The credit turmoil related to US subprime mortgages has produced a liquidity crunch on both sides of the Atlantic. The effect of this on the US-leveraged finance markets has been more marked than on the European market. There are a number of reasons for this. Firstly, the US pipeline for leveraged loans is much larger than the European pipeline. It is estimated that arrangers were holding more than $300 billion in unplaced US lending commitments in the autumn of 2007 compared with less than a third of this in Europe. The US market has more exposure to single credits. This is because of a growth in deal size. Chrysler, First Data, Alltel, Clear Channel and TXU are leading examples. European credits have also grown, but not to the same extent. Excluding the €16.4 billion Boots transaction, which is thought to represent around 10% of European buy-out deal volume for the first half of 2007, the top European buyout completed in the first half of 2007 had a deal size of approximately €3.5 billion.
| Top of the market covenant provisions |
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(i) Restricted payments baskets: they allow a borrower to pay dividends and repay junior debt with the use of an all-purpose basket often calculated as a fixed dollar amount. They include an accreting amount, based on a percentage of consolidated net income, with increases based on reductions in leverage, and no cap on equity proceeds obtained for such purposes.
[The European equivalent for larger deals pre-credit crunch is now less common. It allowed the borrower to pay dividends and repay junior debt from retained profit, flotation or disposal proceeds, when leverage had been reduced to an agreed threshold level.The right to pay junior debt is now subject to a higher threshold level or such payments are prohibited without lender consent.]
(ii) Incremental facility: this allows an additional facility up to an agreed amount with the consent of the lenders providing the commitments for the new facility. The new facility would benefit from (and dilute) the security for the existing facility. Initially, these incremental facilities included protections to existing lenders, in the form of controls on pricing (for instance, pricing for a new facility had to be within 0.25% and 0.5% per annum of the pricing of the existing facility). This quickly became the exception. Controls also included financial ratio compliance (often tested based on senior secured leverage). Increasing cushions, the ability of borrowers to make good faith pro-forma adjustments for synergies, and cost savings for any intended use of an incremental facility, eroded the efficacy of financial ratio compliance, tests.
[The European equivalent for larger deals pre-credit crunch provided for the introduction of a new senior acquisitions facility for permitted acquisitions up to an agreed amount with the consent only of the lenders providing the new facility. Alternatively, voting provisions allowed the introduction of an additional senior tranche or an increase of a facility, with the consent of the majority banks and those banks providing the new money. Stricter parameters on the new facility are now required.]
(iii) Financial covenant headroom of over 30% (increasing to 35% or more in some cases), or an absence of all or certain financial covenant tests. The calculations used to test financial covenants typically allowed for pro-forma adjustments, as determined by the borrower in connection with acquisitions and dispositions. This gave borrowers greater flexibility to meet ratios.
[European equivalent: Covenant headroom was generally restricted to 25%. Although some loans lacked fixed-charge cover or interest-cover ratios, most included such ratios. There were few cov-lite loans.]
(iv) Equity cures: they allowed a borrower to cure financial covenant breaches by investing new equity, sometimes with up to three such cures permitted in any four quarters of testing. There was no aggregate limit on cures over the life of the facilities, and none on the use of such proceeds to repay debt or increase cashflow or EBITDA.
[European equity cures were usually limited to a fixed number (such as four) over the life of the facilities. The cure amount may now need to be applied in prepayment of debt as if it were a mandatory prepayment, and EBITDA cures may not be permitted. Deemed remedy (or mulligan) provisions are also resisted (they treat breaches as remedied if the financial covenants are complied with when next tested). US equity cures, if allowed, are now limited to a fixed number per year and over the life of the faculity.]
(v) Flexibility to designate subsidiaries which are initially "restricted subsidiaries" (subject to the covenant restrictions in a US credit agreement) as "unrestricted subsidiaries" (not subject to covenant restrictions, other than investment limitations on amounts funded from the restricted group) and vice versa. This allowed for asset and EBITDA growth to occur outside of the core credit.
[There is no European equivalent; but borrowers and guarantors (each an obligor) are subject to covenant restrictions. A security/guarantor coverage test is often included, especially post credit crunch. An obligor resignation requires lender consent.]
