Hot documentation topics: H1 2017

This Practice Note produced in partnership with Neil Grant summarises key trends affecting the leveraged finance market during the first half of 2017 and explains how loan documentation has evolved in response to those trends.

Key trends

Loan pricing

2017 has seen European Term Loan B (TLB) price at the lowest yields since the credit crunch and, importantly, lower than both high yield bonds and US. TLBs. Several factors have created a significant imbalance between the supply and demand for loan assets:

  • The European collateralised loan obligations (CLO) market has recovered strongly in recent years. As issuance has expanded, CLO pricing has contracted which, in turn, drives pricing contraction in the institutional loan market.
  • New participants, such as open-ended funds and managed accounts, have been attracted to invest in leveraged loans due to their status in the capital structure and relative value compared with other assets.
  • Finally, the leveraged finance market remains a lucrative source of revenues for underwriting banks. Most market participants have repaired any legacy issues and are back in 'risk-on' mode. The underwriting market is as competitive as it has ever been with investment banks challenged by rising targets, national banks keen to defend market share in their local jurisdictions and new entrants and direct lenders seeking to win market share for larger transactions

The downward pricing pressure has resulted in activity thus far in 2017 being dominated by loan repricing transactions, add-on facilities and recapitalisations.

Loans are back in vogue

During 2017 to date, attractive loan pricing has driven many borrowers to finance large transactions exclusively through the loan markets. Some high profile transactions even dropped anticipated bond tranches due to the demand for, and pricing of, their loan tranches. A number of borrowers who previously financed themselves through the bond market have even begun to move back to the loan market, unwinding the momentum in favour of bond financings that began around 2011/12.

Other factors which make institutional term loans very attractive to borrowers include:

  • the acceptance of covenant lite terms plus bond-style negative covenants, which together give borrowers all the operational flexibility of a bond financing;
  • no meaningful call protection under an institutional term loan;
  • the flexibility to reprice loans quickly and cheaply as market conditions evolve;
  • cheaper and quicker execution;
  • contractual control over syndicate composition; and
  • private financial reporting

Best efforts financings

Many of the repricings, add-ons and recapitalisations have been arranged on a best efforts basis, rather than being underwritten. Since arranging banks do not commit to an underwrite they may take a lighter touch to documentation negotiations, reasoning that the market should identify and resist any terms it perceives as egregious. Coupling this approach with intense competition between arrangers and a perception (rightly or wrongly held) that institutional investors are less focused on documentation than banks has resulted in a notable erosion of documentary protections.

Impact on loan documentation

Given the prevalence of repricing transactions and the speed at which pricing has compressed, economic terms and provisions facilitating repricing have been in focus.

Refinancing Indebtedness

Most repricings are implemented by creating an additional facility (carrying the lower margin) under the borrower’s existing facility agreement and inviting existing lenders to roll their participation in the existing facility into the additional facility on a cashless basis. Existing lenders may also offer 'new money' commitments under the additional facility, which can be drawn to repay lenders who do not roll all their participation into the additional facility.

The key to executing a repricing quickly is to have the flexibility to insert the additional facility into the facility agreement without lender consent. Documents for many top-tier sponsors include a 'Refinancing Indebtedness' concept. The premise is that because a refinancing is leverage neutral (and credit enhancing given the reduced funding cost), no lender consent is required to incur indebtedness that refinances existing indebtedness.

However, if additional facility incurrence has been restricted or limited by a fixed € basket or leverage ratio test set below current leverage, borrowers have required lender consent for the additional facility. That has seldom been an issue given recent conditions but a borrower who has reviewed its documents and discovered it requires a waiver or consent under the 'Structural Adjustment' definition is likely to include a Refinancing Indebtedness concept in future.

Margin ratchets

With borrowers focused on all aspects of pricing, the margin ratchet has also been eroded. It used to be well entrenched that:

  • the opening margin applied for 12 months before the margin grid took effect; and
  • the borrower could only profit from one step down per quarter date (even if reported de-leveraging justified more than one step down according to the grid)

For large transaction the one step down restriction was jettisoned long ago but, increasingly, the duration for which the opening margin applies has reduced. In some deals, the opening margin only applies until the first quarter date following closing, which could be a matter of days.

Traditionally, whilst an event of default continued the margin would revert to the highest level on the grid (reflecting the increased credit risk in a default scenario). However, strong borrowers have recently successfully negotiated that margin reversion only applies whilst payment or insolvency-related events of default continue.

