Good times, Bad times: a leveraged finance viewpoint

Good times, Bad times: a leveraged finance viewpoint

A typical leveraged facilities agreement attempts not only to prescribe core loan mechanics but also to provide the parties with sufficient flexibility and protection over the term of the debt. Inevitably, certain of these provisions are more or less relevant at different points in a company's growth. With both our lender and borrower "hats" on, we've focussed in on some of the key provisions of interest to the parties when times are good, and when they turn bad.

Good times

When times are good with stable market conditions and healthy revenue streams, businesses with leveraged debt structures tend to focus on amplifying growth opportunities, often through capex investment and/or bolt-on acquisitions. Both may deploy debt, either through dry powder in an already existing capital expenditure and acquisition line or through an upsize in the senior debt facilities. Regardless of whether or not they are debt funded, business acquisitions will require close attention to the "Permitted Acquisition" criteria in a facilities agreement.

Most senior facilities agreements will contain mechanics for establishing "incremental facilities" (or "accordions") subject to certain criteria being met. Including these provisions from the outset means that putting one in place can, subject to lender appetite, be done quickly as it neatly sits within the existing documentation framework and, importantly from a lender's standpoint, the existing security and guarantee package. Purpose, pricing and any other specific conditions can be set at the time, but all other terms will be per the existing financing documentation.

Existing lenders will want to ensure that any requests for incremental facilities come to them first, so they have the opportunity to follow their initial investment. For borrowers and sponsors, that will, normally, also be the easiest route to increasing their debt given those lenders already know the business and the documentation well. Should the existing lenders decline, however, the borrower will want to have - as is market standard - the flexibility to bring in new lenders to provide the incremental facility.

A key negotiation point here is the point at which the existing lenders are engaged. They can either be offered (1) a "right of first offer" ("ROFO"), where they must be offered the opportunity before any third party lenders, or (2) a "right of first refusal" ("ROFR"), where the existing lenders must be offered the opportunity after any third party lender, giving them the right to match any terms the borrower obtains in the market. The later (the ROFR) favours the existing lenders and can make it difficult for the borrower to obtain genuine competitive tension when seeking terms in the broader market - potential third-party lenders may be deterred by the right existing lenders have to match their terms and thereby land the deal.

Where a ROFO is present, another point frequently discussed is how the existing lenders are treated where the terms the borrower offers to third party lenders are more lender friendly than those they were originally offered. Some return to the existing lenders is not unusual, but borrowers should have a keen eye on timings for this to avoid the process becoming unduly drawn out, and a shorter period than was initially given is not unusual.

Typically, there will also be a cap on the aggregate quantum of incremental facility commitments that can be established, calculated either as a hard number or a leverage ratio tested on incurrence, or a combination of both. A standalone hard cap offers a more borrower friendly formulation for stronger credits or towards the upper mid-market as it permits debt incurrence without deleveraging beyond that required by the financial covenant regime. Where there are super senior debt tranches in the structure, it is also important from a senior lender perspective to consider how this cap be apportioned across the super senior/senior layers of debt to maintain the correct balance. 

Where the incremental facility is used to fund capital expenditure or acquisition of assets, absent a capex covenant (which has become fairly unusual in the mid-market), there tend to be no other restrictions as to the application of those funds. The position is quite different where the debt is being used to acquire a business or a company. In that scenario, the acquisitions undertaking will restrict the activity unless it falls within the definition of "Permitted Acquisition".