(vi) Carve-outs from restrictions on borrowing and granting security. These may allow borrowing of unlimited subordinated debt provided covenants (if any) are met or borrowing of a capped amount of debt with security ranking ahead of or equal to the security for the facilities subject to pro-forma compliance with a senior secured indebtedness test, presenting the same issues as noted above with respect to incremental facilities.
[Baskets of permitted debt and security are included in European loans but senior lenders do not vary their priority arrangements to give new debt super priority. The ability to borrow unlimited subordinated debt was fairly unusual pre-credit crunch. Some recent European high-yield bond covenants (like their US equivalents) allowed for unlimited security to be granted for second-lien loans.]
(vii) Large basket amounts and build-up baskets in negative covenants, with few restrictions on use of equity proceeds to increase baskets, and the ability to not only carry forward unused basket amounts from prior periods, but to pull back amounts designated for future years, so softening the negative undertakings.
[Provisions had been included in pre-credit crunch European deals allowing for all unused basket amounts to be rolled over to the following year but the ability to carry forward and carry back such amounts is now limited.]
(viii) Mix-and-match use of high-yield bond covenants in substitution for more conventional maintenance covenants producing hybrid terms.
[Although some European loans had high-yield incurrence covenants this was unusual, as were loans with a mix of maintenance and high yield style covenants. Cov-lite loans with high-yield style incurrence covenants were generally limited to working capital facilities in debt capital structures with high-yield bonds. High-yield bondholders did not want the lenders to have disproportionate control in such cases.] |
Covenant-lite (cov-lite) debt issuances represented about a third of all debt issuances in the US in the first half of 2007. There were only a few such loans in Europe. In addition, US lending terms were often more aggressive than European lending terms. An overestimation of the leveraged lending market's capacity to handle the substantial increase in debt-funded LBO activity fuelled the aggression. Lastly, US financial institutions have greater exposure to the US sub-prime market than European financial institutions. As the US economy softens, US lenders have much more debt than European lenders. This is often on terms that present a greater credit risk, and which may not permit the lenders to intervene as early to maximise their recoveries.
US variation
Recently, both the European and US markets have seen an erosion in the strength of the covenant package in leveraged finance loan agreements. Competition for acquisition finance mandates, and the ability of underwriting banks to distribute debt without warehousing a portion, has encouraged this. However, credit agreements and term sheets for US deals vary to a greater extent than those for European deals. This is partly because there is no generally accepted US equivalent to the Loan Markets Association (LMA) precedent documentation, the European market uses particularly for mid-market deals. The documentation for larger European deals is less standardised than that used for European mid-market deals. Sponsors often provide their own draft commitment documents and draft credit agreement for larger deals. Such documentation usually contains a covenant package that is significantly softer than the covenant package in LMA-precedent documentation. In the case of global sponsors it may include features imported their US deals. Conversely, large global sponsors managed to successfully import key elements of UK-style funds conditionality into US financing commitments, while preserving their gains in terms of looseness of covenants in the ultimate documentation.
In both markets, the coupling of sponsors in large transactions, together with the consistent use of a select group of recognised sponsor-counsel, hastened the spread and scope of sponsor terms in LBO financings of all sizes. This led to the development of best sponsor precedent, an increasingly borrower-friendly set of terms. Commitments and documentation were negotiated on this basis, as long as the market was receptive to new debt issues.
Tightening covenant packages
The erosion of the covenant package in pre-credit crunch documentation means that a borrower can often suffer large deterioration in its financial situation before a default, and lenders can exit, reprice their risk and/or force a restructuring. Lenders risk suffering a greater loss on a bankruptcy than if they had been able to intervene earlier.
