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Cash Sweep
Practical Law Glossary Item 6-583-0486 (Approx. 3 pages)
Glossary
Cash Sweep
In finance transactions, this refers to the use of a borrower's excess cash to prepay its loans. It is called a cash sweep because the cash is taken or swept from the borrower's bank accounts and applied to pay down debt. Some bank accounts such as sweep accounts and zero balance accounts are specifically designed to effectuate cash sweeps, by regularly transferring the funds held in them to an account under the lenders control or in its name. Excess cash is generally the amount remaining after the borrower's operating costs and regular debt service have been paid. A cash sweep provision reduces the outstanding balance of the borrower's loans and, consequently, the lenders' exposure to the borrower.
Benefits of a cash sweep include:
- Potentially making it easier for the borrower to:
- refinance the loans because of the lower outstanding balance; and
- satisfy any financial ratios set out in the loan documents (for example, a leverage ratio, a debt service coverage ratio or a debt to equity ratio).
- Enabling the lenders to benefit from any upside in the borrower's financial performance. If the borrower performs better than expected, the lenders are repaid on an accelerated basis.
A transaction may include a cash sweep provision:
- If the borrower's cash flow is volatile or uncertain (for example, a merchant power plant). Applying the project's excess cash in good years to reduce the debt acts as a buffer against those years when the project's revenues may be lower.
- As a concession to the lenders to convince them to lengthen the tenor of the loans. For regulatory or internal policy reasons, some lenders may not want to make loans in excess of a certain number of years. However, they may be willing to do so if the transaction includes a broad cash sweep mechanism that effectively reduces the loan term.
Loan agreements typically stipulate a percentage of the borrower's excess cash that must be applied to prepay the loans. The specified percentage is a matter to be agreed by the parties. For example, in a project financing, the parties typically agree that 100% of the excess cash will be applied to prepay the project's senior debt. The agreed percentage may be significantly lower in more liquid credit markets when borrowers can negotiate looser covenants and more borrower-friendly financial terms. For example, the borrower and the lenders may agree that:
- They share the excess cash, where a percentage is applied to prepay the loans and the remainder is retained by the borrower. In a project financing, this amount is typically distributed to the project sponsor in the form of a dividend. This may be in addition to any agreed distribution amount.
- The borrower prepays the senior loans up to a certain amount.
These borrower-friendly provisions generally only apply in the absence of a default under the loan documents. Following a default, the amounts that are otherwise retained by the borrower are used to prepay the loans or, in some transactions, are deposited into a segregated account and paid to the borrower once the default is cured. If the default is not cured within a reasonable time, the segregated funds may be used to pay down the debt.
For more information on the cash sweep, see Practice Note, Financial Covenants: Project Finance Transactions.