Recent years have been marked by low interest rates and a highly liquid loan market, creating a very favorable environment for leveraged loans used to fund mergers and acquisitions, sometimes in conjunction with large one-time dividend payouts. As a result, liquidity has increased and borrowers have been successful in expanding the scope of and in adding new features to incremental loan facilities (also called an “accordion”).
Generally, an incremental facility allows a borrower to add another term loan tranche or to increase revolving commitments. The benefit to the borrower is obviously the easy access to additional liquidity already pre-approved by the existing group of lenders.
Traditional incremental facilities - typical terms and conditions
Traditional incremental facilities are generally made available to borrowers within the confines of the existing credit agreement and require incremental lenders not already a lender to become a party to the existing credit facility. While these facilities usually have a cap, a very limited number of large-cap facilities provide for unlimited incremental facilities. Typical conditions for these loans include:
- Pro forma compliance with the existing (or adjusted/ improved) financial covenants
- A maximum amount of the total incremental debt
- A maximum number of times the incremental facility may be used
- Customary closing conditions
- The absence of a default or event of default, and the accuracy of representations and warranties
These incremental loans typically:
- Mature at or before the existing maturity date and may share pari passu in the collateral of the existing loans or be junior to them.
- Contain, as to pricing, a so-called most favored nation clause, effectively tying the pricing of the existing debt to the pricing of the new debt. Thus, if the pricing of an incremental loan is higher than for the existing loan, the interest rate margin on the existing loan will be adjusted. Typically, the adjustment will be expressed in a specified number of basis points (usually 50) less than the rate on the incremental loan.
Traditional incremental facilities - addition of SunGard language
Recently, term sheets providing for incremental facilities, which are permitted to be used for future acquisitions, have added so-called “SunGard” language, effectively allowing the borrower to limit the closing conditions of the incremental loan. Recall that, out of a concern for deal certainty, buyers started requesting SunGard language (also called a “certain funds” provision) at the commitment letter stage. This provision limits:
- The closing conditions to conditions precedent specifically listed, typically in an annex to the commitment papers
- The representations and warranties required to be true at closing to those set forth in the acquisition agreement and a narrow set of additional “specified representations”
- The specified representations typically encompassing corporate governance issues (from existence, power and authority to due authorization), compliance and regulatory issues (anti-terrorism laws, margin regulations and compliance with the Investment Company Act of 1940, for example), as well as validity of the loan and security documents
Further, with respect to collateral at closing, the certain funds provision allows the borrower to only deliver UCC 1 financial statements for filing, documentation sufficient to enable a stock pledge to be perfected and, under some circumstances, intellectual property filings to be made. All other items needed to perfect the lender’s security interest can be delivered post-closing within a specified time period allowing for a smooth closing of the M&A deal concurrent with the financing.
This addition to the conditions of an incremental loan facility effectively turns the accordion feature into a true option for financing a follow-on acquisition, which should be a very attractive feature for sponsor-led deals.
“Sidecar” incremental facilities
Large-cap borrowers have been able to push the envelope and are now sometimes permitted to incur incremental loans outside of the existing credit facility. The obvious benefit of this structure for the borrower is the potential to negotiate better terms with a new lender or new group of lenders.
To make this provision work smoothly in its implementation phase, it is prudent for both the borrower and the agent to draft a form of intercreditor agreement that can be attached to the original credit agreement and that would be required from each incremental lender. While not all facilities with sidecar incremental facilities also have an intercreditor agreement, it is a helpful tool, on the one hand, to manage the increased risk for existing lenders who now have new lenders competing for the same collateral, and on the other hand, for the borrower to ensure the smooth addition of a new incremental lender, thus avoiding the need to negotiate a new intercreditor agreement.
Considerations for 2015
A renewed regulatory focus on the leveraged loan industry may have an impact on incremental facilities and other terms in leveraged loans in 2015. The Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp revised their 2013 Interagency Guidance on Leveraged Lending, which generally outlines principles of leveraged lending with the goal of avoiding systemic risk to the financial industry.
Some of the requirements contained in the guidance speak to the absence of “meaningful” financial covenants, the fact that leverage should not exceed six times EBITDA or the ability of a company to pay off at least half its debt within five to seven years. While the regulators state that these requirements are not “a bright line,” one can expect the market to react in order to respond to the risk factors identified by the regulators.
- First, lenders’ and investors’ demand for leveraged loans may decrease as today’s widespread borrower-friendly terms and higher leverage ratios may come under increased scrutiny in the future.
- Second, that increased scrutiny may lead lenders to reconsider the loan terms they can offer borrowers. One can expect that the bargaining power borrowers have enjoyed in the leveraged loan market in the past will be reduced as banks have to face the renewed regulatory scrutiny.
In particular, provisions impacting leverage are likely to be scrutinized. Incremental loans, for instance, increase leverage and may consequently be the subject of debate in the leveraged loan market. Similarly, regulators’ concern regarding a borrower’s ability to repay a loan within a certain time frame may push lenders to revisit their repayment terms. This could trigger an increase in scheduled amortization payments, as well as mandatory prepayments with excess cash flow.