MCC: Please give us a 2014 market recap for middle-market leveraged finance transactions.
Hong: 2014 continued to be a year that generally favored borrowers and private equity sponsors, and terms in the loan transactions became increasingly more borrower and sponsor friendly. Many elements played a part in those developments. Specifically, there was an imbalance between supply and demand: there were more available financing sources chasing yield than the need driven by LBOs and other new money opportunities. It was not unusual to see multiple lenders bending over backwards to compete to win attractive deals. Seasoned private equity sponsors and their counsels were able to take advantage of the market dynamic and push for their gold standard terms as much as possible.
MCC: Can you give us some examples of these market trends or developments?
Hong: In general, borrowers for middle-market deals were able to negotiate and demand favorable terms, including those that were traditionally high-yield bond terms. Increasingly, there was a similarity of term loan B and high-yield bond terms, in particular in the upper range of middle-market and large-cap transactions. More operational flexibilities in favor of borrowers were seen in the credit facilities. Here are a few specific examples:
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Ratio debt basket. Traditionally, term loan B facilities gave borrowers the ability to incur additional debt up to a hard dollar cap. Now, ratio debt basket from high-yield bond deals has been routinely requested, even in the lower middle-market loan transactions, especially in cases where the private equity sponsor with a plan to do add-on acquisitions is keen to build in flexibility that would measure up the growing need and scale of the acquisition platform. A ratio debt basket would typically allow the borrower to incur debt secured on a senior secured basis subject to a maximum senior secured leverage ratio and unsecured debt subject to a maximum total leverage ratio.
Depending on how the baskets are specifically structured, the borrower could effectively incur debt at a much higher leverage level than those dictated by the ratio debt basket, by way of shuffling the order of incurrence. For example, the borrower may first incur debt under the ratio debt basket and then incur additional debt under fixed dollar baskets (which are typically free and clear of any leverage ratio conditions). Or the borrower can first incur unsecured debt up to the pro forma total leverage ratio, and then later incur additional senior debt (which could result in total leverage being much higher than in the ratio debt basket). As a result, in tighter terms, the borrower may be required to exhaust the “free and clear” basket first, or to meet both the pro forma senior secured leverage test and the pro forma total leverage test, in order to incur additional secured debt.
- Contribution debt basket. This basket allows the borrower to incur debt in an amount equal to any qualified equity contributed to the borrower. It is more commonly seen in bond deals, but sponsors were increasingly requesting this in term loan facilities as well. The premise justifying this flexibility is that there is no effect on credit quality, given that the debt-to-equity ratio remains same. However, lenders in smaller deals have been resisting due to concerns that cash is fungible and that there may be a mismatch in timing between the equity contribution and the debt incurrence, and because the use of the contributed equity for other purposes in the interim is often not captured.
- Reclassification of debt. Not yet routinely seen in the term loan facilities, but in upper middle- market deals, some borrowers have been trying to negotiate for the ability to reclassify their debt incurrence from one exception or basket to another. This mechanism will work in the borrower’s favor such that it could potentially replenish its fixed dollar basket by subsequently reclassifying its debt incurred under a fixed dollar basket to its ratio debt basket.
- Grower basket. A grower basket is structured to be the greater of a fixed dollar amount and the amount measured off the borrower’s total assets (or net tangible assets or EBITDA), which is traditionally a feature under bond indentures. Sponsors now are continuing to push to have grower baskets available for debt incurrence; the ability to do assets sales and make investments; and, in some instances, the ability to make restricted payments, such that the operational flexibilities will grow (without having to go back to lenders for consent) as the business grows.
- Builder basket. This is another concept that migrated from bond indentures. A builder basket is now very commonly seen in term loan facilities, and typically has been structured to be based on a certain percentage of retained excess cash flow – and in some instances, is considered together with a guaranteed starter amount. The market is also seeing some sponsors push to formulate the builder basket to be based on the borrower’s net income. The size of the builder basket will also be increased by qualified equity issuances and equity contributions. The borrower could access the builder basket to do such things as make acquisitions and other investments, prepay junior capital and pay dividends, subject to conditionality (which typically would include a pro forma leverage test).
- Permitted acquisitions. It has been increasingly common for sponsors to seek the ability to do permitted acquisitions without a hard dollar cap, but subject to a pro forma leverage ratio test.
- Financial covenants. The market has also seen developments that more favor the borrower. We have seen the cushion of covenant levels commonly set at 25 to 35 percent of the sponsor model. EBITDA add-backs more routinely include pro forma cost savings and run-rate synergies, though they generally are capped at a percentage of adjusted EBITDA for middle-market deals. Also, leverage ratio covenants now routinely are based on a certain level of net debt concept, though it is not uncommon in the lower end of middle-market deals to have a dollar cap for the amount to be netted. Further, the market has been accepting of the elimination of the capital expenditure limitation covenant – in particular where there is a fixed charge coverage ratio.
Also, technologies around equity cure, SunGard provisions, disqualified institutions provisions and the like, as driven at the insistence of sponsors and borrowers, have now routinely been built in, and the market has continued to move in favor of the borrowers for specific terms that are still evolving and less defined.
MCC: In 2014, we also saw sponsors taking more control in the deal-structuring and syndication process. Is that consistent with your experience? What is the dynamic there?
Hong: Yes, and particularly in the upper middle-market space. When sponsors shop for financings, it has now become common practice to have sponsors’ counsel draft the commitment papers. This allows the sponsor and its counsel to shop and negotiate with separate financing sources more efficiently, and it gives them the ability to combine terms by incorporating the most favorable points and push for the “best scenario” with each separate financing source.
The recent market has also seen sponsors sometimes pushing to have their counsel prepare initial drafts of credit agreements and other major loan documents. Middle-market lenders generally have been resisting this.
In the last year or so, we have seen more large-cap sponsors entering the middle market with more bargaining power and an expectation of terms more characteristic of large-cap deals in their middle-market loans. Over the course of time and after several transactions, the preferential terms these sponsors managed to get started to have an impact and effectively pushed the market terms in favor of borrowers.
MCC: January 2015 appears to be a slower month for the leveraged finance market compared to the same period in the past few years. Are things are ramping up? Do you think these trends favoring sponsors and borrowers will continue?
Hong: Markets could change within weeks, so it is hard to predict by any means. However, I am optimistic that there will still be a lot of transactions happening in the middle-market loan space. The intrinsic characteristics of the middle market are that it is subject to less market volatility, more insulated from macroeconomic elements, lower leverage, and offers more robust covenant packages. These features make middle-market deals very attractive to a broad range of capital providers, including traditional banks and alternative financing providers. Also, the volume of “dry powder” that private equity funds hold should continue to fuel the LBOs and acquisition activities while private equity funds seek to realize gains for their capital.
Market trends are uncertain, and a lot will depend on whether borrowers and sponsors will continue to have the same level of market advantages. In light of the increased regulatory scrutiny and the further-clarified lending guidance by the primary U.S. bank regulators for leveraged lending practices, lenders (particularly regulated lenders) may have to consider more factors before committing to aggressive terms favoring the borrowers. Especially in the areas of leverage ratios, financial covenants, and the borrower’s ability to incur debt and to make restricted payments, I would not be surprised if lenders become more resistant to providing as much flexibility for these companies.
Even though borrowers can often resort to alternative non-bank financing resources in the middle market, I believe that if bank lenders start to tighten the terms, it will start to have an impact on market terms overall, including those provided by alternative financing resources. While that impact may not be literal, it does mean that borrowers and sponsors will have to do more negotiating than they otherwise would in an environment that is uniformly borrower friendly.
Published February 24, 2015.