The credit crunch has led lenders to review and negotiate credit documentation in more detail against a backdrop of lessening competitive tension. A larger number of lenders is typically involved in the process. Arrangers unable to underwrite a deal may instead arrange a syndicate of lenders upfront to provide a loan. Alternatively, a number of underwriters may underwrite a deal, since the individual underwriting limits of lenders are often smaller than before the credit crunch. Lending terms have tightened in both markets, although because European lending terms had not relaxed to the same extent, the effect on credit documentation may seem greater in the US. Pricing has increased and cov-lite loans, Pik toggles and equity bridges have fallen out of favour in both markets. However, other top of the market provisions included before the credit crunch, which diluted lender protections, are also now receiving scrutiny from financial institutions.
Structural changes
When the credit crunch first occurred in the US market, some lenders tried to finance deals by turning to the European markets and by including European tranches in the financing package. This is no longer an easy option, as the European markets have also tightened up. In both the US and Europe, a higher proportion of equity is being required, typically 25% to 30% or more of the funded capital structure, compared with equity contributions as low as the 15% (often partially issued on preferred or debt-like terms), seen before the credit crunch. Amortising A tranches have become more common in the US and Europe as institutional demand for non-amortising B and C tranches has fallen. The increase in amortising debt in the capital structure will reduce debt capacity and deal size. Asset-based tranches (such as borrowing-base-revolving credit facilities) have also become more common in the US and Europe. The laws of many European jurisdictions impose restrictions on the collateral cover available for asset-based lending, making this type of tranche less attractive for some European deals. In both the US and Europe, lenders are carefully considering the concessions that they give in terms of security package requirements. Before the credit crunch there was less emphasis on tangible asset security, and security was usually required with 90 days of closing.
In both the US and European markets, second lien and Pik debt is now less prevalent and mezzanine tranches are more prevalent than before the credit crunch. Some financings contain an option for a take-out by a mezzanine facility rather than a high-yield issuance. The increase in mezzanine debt is partly due to the availability of mezzanine finance compared with high-yield bridge financings. It may also be due to pricing concerns. Most high-yield bridge-loan agreements provide for the interest rate to increase over the first year by up to an aggregate of 100 basis points in three or four instalments. This type of financing would be very expensive for sponsors if refinancing by a high-yield issuance were not possible. Overall pricing levels have increased and there is demand for warranted mezzanine.
Unfunded commitments
Commitment letters signed before the credit crunch typically contained few outs and acquisition agreements generally did not have a financing out. A market-out condition that no disruption in the financial markets would impair syndication had virtually disappeared from US and European commitment letters. Lenders need to fund these pipeline deals despite market conditions. Commitment letters had also ceased to include an independent definition of a material adverse change for the material adverse change (MAC) out. Instead they referred to the business MAC (if any) in the relevant acquisition agreement. Lenders could only refuse to fund if the business MAC (or another termination right) under the acquisition agreement could be invoked or there was a breach of a limited number of provisions relating to the acquiror group.
Business MAC provisions in US acquisition agreements commonly provide that a material adverse change will occur only if the target experiences a deterioration in its business and financial performance, which is more adverse than that of (or sometimes materally more adverse) other businesses in the same industry. US acquisition agreements may also have provisions which allow the purchaser to terminate the acquisition agreement and pay break-up fees. In the recent cases of Harman International Industries and US Student Loan provider SLM Corporation (previously known as Sallie MAE) the buyers asserted that a MAC in the target's business had occurred but the MAC clause did not state how disproportionate the charges to the target have to be when compared to the industry. In both cases the interpretance of the MAC clause was disputed. European acquisition agreements for private acquisitions usually include a similar business MAC. But they do not normally include reverse break-up fee provisions, except where a deal cannot be completed due to anti-trust or other regulatory concerns. The net effect of these provisions is that if the target's whole industry suffers a material downturn (i) the purchaser will still be required to complete the acquisition (subject to any break-up fee option) and (ii) lenders will still be required to fund. European credit agreements usually contain a material adverse change event of default. It entitles lenders to immediately force a restructuring or demand repayment if they have funded an acquisition of a business which has suffered a MAC. US credit agreements do not include this protection, leaving potentially extended periods before lenders can take action under the facilities. Lenders now require a business MAC in the acquisition agreement or commitment letter. They focus in more detail on the terms of the business MAC and, in European deals, on the MAC event of default. Lenders are also requesting market MACs.