LIBOR floors

LIBOR floors serve two purposes:

  • if set at 0%, they protect lenders against the risk of negative LIBOR rates; and
  • if set above 0%, they enhance an investment’s yield to investors

LIBOR floors above 0% are not necessary for most borrowers in current market conditions. Reducing legacy floors has been a component of repricing exercises for affected borrowers. Most deals do retain a 0% LIBOR floor to protect lenders against margin erosion fur to negative funding rates. It remains to be seen whether the 0% floor will also come under pressure. Some investment grade borrowers have negotiated facilities which floor the aggregate of LIBOR plus margin, which could seep into the leveraged finance market if borrower-friendly conditions endure.

Soft call

'Soft call protection gives TLB investors a degree of protection against repricing of their investment and the risk of being repaid from the proceeds of a cheaper financing (often defined as a 'Repricing Event'). If a transaction qualifies as a Repricing Event the borrower must pay lenders a modest prepayment fee (usually 1% of the prepaid principal). Typically TLB tranches benefit from a period of soft call protection; 12 months post-closing was once common, but 6 months is increasingly standard.

As always, the devil is in the detail and many sponsors have chipped away at the 'Repricing Event' definition to curtail the soft call’s application. It is now usual that soft call protection is excluded in the following situations:

  • following a change of control, listing or 'transformative acquisition' (being an acquisition that is either prohibited by the facility agreement or permitted but, following which, the borrower determines it does not have sufficient operational flexibility);
  • if the prepayment is financed from proceeds of a financing other than a broadly syndicated term loan that is similar to the refinanced facility (meaning that prepayment from the proceeds of a bond issue, RCF upsize or bilateral/club term facility does not trigger soft call protection); and
  • if the borrower determines that the primary purpose of the transaction was to achieve something other than a reduction in the effective yield on its financing (relevant where a repricing occurs alongside another transaction, such as an acquisition or a recapitalisation)

While lenders should be aware of these inroads and their potential impact, it is worth noting that some borrowers have simply accepted the soft call fee and paid it as a cost of locking in reduced funding costs.

MFN

To protect TLB investors against a borrower incurring debt paying a higher yield, TLB investors expect a period of 'Most Favoured Nation' (or just 'MFN') protection. The premise is that if the borrower raises more expensive debt than the TLB (allowing some degree of headroom), the TLB pricing must be increased to match the new debt minus the agreed headroom. Understandably, borrowers want full flexibility to incur debt based on the prevailing market terms, which makes MFN protection a sensitive negotiating topic.

Traditionally arrangers sought for MFN protection to apply to new debt raised before a 'sunset' date falling 12 months after closing, coupled with a flex right to extend or even remove the sunset. As with soft call protection, the duration of MFN protection has come under pressure. Deals are being successfully syndicated with a sunset date just 6 months after the closing date. Likewise, the headroom rate above TLB pricing was once 50 basis points whereas recent deals have pushed this up to 100bps, sometimes higher.

A further variable is whether MFN protection is calculated by reference to an instrument’s all-in yield (better for TLB investors since the calculation includes the effect of original issue discounts and LIBOR floors) or just its margin. Some recent aggressive deals used a margin-only formulation. Other sponsors have argued that for MFN calculations the TLB’s yield should be assumed as the maximum potentially applicable yield (ie after giving effect to any pricing flex even if it was not used). The author is not aware of this formulation clearing the market and it is hard to see the logic for this position if TLB pricing was not, in fact, flexed.

A final MFN consideration is whether the borrower can incur categories of debt that are exempt from the MFN protection. Exemptions can now be seen for bridge facilities, debt raised in different currencies from the TLB, facilities maturing after the TLB and debt raised that is not a senior secured term loan.

Other provisions

Other lender protections that have come under pressure include financial covenants, incremental debt, dividends and bond-style negative covenants.

Financial covenants

Perhaps most importantly, reliance on pro forma EBITDA calculations that incorporate anticipated synergy benefits has become more widespread. To be eligible as an add back to EBITDA under a loan agreement, anticipated synergy benefits would usually be:

  • capped;
  • verified by a third party if they exceed a threshold; and
  • expected to be achievable within a specific period after the event (say 12 months).