Lenders will want to ensure sufficient controls are in place for such Permitted Acquisitions to ensure that, amongst other things:

a) the target business is in line with the existing business focus, with borrowers keen to ensure some flexibility to acquire targets in complimentary or adjacent business or geographic areas;

b) the target group is EBITDA generative, with borrowers potentially looking for the option to acquire business with EBITDA negative up to a limit, set either on a per acquisition or lifetime basis;

c) the acquisition will not put pressure on the group's ability to meet its financial covenants going forwards, borrowers are in alignment on this requirement and should bear in mind the Permitted Synergies when calculating look forward compliance;

d) the acquisition has a suitable consideration structure including a limit (typically of 50% where included) on deferred consideration, borrowers' views on this may differ depending on their industry and any restriction should exclude earn-out deferred consideration given this is target generated; and

e) the acquisition is appropriately diligenced, with borrowers focussed on ensuring suitable purchase price thresholds are included for the provision of financial and legal diligence to the lenders, both on a hold-harmless and reliance basis, and that the timing for delivery is achievable with delivery post-acquisition preferable.

Where a business is sponsor backed, a period of growth and stability may also be the right time for a sponsor to extract some value in the form of a dividend or repayment of any shareholder debt. Often this entails the borrower taking on additional debt to fund the payment. If this is envisaged at the outset, the sponsor should push for it to be specifically negotiated into the documents, both in how incremental facility mechanics are structured and the Permitted Payment regime. If commercially agreed, lenders should ensure suitable leverage thresholds and timing parameters are included to ensure the anticipated cash leakage is feasible for the business and the payment is time limited. Where not specifically permitted, this will require the documents to be reopened or a wider refinancing to be entered into. 

And bad

When trading goes south or the macro environment becomes more challenging - or worse, both - lenders' attention turns more acutely to value protection.

Early on, leverage blockers on acquisitions and new debt incurrence through incremental facilities are an important means of restricting releveraging at a time when the focus should be on preserving value. It will be important from the lenders' perspective that the figures these leverage numbers are calculated on are the most recent verifiable available (typically the most recent quarterly figures delivered), and from the borrower's perspective that synergies from any events occurring after the date of those accounts are pro-forma'd in.

In order to preserve cash, the borrower might elect to PIK (i.e. capitalise rather than cash pay) interest or introduce this mechanic if it is not already an option available to them. Borrowers must balance the short-term benefit against the medium-term risk of increased leverage and debt service where a PIK option is exercised. Provided that suitable guardrails are included to ensure the PIK'ing option is appropriately time limited with sufficient premia for the lenders to compensate for the reduction of cash pay interest, this is often a useful short-term lever for the lenders to provide cashflow support without extending new monies.

In the large-cap space where groups may have multiple layers of debt, more creative structures are often applied (including so called "up-tiering" or "drop downs") to manage liabilities, increase debt capacity and/or minimise the cash service requirement at a time of financial pressure.

If things continue to worsen, lenders should review their transferability provisions. Typically, these will permit transfers without borrower consent where certain Events of Default are continuing. There may, however, be a narrower range of Events of Default which must be triggered before a transfer to a "distressed investor" (i.e. one who has a strategy of taking loans with a view to stepping into the equity of a company). These will almost certainly include non-payment and the solvency related Events of Default. Inclusion of financial covenant (and related information undertaking) defaults, however, is a point of negotiation. From the borrower perspective, this is too early a point for the lenders to be stepping away, and exactly the point at which they need their original lender group to step up and work collaboratively with the sponsor.

At the point a financial covenant breach is looking likely, parties may turn to the equity cure provisions. Whilst it is unusual for an equity cure to be injected exactly as it is written in the facilities agreement, the strength of the provision as written will shape negotiations. For example, if the equity cure does not require the funds injected to be applied in prepayment, it is then difficult for lenders to require that the sponsor's rescue injection simply pays them down. A financial covenant breach opens up discussions between the parties as to - from the borrower perspective - covenant resets (with lenders considering additional conditions to any reset around additional sponsor support or even exit planning), and - from a lender perspective - the introduction of additional liquidity covenants and a more detailed, regular information flow.  

Ultimately, a primary risk for both sides lies in treating documentation as static, rather than anticipating how provisions will operate across growth, stress and recovery phases. Understanding how these mechanics operate across the life of the debt is not just a documentation exercise, but a core part of effective capital structure planning.