The certain funds provisions in European credit documents for acquisitions are standardised. They are based on the certainty of funding provisions required for public offers even for private company acquisitions. They leave almost no outs for lenders unless there are termination events under the relevant acquisition agreement, such as a business MAC, as noted above, or there are a limited number of defaults in relation to the purchaser (usually a newco). It has also become common in European private equity acquisition financings to sign a short-form interim loan agreement on the date the commitment papers are signed. Under this agreement, the underwriters must lend upon the closing of the acquisition for a short period (such as 30 days), if long-form documentation cannot be agreed before funding. This enables a borrower to make an offer that is not conditional on negotiating long-form credit documentation. The borrower takes the risk that, because the terms are not agreed before commitment, underwriters may require unattractive terms in the long-form documentation. This is unless they have obtained the permission of the banks to base their terms on a previous credit agreement, which may be difficult. Previous credit agreements may not reflect current market terms.
Lenders are now more reluctant to agree to negotiate documentation based on sponsor precedent from before the credit crunch. They may require that documentation be based on market terms or, in Europe, on LMA documentation; market terms may be hard to determine in the current volatile market. Lenders' counsel may also be asked to prepare first drafts of documentation, based on historical, rather than recent, sponsor precedent. As a result of the sponsor's lack of certainty over the terms likely to be incorporated in long form credit documentation after commitment documentation has been signed some sponsors are choosing not to use interim loan agreements.
US certain funds provisions are far less standardised. The use of interim loan agreements is not widespread in the US, although as noted above, elements of certain funds conditionality were imported into the US lending market before the credit crunch. As a result it is more likely that in some cases the conditions to lending will not be met. Lenders may pay break-up fees rather than fund the deal. They may also use the failure to meet certain conditions in negotiating market-clearing terms. It is also possible that US style break-up fee provisions will appear in European acquisition agreements. Break-up fee provisions may be drafted to allow the purchasers to walk away after paying the break-up fee with no right of the seller to force the purchaser to draw on its financing and close the deal. In both the US and the UK great attention is now given to MAC provisions in credit documentation and acquisition agreements. Sellers are, however, likely to resist any decrease in certainty in the current market.
More market flex rights
| Cov-lite loan |
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Covenant-lite loans have no financial covenants. In the US this term has typically come to mean loans with incurrence-based covenants as well as no financial debt and lien baskets (other than, sometimes, a single leverage test applicable solely to the revolving credit facility). Standard & Poor's reported a drop in cov-lite loans from $25 billion in February 2007 to $150 million in July 2007. In June and July 51 deals were cancelled, two more postponed and financial covenants were added to 21 further deals. |
Commitment papers signed before the credit crunch often restricted the right of lenders to change pricing if a deal could not be syndicated. Lenders were only allowed to make a limited margin increase (for example, by 25 to 50 basis points) and possibly to reallocate between tranches, subject to a cap on the weighted average increase. They had to exercise their rights within a short time following initial funding, often on or before closing in US commitments.
Lenders in both the US and European markets are now looking for much wider flex rights to facilitate syndication covering pricing, terms and structure. These rights may include the rights to change the debt structure by re-tranching, to introduce another layer of subordinated debt, to add financial covenants, to increase fees and/or introduce original offer issue discount fees. Lenders also request greater periods in which to exercise such rights – up to six months although rarely longer. Open flexes with unlimited rights to change the price, structure or terms have also been seen in the US. The use of original issue discount, which was removed from flex provisions pre-credit crunch, is now a virtual given for new US debt facilities (to compete with facilities such as First Data which launched at $0.96). This reflects the fact that commitments negotiated in the current market will face competition from the backlog of unplaced facilities that are being offered at large discounts.
