As we discussed in a prior newsletter, the evolving landscape for regulated financiers under the Leveraged Lending Guidance1 promulgated by the Federal Reserve Board, FDIC and OCC has increased uncertainty for regulated institutions in certain lending markets. Arranging the financing for private equity sponsors for their LBOs of middle market companies is one area where unregulated arrangers have increasingly stepped in, as regulated entities continue to work their way through the evolving regulatory environment. As the activity of alternative financiers increases in this space, issues arising under the types of financings they commonly provide become more prominent and of increasing concern to the overall market. One such financing structure, the unitranche facility, has become more common with the increased role of alternative financiers, with whom the structure originated. This structure presents certain unique issues of which private equity sponsors should be aware.
Agreements Among Lenders – Should Borrowers Mind Their Own Business?
Unitranche facilities combine a first-lien loan and second-lien loan into a single facility, enabling the arranger to offer its private equity client a simpler debt arrangement, with a single set of operating covenants for the acquired business and a single set of conditions for closing the financing. A traditional first-lien financing coupled with a second-lien financing, on the other hand, would ordinarily contain two complete sets of documentation. A classic unitranche facility features a single class of lenders and a single administrative agent for the lenders, simplifying things from the borrower’s perspective as compared with a typical first-lien and second-lien financing with two distinct classes of lenders, each with its own agent. The classic unitranche structure further distinguishes itself by replacing the first-lien/second lien intercreditor agreement, by which the borrower would be bound, with an agreement among lenders, to which the borrower is not a party and would not be privy. The agreement among lenders, as its name implies, governs how lenders divide themselves up into first-out and last-out classes, how they apportion interest and fees among themselves, and how they vote and act on numerous matters, while not presuming to affect or bind the borrower in any way.
There has been growing unease among private equity sponsors with respect to the unknown terms contained in agreements among lenders. There has also been a growing trend for private equity sponsors to request and even demand to see the agreement among lenders, both as it is finalized and as it is being negotiated, even when the borrower is not a party to the agreement and is not even requested to be bound by it. This article will explore certain issues facing private equity sponsors in this regard.2
What might interest a borrower in connection with an agreement among its unitranche lenders? After all, if the borrower is not being asked to become a party to the agreement, or even to acknowledge it, then why should it care about its terms?
Consider a situation in which a borrower may, down the road, wish to ask its lender group for some waiver or amendment in respect of an operating covenant under its credit agreement. Typically the credit agreement itself will specify the level of lender approval required. From the borrower’s vantage point, that will govern the voting issue. But not so fast. Under the agreement among lenders, the lenders, as among themselves, will be bound by additional requirements regarding such voting. For example, they may have agreed that certain matters require a majority of each of the first-out and last-out groups into which the lenders have divided themselves under the agreement among lenders, unbeknownst to the borrower. Borrowers and private equity sponsors, who are often proactive in reaching out to lenders to test the waters and assess the likelihood of lender approval for particular amendments they are considering seeking, are obviously interested in knowing precisely whose consent would in fact be needed in such a situation.
Now consider a situation perhaps a bit further down the road, involving a possible future deterioration in the performance of the portfolio company and a looming workout scenario for the secured debt under the unitranche facility. The private equity sponsor, the borrower and their counsel in such a scenario will need to carefully consider a range of options that can satisfy the lenders and their concerns, while preserving for themselves as much value as is feasible under the circumstances. In order to do this effectively, the interests and perspectives of the debt stakeholders need to be well understood. That the lenders have divergent interests because they are split into separate groups, as they typically would be under the agreement among lenders, and the details of their arrangements, would be highly relevant to the sponsor and borrower in formulating their strategy and achieving an optimal outcome.
