Over the past year the European private equity market has been fuelled by continued spiralling liquidity in a highly competitive M&A arena. To win deals, sponsors have needed ever-increasing amounts of debt finance on extremely tight timetables. At the same time, the number of institutional investors in the market has ballooned and they have been clamouring to lend them that money.

According to Standard & Poor's, institutional investors now represent 37% of the European leveraged debt market, compared with just 4% in 1999. Startling as this statistic is, in the US institutional investors make up 80% of the leveraged finance market, so it looks like their role is only set to increase in Europe. These new lenders include hedge funds, insurance companies, CDOs and CLO vehicles (and the like), US investor groups and other institutional lenders (collectively, institutional investors).

Lead banks arranging debt finance packages for sponsors have been able to exploit the availability of capital offered by institutional investors to structure ever bigger and more complicated debt packages comprising tranches of senior debt, second lien, mezzanine and sometimes junior mezzanine too. At the time of writing for instance, the debt finance package provided to Gala Group funding its takeover of Coral Eurobet has launched into syndication. It comprises senior debt of £2.2 billion ($3.7 billion), split into the usual A, B and C tranches (plus capex and revolving credit lines), a £150 million second-lien tranche, and a £460 million mezzanine tranche (reputedly the largest European mezzanine tranche ever).

Senior debt

In larger deals, senior debt is itself invariably divided into alphabet tranches - the A tranche corresponding to the old-style traditional senior debt instrument, typically amortizing over seven years, and the B and C tranches being designed to appeal to institutional investors, having bullet repayments at the end of years eight and nine. These alphabet tranches have been around for the past couple of years, but the last few months have seen the growth of flexible pricing. At the beginning of the year, A, B and C tranches had set pricing of 225bp, 275bp and 325bp respectively. Now, while syndication might launch at those standard rates, a number of deals have seen the rates flexed down in syndication in response to strong institutional demand for the paper. This follows the US experience, where demand pricing has operated for some time. Most lead arrangers' mandate letters now contain language that they will use best efforts to achieve a flex down and they are sometimes rewarded by an incentive fee if they achieve a margin reduction.

Second-lien

The most obvious change in the debt finance market, though, has been the growth in the types of subordinated debt introduced to the capital structure to use all this liquidity.

The growth of second-lien debt in the European market is one of the biggest stories of the past year or so. Originally imported from the US, second-liens have reappeared in Europe as a result of current market conditions.

In the US, subordinated debt is most often raised on the capital markets in the larger, syndicated deals (as, unlike Europe, mezzanine debt is not prevalent) so a natural gap exists for second-ranking loans, which is filled by second-liens. US second-lien loans were originally designed to appeal to institutional lenders who cannot participate in subordinated debt, such as traditional mezzanine, because of constitutional constraints. US second-lien loans are therefore neither structurally subordinated nor contractually subordinated to senior debt: the senior debt and second-lien debt claims rank equally and the senior lenders generally have no right to shut off payments to second-lien holders in a default situation. It is only the second-lien holders' claims to the proceeds of the shared security package that are subordinated to the senior lender's claims to those proceeds.

For the sponsors, second-lien debt is cheaper than traditional mezzanine and other subordinated debt, including high yield. Sponsors also like that it does not carry warrants and can be repaid at par without penalty (or sometimes subject to a prepayment fee which tends to be lower in amount and applicable for a shorter period than prepayment fees demanded on mezzanine debt).

Second-liens now feature in many European deals as a cushion below the senior debt (but above mezzanine) to enable the senior debt element to fall within an acceptable leverage multiple to facilitate senior syndication while using institutional investor liquidity. However, when imported into European deals, second-lien strips have had to mutate away from the US precedent.

Second liens in Europe are often not documented as a separate facility to the senior debt. On many deals the second-lien is in fact just another tranche of senior debt (the D tranche) and documented as part of the senior credit agreement. Some banks call this type of instrument a First Loss to differentiate it from separately documented second-lien facilities.