Fewer syndication restrictions
Pre-credit crunch commitment documentation in both the US and UK typically allowed sponsors to reject syndicate members, either on syndication and/or in the secondary market. It sometimes allowed sponsors to introduce additional arrangers, or to syndicate to funds which sponsors managed, in relation to an agreed proportion of the debt. The response to current market conditions has been similar. Lenders now require more freedom to syndicate and transfer debt without borrower consent and free of some of the restrictions arising from borrower predictions in the increased costs and taxes provisions. They also want the freedom to transfer voting rights on a European sub-participation or a participation, its US equivalent.
| Pik toggles |
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Where a loan has a Payment-in-Kind (Pik) toggle, a borrower may elect not to pay cash interest on the loan for a period or to issue additional notes. During the period when interest is not paid a higher interest rate applies. Standard & Poor's reported that several deals were withdrawn in June and July 2007. Other deals have been modified to remove the Pik toggle element. |
Commitment periods and periods for accepting commitment letters increased leading up to the credit crunch. Since then they have decreased in both markets. Sponsors may exchange a requirement to accept a commitment at an early stage (before the acquisition terms have been finalised) for a right to terminate exclusivity if the acquisition terms change necessitating changes to the finance structure which the lenders do not agree to. The alterations are subject in some cases to payment of a deal away fee (this had disappeared from financing commitments) if the sponsor completes the transaction with funding from the other lenders. Underwriters also seek to syndicate on or before closing. Sponsors had eliminated this right as it gives rise to a funding risk. Borrower syndicate members that are institutional investors may be unable to fund at closing if they are unable to raise funds or are facing margin calls.
Staged syndications of larger deals are also now taking place in both the US and European markets. They maintain scarcity value and help the debt to trade in the secondary market. An underwriter may also avoid crystallising a loss on any debt it holds if it does not have to market (most likely through the use of original issue discount). Banks are also offering finance with preferential pricing to funds which agree to purchase leveraged loans participations.
Bankruptcy: US v EU
What is the outlook for creditors of a European debtor in bankruptcy, compared with those of a US debtor? A borrower is more likely to survive a US Chapter 11 bankruptcy than a European proceeding. Creditors are likely to have more influence on a debtor's restructuring after the opening of US proceedings than in European bankruptcies. The Chapter 11 proceeding also applies to all US states. If European borrowers have subsidiaries in a number of European jurisdictions, the position may be complicated, as there may be insolvency proceedings in several European jurisdictions. The EU Insolvency Regulation outlines mandatory rules regarding the coordination and recognition of the various European insolvency proceedings. However national laws still determine the substantive laws on insolvency in an EU member state, and these laws differ considerably. National laws in Europe also determine the rules on creation and enforcement of security. These also vary significantly. In the US, the rules of each US state are based on the Uniform Commercial Code. In practice pan-European bankruptcies are often complex, lengthy and expensive.
| Equity bridge |
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Lead-arrangers provide an equity bridge by making an equity co-investment with a sponsor. Usually the lead arrangers purchase non-voting common equity which they agree to hold for an agreed period. During this time the sponsor has an exclusive right to find buyers and to select its equity syndicate. After this period the lead-arrangers are permitted to sell. There is a risk that the lead-arrangers will not find buyers if the equity syndication is unsuccessful. Arrangers often agreed to provide an equity bridge in return for being awarded the mandate to lead-arrange a deal. The increased credit risk and the reduction in competition for mandates have made equity bridges much less attractive since the credit crunch. |
The repercussions
In both the US and European markets, at least in the short term, we can expect a number of repercussions: less leverage, a drop in deal size, tighter lending terms, higher pricing, wider flex terms and more flexibility to syndicate and transfer debt, more conditionality and shorter commitment periods. It remains to be seen whether lenders will retain the adjustments, which would recreate conventional lending terms and lender-focused protections, once the markets stabilise. Refinancing debt will be less readily available, as will debt for leveraged recapitalisations and secondary or tertiary buy-outs. Exits may take longer and loans may be outstanding for longer. The tighter lending terms and stricter voting provisions will need to be balanced by recognition of the practical difficulties of obtaining consents from large syndicates. These may lead to inflexibility, particularly in Europe where the voting threshold for most decisions will be 66.66% rather than 50%, as is typical in the US. It has also become more difficult to obtain even simple amendments or waivers to existing credit facilities, especially those negotiated on sponsor-friendly terms, without the payment of fees.
By Michael Baker in New York and Caroline Leeds Ruby in London, both of Shearman & Sterling LLP
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