As another example, suppose the combined unitranche debt principal amount is US$100 million and the assumed valuation range of the blanket lien covering the borrower’s assets is US$80-90 million. The types of proposals the sponsor and borrower would make could be quite different if the first-out and last-out lender groups were each US$50 million, as opposed to, say, if the first-out group were US$75 million and the last-out group were US$25 million. In the first case, the first-out group is well oversecured, while the last-out group is partially undersecured. In the second case, the first-out group is still oversecured (even if not by much), but the last-out group is grossly undersecured, and may well require a different approach in light of the different facts. The sponsor and borrower are of course aware at the outset that these future scenarios are possible, and should do what they can to ensure that they will have the information in hand, in order to facilitate their handling of such situations should they arise. This can be achieved by a private equity sponsor’s continuing the current trend and insisting that it be kept apprised of the terms of the agreement among lenders as it is being prepared and finalized by the lenders. Similar considerations apply to subsequent amendments by the lenders of the agreement among lenders, although amendments to such agreements will be far less common.
Leveraged Lending Guidance – Complicating Clarifications?
The Federal Reserve Board, FDIC and OCC jointly hosted a conference call for regulated institutions under the Leveraged Lending Guidance in late February, in order to clarify certain interpretive issues under the Guidance, which frowns on debt arrangements featuring senior or overall leverage levels above certain limits. But some of the information given seems to have raised as many questions as were answered.
For example, as has been reported,3 regulators affirmed that debt baskets in credit agreements, as well as accordion and sidecar facilities provided for under such agreements, must be included when figuring leverage levels for purposes of the Guidance. But what does it really mean to include debt baskets for this purpose? Suppose the debt basket contains incurrence tests that are as yet not satisfied. Such debt shouldn’t be includable, one would suppose, so long as the conditions to its utilization are not met. One would imagine that the debt baskets regulators had in mind were more of the unconditional, fixed-amount variety. Presumably the regulatory intent was to charge the borrower with the full fixed basket amount, whether or not it has been utilized, since the borrower has the unfettered right under the credit agreement to utilize it. There is certainly a logic to that, despite the fact that it puts the leverage calculation for such regulatory purposes at odds with the calculation under most credit agreements themselves and traditional methodology, which typically limit leverage calculations to actual leverage employed (except when calculating leverage on a pro forma basis for a particular purpose).
But what would one then say about common debt baskets for items such as capital lease obligations or for net amounts owing under permitted hedging arrangements? Would the maximum allowed capital lease obligation amount be includable within the borrower’s “leverage” even if the borrower had no capital leases and no such obligations? And how about if it had chosen not to hedge certain exposures that it had the right to hedge? Would it somehow be charged with debt in some amount if prices were moving the wrong way on the type of hedging contracts it had the right to employ? And if so, what would the amount be?
The above examples illustrate some of the difficulties facing regulated arrangers of leveraged loans in attempting to fix leverage levels tied not to actual leverage (or to pro forma leverage based on a concrete proposal) but, instead, tied to hypothetical leverage that assumes full utilization of unutilized debt baskets in loan agreements. Similar issues would arise in the context of accordion and other incremental facilities.
If unutilized debt baskets raise the above concerns, then it would seem that affirmative consents sought from a regulated entity, such as an administrative agent that is an affiliate of a regulated arranger of a credit facility, would present an easier case. An administrative agent may commonly be asked by a borrower to coordinate approval and execution by lenders of a particular amendment or waiver of a term in an existing loan agreement. And yes, in fact the Guidance will indeed be applied, according to the regulators, to any modification of an existing credit facility4 (and not only to changes that would increase debt levels or allow the borrower to dispose of cash-producing assets or collateral generally).
The reach of the Leveraged Lending Guidance is thus potentially quite long, and can affect even unregulated arrangers contemplating involvement with a borrower that already has a credit facility in place arranged by a regulated institution. Even where a new facility would fit within existing debt baskets and would require no changes to the existing credit facility, even the need to just put in place intercreditor arrangements with existing creditors could potentially raise issues for certain existing regulated entities under the Guidance, as they consider proposals relating to the disposition of shared collateral or of other cash-producing assets of the borrower.
Also of note was the regulators’ clarification on the conference call that adjustments to EBITDA, which effectively reduce leverage ratios under credit documentation, will be scrutinized and not automatically accepted by regulators in determining compliance with leverage tests under the Guidance. The regulators said they would expect such adjustments to be supported by third party diligence as to appropriateness, and would in any event deem adjustments that are “too large” in total as red flags for criticism.
It is important that private equity sponsors be aware of the evolving market environment so that they are not handicapped as they try to make the most of market opportunities.