With the primary leveraged loan markets plagued by volatility in the US and China, trouble in the oil and gas sector, and uncertainty caused by a potential Brexit, arrangers' focus has been firmly on the market flex provisions in their fee letters.
Market flex allows arrangers to change the pricing, terms or structure of underlying senior debt instruments to increase the prospects of a successful syndication. We surveyed 10 European senior term loan transactions in the upper-mid cap to large cap markets that our clients and/or ourselves were involved in during Q1 2016. Below we enclose an overview of our findings.
First things first
In order to exercise its flex rights, an arranger must first demonstrate through consultation with the financial sponsor that the facilities cannot be syndicated on their original terms, and that flex is necessary or desirable to enhance the prospects of a successful syndication (normally defined by a specified reduction in the arrangers' hold levels).
In practice, this will be determined by reference to investor feedback and the arrangers themselves will be expected to have shared the sponsor's pain by paying away some of their fees to the market to further entice potential syndicate members.
Margins on those transactions surveyed tended to settle between 475-550 bps with average OID (original issue discount) at 97 and average incremental increase in yield during the syndication process running to 0.6%.
The majority of the deals surveyed also saw an increase or introduction of a LIBOR/EURIBOR floor during the syndication period of up to 100 bps, with many flex provisions permitting floors of up to 125 bps if required.
In 70% of the surveyed transactions, some level of flex was applied to the key documentary terms in response to investor feedback, the most common being:
- an extension of the 101 soft call period from 6 to 12 months;
- removal of the MFN (most favoured nation) sunset language which affords time-bound yield protection to existing lenders in cases where an incremental facility is subsequently entered into by the borrower group; and
- a reduction in the ratio debt basket for incurrence of additional indebtedness of 0.25x EBITDA.
Less common but still exercised in 20% of the transactions we surveyed were:
- the deletion of one or more step-downs in the margin ratchet provision;
- the introduction of an additional excess cash-flow sweep of 75% at a pre-determined leverage level; and
- the introduction of quarterly investor calls.
The amount of flex applied is typically restricted such that its cumulative effect should not result in an increase to the weighted average cost of funding to the group in excess of a specified threshold. This threshold varied materially between different transactions.
Structural flex, i.e. the reallocation of commitments between different tranches of secured debt in the capital structure (usually subject to an agreed cap), was also provided for in each of the surveyed transactions, including those with a bond element.
Reverse flex and post-flex considerations
Reverse flex, i.e. the ability of arrangers to reduce pricing (primarily the margin) on the senior facilities in the event of a material oversubscription, remains a common feature in leveraged finance transactions. Arrangers have typically been able to negotiate a one-off incentive fee of the first full year's cost saving as a result of any consequential reduction in the margin. Given market conditions, exercise of reverse flex has generally been less common so far this year.
In the transactions we reviewed, arrangers were bound post-flex to amend the financial ratios in the loan documentation to reflect any higher costs of borrowing or any increased indebtedness resulting from operation of the market flex provision.
The direct lenders
In the non-distribution-focused direct lending market, we have started to see certain flex rights being requested by strong credit providers, particularly where parties expect a long lead time between signing and closing. In particular, upward margin flex rights have been sought in cases where there has been a material or sudden downward movement in the iTraxx European leveraged loan index prior to financial close.
We expect flex rights to continue to be one of the most carefully negotiated features in leveraged loan documentation with arrangers further developing innovative ways to mitigate potential distribution risk.