First published in LexisPSL Banking and Finance Mini-Mag: Autumn 2018 as distributed at the Loan Market Association Conference 2018
Many investors have voiced concerns in recent months that loan documentation terms have become so flexible in favour of sponsor-backed borrowers that they may lack key lender protections.
Faced with such terms, lenders' focus has centered on the following fundamental principles: how much secured debt can be added to this deal going forward? How can I get to the table should things go wrong? Can I trade out if I need to?
In that context, we summarise below some of the hot topics in today's market.
Financial covenants. Whilst cov-lite deals remain less common in the European mid-market space, most deals, with the exception of the lower end of the market, are now coy-loose and rely on a sole leverage test. However, investors are concerned about continued erosion of the benefit of that financial test citing demands for high headroom levels coupled with generous EBITDA add-backs, including synergies, incorporating FD nominated proforma adjustments and requests for 12 to 18 month covenant holidays. It is not uncommon to hear the view that "some covenants are not worth the paper they are written on".
Some query whether lenders are being adequately compensated for this erosion compared to the higher margins carried by cov-lite loans. Lower mid-market deals do still tend to get two or more maintenance tests and generally less aggressive terms.
Ability to incur debt. Almost every deal contains an incremental/ accordion facility, which is often uncapped (other than by reference to opening leverage), generally available over the life of the transaction and commonly without a right of first refusal for existing lenders. MFN protections are also being eroded, with sunsets filtering down into the upper end of the mid-market and economic controls on occasion only applying to the margin and not any related fees.
As well as allowing the business to gear back up to opening leverage, the accordion feature means lenders risk having their vote diluted and losing the level of control they benefitted from on day one. As companies lever up and amortising debt becomes the exception, lenders can no longer always rely on there being a cash sweep to provide some comfort, though some funds would prefer to have their money put to work than de-risking via such prepayments anyway.
It is vital to do full diligence. To be able to agree to the levels of flexibility being demanded by sponsors, lenders have commented that they have to be comfortable that the business is sound and supported by a good equity cushion to ride any downturn. Of course, the initial sourcing of deals which constitute solid credits is the hardest part. At the Debtwire European Mid-Market Forum earlier this summer, one panellist commented that last year his fund only proceeded with 2.8% of the deals that they looked at.
Once their initial diligence is done, lenders also have to contend with fewer controls around Permitted Acquisitions which have the potential to change the nature of the credit. Businesses can now make acquisitions in a broader range of jurisdictions than before, which can have a knock-on effect on the quality of the guarantee and security package the lenders receive. Sponsors also benefit from greater flexibility regarding sources of funding for acquisitions and the ability to acquire businesses with negative EBITDA and contingent liabilities. If acquisitions are capped other than by reference to opening leverage, non-cashflow items will often be carved out of such baskets.
Transferability. Sponsors continue to demand fetters on loan transferability. Borrower consent rights for sales (other than to other lenders and affiliates and to white-listed institutions) prior to an event of default have become the norm. Such consent rights will often now survive the occurrence of events of default with the exception of non-payment, financial covenant breach (which itself is subject to wide equity cure rights) and insolvency. Common too, are blanket prohibitions on sales to "competitors" (often defined extremely widely) and "distressed funds". These fetters are also usually extended to sub-participations and other transfers of economic value, though predominantly to those pursuant to which voting rights transfer.
Investors have commented that much of the documentation flexibility would be more palatable if they could at least freely transfer out of the investment should they no longer like the credit. After all, many of the terms being demanded by sponsors originate in the US market or the high-yield bond market where the debt is more freely transferable.
Several panellists from the Debtwire conference stressed that it is vital for investors to stay disciplined and to walk away from those deals where terms are just too aggressive for comfort. However, the reality remains that in a market awash with liquidity, there remains appetite to tolerate such terms for the right credit.