As liquidity has flooded the bank debt market and new sources of funding with different priorities to more traditional lenders have allowed more borrower-friendly facility terms to become the norm, financial sponsors have taken advantage of the situation. In most cases they have made it their business to learn from each previous successfully syndicated deal and to push the market for at least as good terms in the next one.
Examples include equity cures, covenant mulligans, yank the bank provisions and more lenient financial covenants.
While some of these borrower-friendly terms will be retained in a downturn as they have positive aspects for all sides, there will be others that are likely to swing back in due course to a more balanced position. Meanwhile, more of these terms are crossing over into other banking streams while the market remains buoyant.
To pick 10 examples:
Equity cures enable a financial sponsor to avoid a breach of financial covenants during a period of sub-par performance. The sponsor injects equity into the group during a financial test period or shortly after it ends and the bank agrees to count this as an uplift to a shortfall in Ebitda or cashflow.
In allowing equity cures, the bank syndicate is effectively removing its ability to rely on the financial covenants as an effective test of the continued minimum level of performance. The situation is exacerbated by the trend to allow equity cures to increase both Ebitda and cashflow.
The sponsor may be less fussed about risking a relatively small extra investment of new money to buy extra time to improve performance, particularly if it has already recovered much of its equity through a recap or lost it due to the reduced enterprise value.
In contrast, the bank syndicate has potentially substantially more at risk, is prevented from calling a financial covenant default as a result of deteriorating performance and, given that most other covenants are heavily qualified by Material Adverse Effect, has to sit back and wait while its borrower’s performance may deteriorate further.
Another concept being requested in the current market is the so-called “covenant mulligan”, which permits the borrower to fail a particular financial covenant on a particular test date without causing a default – a default only occurs if the following test date the borrower fails again.
For non-golfers, the phrase “a mulligan” in golf is a second shot retaken with the permission of the opponent and not counted towards the score, should the first shot be badly taken or missed completely. Needless to say, this clause is not widely accepted but it is arguably a sign of the times.
Yank the bank and snooze and lose
Sponsors have increasingly expected the right (a) to manage out non-consenting lenders under a “yank the bank” clause provided a majority of lenders agree to a consent and (b) to disenfranchise the votes of lenders who do not respond at all within a tight timetable to a request for consent using a “use it or lose it” or “snooze and lose” clause.
This is at least in part a reaction to arrangers pushing for the maximum liquidity in the secondary market, allowing syndication to an increasingly wide range of non-traditional financial institutions not all of which are geared up to respond to borrower requests.
Also with regard to voting and in response to difficulties in amending existing facilities in the context of events such as recaps and bolt-on acquisitions, the all bank amendment clause has been adapted to allow structural adjustments on a majority lender decision basis provided all the banks whose commitments are changed or extended agree.
In contrast to certain other relatively recent changes pushed by sponsors in LBO market positions such as certain equity cures, I would expect that this sort of structural adjustment concept will be something that will survive any future downturn in the market as it often makes commercial sense for agents and MLAs as well as borrowers.
Mandatory prepayment provisions
While mandatory prepayment provisions are generally provided, their provisions have been substantially watered down, with fewer prepayments required to be applied in prepayment in practice.
Increasingly, carve-outs for proceeds reinvested within a 12 to 18-month period are given and proceeds that are to be prepaid are further reduced by a percentage linked to the then current leverage of the group.
In auction situations, the combination of a short timetable, a requirement for financing to support a bid to be on a “certain funds” basis and a desire to keep costs down, particularly before it is sure that the sponsor and banks have won the auction or bid, is leading to banks and sponsors agreeing a long-form term sheet but providing for certain funds financing in the form of a separate very short standalone facility to give the vendor the comfort that financing will be there.
This leaves both bank and borrower dependent upon one another to agree the full form documentation at a later date, but there are no reports, yet, of such a deal where the sides have then been unable to reach agreement.
Structure and fees
Fee structures have evolved and the traditional European TLA/B/C margins of 2.25%, 2.75% and 3.25% are being reduced. Pressures are driven by general liquidity and matters such as ratchets on TLB as well as TLA, the increased liquidity of the mezzanine market, the introduction of second lien, the reduction or even removal of amortising TLA, the lower fees payable to many institutional investors, the property and infrastructure sector using leveraged loans as initial financing and the use of reverse flex in general syndication.
Delayed accrual of commitment fees has gone hand in hand at times with the “no deal, no fee” philosophy of sharing the pain in competitive auctions where there are always far more losers than winners.
Newer structural features, now that second lien and opco/propco structures have become common over the last year or two, include equity toggles with terms such as a step-up in margin if the borrower elects to take a PIK instead of a non-cash return, and perpetual debt.
Covenant flexibility for borrowers has been driven by long-form term sheets drafted by borrowers’ counsel and tightly defining covenants with materiality qualifications that neuter their effectiveness, coupled with an increased right to carry forward and carry back capex and, in some cases, permitted exceptions baskets.
Change of control
Significantly, there are limited examples of exceptions to prepayment on change of control creeping into certain deals on a case-by-case basis where a particular transfer is already expected or the sponsor feels that there may be a pricing advantage to it in being able to sell the group with its existing debt in place.
In the past, this has been regarded as unacceptable and it is unlikely that any trend in this direction if it developed would survive a market downturn.
Bridges to take-outs
The increased use of diverse bridges to a permanent take-out such as opco/propco, securitisation or HY structures has been a feature of the last couple of years and promoted increased flexibility in structuring deals.
Mezzanine backstops, meanwhile, with greater certainty and cheaper prepayment protection than classic US bridges with exploding pricing, registration requirements and securities demand language have won market share where the capacity of the mezzanine market has been large enough to allow the possibility of syndicating the bridge facility and not therefore requiring a high yield take-out as for the very largest bridge facilities – in 2005 the £460m Gala mezzanine tranche was double the largest tranche ever from two years previously, but this year it is likely to be at least €1bn.
Even some of the seemingly bank-unfriendly facility provisions, though often driven by the sponsors pushing a traditionally conservative bank market, have their place and may survive in some form or another in the next market downturn. That said, others tailored to the times are likely to be swiftly withdrawn, particularly in so far as they may be seen to alter the pricing, trading or recovery rate on a loan asset.