In Europe, the second-lien strip (particularly if it is a separate facility) is unlikely to rank equally with the debt claims of the senior lenders. In many deals the senior lenders can impose payment blockage on the second-lien lenders. For instance, in the Cognis transaction, after a senior payment default, an automatic block on payments to the second-lien holders applies and, in relation to other senior defaults, the senior lenders can serve a blockage notice on the second-lien holders (whereby payments would be blocked for a maximum of 179 days after that notice was served). This change from the US model is needed in the absence of a US Chapter 11 debtor-in-possession moratorium concept in Europe to give the senior lenders the ability to conserve cash in the business in a workout situation. In addition, in some European deals the second-lien debt claim is contractually subordinated to the senior debt - reflecting the identity of the institutions to whom it is marketed, who typically do not have the same constraints on participating in subordinated debt as some US investors.

Again, the absence of Chapter 11-type protection leads European deals to include standstill provisions on enforcement action being taken by second-lien holders and to do so deals have duplicated the standard mezzanine standstill structure and applied it to second-lien holders too. Generally the senior finance parties will have control of any enforcement procedure - and the subordinated security and guarantees will be released to allow the senior finance parties to sell free of the subordinated debt, provided they account for the proceeds under the payment waterfall in the intercreditor agreement.

How much power second-lien lenders wield depends on whether their facility is documented as a separate facility or as a tranche D of senior debt. The second-lien will be more benign if structured as a tranche of senior debt because, depending on the size of the second-lien strip, second-lien lenders are likely to be outvoted by the majority senior lenders. Conversely, if documented as a separate facility, even though second-lien lenders represent a small piece of the capital structure, their existence will make decisions more complex as they have a separate, independent say and so potentially a hold-out value.

Views differ on for how long second-liens will survive. Many believe that they will continue to be offered for as long as the combination of high liquidity and high debt multiples remain. They could quickly disappear if the predicted market downturn materializes. There is another debate as to whether European second-liens are correctly priced (particularly where a separate second-lien facility has replaced a mezzanine strip in a particular deal).

Mezzanine developments

Although reportedly recently declining in volume as a result of the surge of second-lien debt, mezzanine is still an integral part of the capital structure on the bigger deals. Institutional investors have jumped at mezzanine participations too and this has resulted in the decline in the popularity of warrants, because the individual funds set up by institutional investors to invest in this type of debt cannot also hold equity.

Seventy-five percent of the mezzanine that Fitch rated in the first half of 2005 was warrantless. On some of the larger deals, mezzanine has been split into warrantless and warranted tranches to maximize liquidity offered by potential participants.

The independent mezzanine houses are understandably not keen on this development, saying that warrantless mezzanine rewards do not justify the risk profile, particularly if the facility may be repaid in a couple of years. Some also argue that warrantless mezzanine has a downside for the borrower, despite being cheaper, because the mezzanine creditors have no interest in the potential equity upside of the business. If the credit becomes troubled, those mezzanine investors will not have the carrot of a warrant to keep them supportive.

There has also been an increase in the use of PIK (payment-in-kind) tranches of mezzanine debt where interest is capitalized during the life of the facility. This is necessary to achieve high debt multiples but is also attractive in nature to institutional investors.

Junior mezzanine/subordinated debt

On larger deals, a technique borrowed from the real estate finance market has started to make its way into private equity debt structures – a layer of junior subordinated/junior mezzanine debt. This debt sits below senior, any second lien and mezzanine debt but above shareholder debt in the structure. It does not amortize during its life and is also usually a PIK instrument. As well as maximizing institutional investor appetite while controlling debt service payments on such high multiples, the growth of this kind of debt can be also attributed to thin-capitalization/transfer-pricing tax concerns across much of Europe, and in particular in the UK and in Germany.

