property mortgage and the CCI pledge.
IP schedule preparation. As a practical matter, the Company will need to prepare a comprehensive schedule of its trademarks, service marks, and other registered intellectual property for inclusion in the Security Agreement. Raymond Cho should coordinate with the Company's intellectual property counsel (if any) to compile this schedule. We note that the trademark schedule should include all federal and state trademark registrations and pending applications, together with registration numbers, dates, and jurisdictions.
C. Recommended Borrower Position
Accept the collateral package generally. The second-lien collateral package described in the Term Sheet is generally consistent with market practice for subordinated mezzanine loans. The scope of collateral (substantially all assets, including real property and equity interests in subsidiaries) is standard and is unlikely to be a productive area for significant pushback. Ironwood will expect the same collateral package as Pinnacle, albeit on a second-priority basis.
IP protections upon enforcement. We recommend negotiating the following protections with respect to the IP Collateral:
(a) The Security Agreement should include a covenant by Ironwood (and any successor or assignee) to maintain the confidentiality of all trade secret information included in the IP Collateral and to take all steps necessary to preserve the trade secret status of such information;
(b) In any enforcement proceeding, any transferee of the IP Collateral must agree, as a condition of the transfer, to be bound by confidentiality obligations no less protective than those applicable to the Company;
(c) The collateral schedule for trade secrets should describe the relevant intellectual property in general categorical terms (e.g., "proprietary coating formulations for food-grade packaging applications") without disclosing specific formulations, processes, or technical data; and
(d) Ironwood should agree that it will not license, sublicense, or otherwise transfer any rights in the IP Collateral prior to an enforcement event.
CCI pledge subordination. The pledge of CCI membership interests should be expressly subordinated to Pinnacle's rights under the Intercreditor Agreement, and any enforcement of the pledge should be subject to the standstill provisions discussed in Issue 5.
Filing and recording costs. We recommend proposing that Ironwood bear the cost of the title search, the Montgomery County mortgage recording fees, and the Ohio Secretary of State UCC-1 filing fees, or, if Ironwood resists, that the parties agree to split such costs evenly. These costs are relatively modest but should be allocated clearly in the closing checklist.
Issue 8: Origination Fee and Closing Costs
A. Ironwood's Proposed Terms
The Term Sheet provides for the following fees and cost allocations:
• Origination Fee: 2.00% of the principal amount of the Mezzanine Loan, equal to $400,000, payable at closing. The Term Sheet indicates that the origination fee will be netted from the funding wire, resulting in a net funding amount of $19,600,000.
• Lender's Counsel Fees: The Company is responsible for payment of all fees and expenses of Ironwood's counsel, Whitfield & Rao LLP, in connection with the negotiation, documentation, and closing of the Mezzanine Loan.
• Third-Party Costs: The Company is responsible for all third-party costs incurred in connection with the closing, including title search fees, mortgage recording taxes and fees, UCC filing fees, appraisal costs, and environmental assessment fees.
B. Key Concerns for Crestline