The bond market tends not to require these protections. Issuers have more flexibility to self-certify synergy benefits. Several loan transactions have moved in line with the bond market approach, opening the door wider to 'smoke and mirrors' around reported EBITDA. The EBITDA definition is fundamental to the entire loan agreement since many triggers, permissions and flexibilities are now linked to a pro forma leverage ratio. The ramifications of an optimistic EBITDA calculation reach much further than the springing financial covenant.

Some borrowers also focus on the total net debt side of the leverage equation. If debt is denominated in multiple currencies, for ratio testing it is usually converted into the base currency using either the applicable exchange rate on the testing date or the weighted average exchange rate over the relevant testing period. Whichever option is selected, the methodology is fixed for life. Savvy borrowers now seek discretion to pick and choose the methodology each time they calculate a ratio.

As expected in a borrower-friendly environment, both the covenant testing condition and the headroom have moved upwards. Covenants are often tested only if the RCF is drawn above 40% on the last day of a financial quarter. Headroom has increased from around 30% to 35–40%. Another way to increase headroom is to assume the revolving facility will be fully drawn when setting the financial covenant level (even though, in practice, that is not normally assumed to be the case). This methodology has cleared the market in some of 2017’s most aggressive deals.

For large transactions, it is common to allow cure amounts to be added to EBITDA and imposing a sub-limit on the number of EBITDA cures has become less common. Borrowers have successfully negotiated for both equity cures and the 'deemed cure' clause to apply if they make the necessary equity injection to either:

  • restore the required financial covenant ratio; or
  • prepay the revolving facility to below the testing condition.

Incremental debt

Sophisticated sponsors usually secure the right to incur a fixed amount of incremental debt on a senior secured or junior ranking basis regardless of leverage at the time of incurrence (the 'free and clear basket'). Recently, the size of this basket has ticked upwards and is now commonly equates to 1x EBITDA. During 2017 sponsors have often added a 'grower' feature to this basket; if EBITDA increases, the basket increases. Loan investors focus on this permission very closely. Even in current market conditions arrangers usually require flex rights to remove the grower component and/or reduce this basket.

One bond market provision appearing more frequently in loan documents is the right for borrowers to reclassify the permission under which debt is incurred from time to time. This allows the borrower to “refresh” debt baskets that subject to a hard cap by reclassifying debt as ratio debt when times are good.

Dividends

With a wider acceptance of bond-style covenants in loan agreements, in 2017 loan documents have become more accommodating to dividends financed from:

  • a 'builder' basket based on 50% of accumulated consolidated net income accumulated. This is often seeded with a 'starter' amount (which is in addition to the general basket described below) giving the sponsor immediate flexibility to reduce it equity at risk. Some sponsors have also tried to add a grower feature to the starter amount but, to date, arrangers have resisted this development
  • a general basket amount, regardless of leverage. As with other baskets, over 2017 this has increased in quantum and commonly includes a grower feature

Deals have also relaxed both the leverage ratio and deleveraging requirement for borrowers to pay unlimited distributions.

Bond-style negative covenants

Although some covenant lite TLBs have replicated all the negative covenants of a bond in the past, until recently these were usually only encountered if the TLB sat alongside a bond. Standalone TLBs employing the full suite of bond-style covenants were relative outliers. That is no longer true in 2017, with a number of TLBs adopting bond-style covenants notwithstanding that the bond tranche was scrapped in syndication or no bond was even contemplated.

Other provisions

Other provisions receiving scrutiny during 2017 include:

  • majority and super majority voting thresholds (the loan market is being pushed towards 50.1%/66.67% thresholds from the traditional 66.67%/85% thresholds);
  • borrower consent rights on transfers (increasingly, these only fall away whilst a payment or insolvency event of default is continuing, rather than any event of default);
  • lender reliance on due diligence reports (it is now common that reliance letters will not be conditions precedent to funding and arrangers are asked to live with no reliance on vendor diligence reports and reliance on only the most important buyer diligence reports); and
  • change of control definitions and requests for portability

Conclusion

2017 to date has been a very good time to be a borrower. Market conditions have been extremely benign allowing borrowers to reprice existing financings opportunistically or raise additional debt on extremely flexible terms. In this environment, the challenge for arrangers is to identify those documentation points they want to argue for, either up front or as flex rights, in case the heat comes out of the market too quickly. For borrowers, the challenge is simply: what next?

First published on LexisPSL Banking & Finance.

Further Reading

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Acquisition finance—introductory guide

Intercreditor rights comparison table: junior debt instruments

Intercreditor rights comparison table: super senior revolving facility and senior secured notes

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