The sting

Concerns about whether or not businesses laden with institutional debt can survive a workout are being voiced. Many fear that institutional investors will not participate in a workout (some funds for instance have constitutions that do not allow them to hold distressed debt) and could sell their debt on the secondary market at the first sign of trouble to funds specializing in distressed companies. With the market on their side, sponsors are now concentrating on the documentation to protect themselves from this risk in any downturn. How successful they are in achieving these documentation controls on a particular deal largely depends on how easily the lead banks see the different layers of debt syndicating at the outset, as they will be reluctant to agree points that could harm syndication. Sponsors are now particularly focused on transferability, wriggle room and syndicate management issues (as described below).

Transferability

Sponsors are concerned to know the identity of potential syndicate members. Some are even trying to amend transfer clauses in the documentation to provide that borrower's consent is required for every transfer. If that is not agreed, some sponsors try to preclude sales to institutional investors specializing in distressed company investments or to the debt-trading arms of existing lenders. In some cases, the more cautious sponsors are even trying to go further and to prohibit transfers to certain categories of institutional investors with whom they do not feel comfortable.

As the Marconi restructuring illustrated, the modern workout will suffer from the fact that it might be difficult to determine at any one moment in time which lenders have an economic interest in the various layers of debt. This is partly due to sub-participations (which some sponsors are also trying to restrict without consent) but also as a result of the blossoming use of credit default swaps.

Wriggle room

Documentation is also being altered in more subtle ways to deal with the issues of syndicate stability. Many bankers are commenting that sponsors are becoming more demanding at term-sheet stage in settling the main terms of the leveraged debt finance package. Most sponsors now produce the draft term sheet themselves to potential lead banks, and these are borrower friendly and contain negotiated points won on that sponsor's recent deals and used as starting positions on new deals (and often regardless of comparative deal size). A couple of such points favoured by sponsors include:

Equity cures - that is, that the sponsors can put in additional equity to cure a cash flow shortfall and in some cases an EBITDA shortfall too. The more aggressive version of this will not include a limit on the number of times that the equity cure can be invoked during the life of the facilities.

Mulligan clause - a familiar concept to corporate day golfers. If financial covenants are breached it is not treated as a default unless that covenant is breached again on the next attempt.

The more cautious sponsors have started to ask for the unanimous decisions clause in the senior credit agreement to be amended to allow any lender to provide additional money without giving a minority senior lender the right to veto the additional debt being put in. Usually the sponsors will ask for the new monies to be a majority lender decision but some sponsors ask for this to be the sole decision of the lender that is agreeing to lend the additional funds. This is reinforced by the senior headroom concept in the intercreditor agreement whereby senior lenders can lend an additional pre-agreed amount (usually 10%) of the senior debt without needing the consent of the subordinated lenders and still retain priority for that additional debt. The injection of additional working capital is often a necessary early stage in a workout and this combination of an amended senior decisions clause and the senior headroom concept should help monies to be made available quickly and easily should the need ever arise.

Syndicate management

Those with workout experience will be familiar with the constraints on restructurings/reschedulings imposed by the decisions clauses in credit agreements. The LMA standard form's list of unanimous decisions is widely drawn and favourable to minority lenders to maximize the lead arranger's ability to syndicate successfully. However, those veto rights can put minority lenders into a disproportionately strong position compared with their financial exposure.

Borrower-drafted term sheets are starting to emerge, which remove the main ransom rights from the list. So-called yank-the-bank clauses (allowing the borrower to replace a minority non-consenting lender) and snooze-and-lose clauses (to stop banks effectively rejecting a proposal simply by not responding) are now also under the spotlight.

The position of the lead banks is not an enviable one. Their task is to win mandates from sponsors in a ferocious debt finance marketplace while maintaining enough protection in the documentation to ensure that syndication is successful. On the other hand, more participants than ever are waiting to pick up the spoils. But the current demand for layered leveraged debt packages will mean that any workouts down the track are likely to be time consuming and complicated.

Author biography

Susan Whitehead Lovells Susan Whitehead is a consultant in Lovells' leveraged and acquisition finance team and is based in London. She has specialized in acquisition finance transactions since the early 1990s, advising both banks and Lovells' private equity clients on the financing arrangements on leveraged finance transactions including domestic and cross-border buyouts, public-to-private deals and bids.