2022 European Leveraged Loans Wrap: Investor Pushback Increases in Turbulent Market But Strong Credits Still Call The (Covenant) Shots

 

• European leveraged loan volumes declined significantly as a result of the market turmoil seen in 2022.
• Such decline in volume could reasonably be expected to cause a significant shift in covenants.
• However, there has not been a significant shift in covenants to being clearly more lender-protective. With capital still to deploy, investors flocked to good credits and borrowers with many suitors could still command their covenant terms. This was evident with aggressive borrower-friendly features continuing to clear the market.
• On top of considerable debt and value leakage capacities, calculation flexibilities which may be used by borrowers to manipulate financial metrics and artificially augment available capacities continued to prevail. Addbacks for uncapped amounts of cost savings and synergies, exclusion of certain debt from ratio calculations, and super-grower baskets were seen in a sizable minority of deals.
• Expansive dividend-to-debt toggles continued to soar in documents, leading to higher leverage risk.
• The presence of double builder baskets in the restricted payment covenant and readily available permitted investment ratio baskets created significant potential for value leakage.
• But with tougher credits also coming to market, lenders took their opportunity to tighten provisions. The proportion of deals featuring pushback in syndication rose in 2022, with broader and deeper changes being made to covenant terms in pushback.
• The turmoil and uncertainty seen in 2022 could provide a springboard from which investors push back on covenants. As the market expects most deals in the first half of 2023 to be refinancings by borrowers with impending maturities, investors could take the opportunity to roll back some of the more aggressive provisions of recent years.

There were record levels of new issuances of leveraged loans in the European market in 2021, with sponsors holding all-time high levels of dry powder and strong demand from investors. In January 2022, the market picked up where it had left off in December 2021 and there was solid deal flow.

When Russia invaded Ukraine at the end of February, however, the political and economic effects were immediate and seismic. Inflation, driven by surges in energy and commodity prices, rising interest rates and a global supply chain still recovering from the impacts of the Covid-19 pandemic have all combined to create turbulence in the global markets. With the resultant surge in pricing, activity in the European leveraged loan market after February was muted and volumes were down considerably from the highs of 2021.

Overall, volumes of new loans and high yield bonds marketed in Europe and priced in 2022 dropped to about €100 billion-equivalent from around €360 billion-equivalent in 2021, according to data compiled by Reorg. Of those, leveraged loans comprised approximately €64 billion-equivalent of the deals in 2022.

If investors expected that the slowdown in 2022 would reset the aggressive nature of leveraged loan covenants, they were to be disappointed. The slowdown was not attributable to a diminution of demand - investors still held considerable funds for deployment. Instead, a more selective approach to investment was evident with an emphasis on risk - strong credits saw a healthy demand from investors and deals that were perceived as higher risk were pulled.

That meant that good credits could still command their covenant terms, evidenced by relatively new borrower-friendly innovations continuing to clear the market.

Aggressive borrower-friendly provisions already known to the market also continued to proliferate. For example, exclusion of revolving debt from ratio calculations continued to soar in 2022.

However, the macroeconomic changes in 2022 meant that there was also opportunity for the buy side to tighten covenants. Banks held debt underwritten from before the Ukrainian invasion that needed to be offloaded and some borrowers needed to refinance. That led to increased volumes and depth of pushback seen in 2022 compared to 2021.

We conclude our wrap with our expectations for 2023 based on how we think the market may shape up (see the end of the article).

As always with the European leveraged loan market, terms are constantly evolving and EMEA Covenants by Reorg will keep you abreast of new developments as they arise.

This article is based on senior facilities agreements (“SFAs”) in the European leveraged finance market, governed primarily by the laws of England and Wales, as analyzed by Reorg from Jan. 1 to Dec. 31, 2022 (“2022 Deals”). From time to time in this article we compare 2022 Deals with SFAs in the European leveraged finance market we have reviewed in previous years (“2020 Deals” or “2021 Deals”, as the case may be).

An analysis of the trends seen in the European high yield bond market is HERE, our ESG wrap is HERE, and our analysis for the European restructuring market is available HERE.

 
Approximately two thirds of 2022 Deals (including add-ons) were used to finance buyouts and bolt-on acquisitions.

This is unsurprising as underwriting banks would have had a stock of loans underwritten prior to the Ukraine invasion to offload. Inflationary pressures and rising rates meant that only the most hard pressed of borrowers needing to refinance would come to market. Those factors came together to contribute to this same trend we observed at the half year mark.
 

 
We identified pushback from investors during syndication in 58% of 2022 Deals, representing a sizable increase from 2021 (45%). Given the deterioration of market conditions in 2022, the increase in pushback is unsurprising.
 

Investors significantly increased their focus on value leakage, leverage risk and calculation flexibilities, while still keeping an eye out for weaknesses in other areas. The graph below compares the areas of investor pushback in 2021 and 2022, as a percentage of deals which saw pushback within the respective years.
 

Key pushback changes are summarized below.
 

Areas	Changes Made in Syndication
Pricing	Margin ratchet:    1. The number of stepdowns reduced.  2. Margin ratchet holiday period either added or extended.
	Ticking fee added or time period shortened.
Calculation Flexibilities	Synergies and cost savings:    1. Cap introduced or reduced. 2. Time limit introduced or reduced. 3. Revenue synergies excluded.
	Ratio Calculations: Cap introduced for exclusion of revolving / working capital facilities.
	"Super-grower" or high water mark basket flexibility removed.
	Covid-related addback to EBITDA removed.
Value Leakage	Leverage ratio test for restricted payments and/or investments reduced.
	Baskets for repayment of subordinated debt removed or tightened.
	General restricted payments basket reduced in amount.
	CNI builder basket tightened:    1. Default blocker introduced. 2. “Zero” floor removed.  3. Starter amount deleted.
	Default blockers added or tightened in respect of certain permitted payments baskets (other than CNI builder basket).
	Separate basket for value leakage using proceeds of specified asset sales removed or tightened.
	Ability to make investments using Available Amount basket removed or tightened.
	J Crew Blocker protective provision introduced.
Leverage	2x contribution debt basket reduced to 1x.
	2x dividend-to-debt basket toggle ("pick your poison" provision) reduced to 1x.
	Ratio cap reduced for ratio debt basket / incremental facilities leverage test, or ratio debt tests otherwise tightened.
	Incremental “free and clear” amount reduced.
	"Inside maturity" basket for incremental facilities reduced or removed.
	General liens basket reduced.
	Acquired/Acquisition Debt Basket: ‘‘No worse’’ ratio test for incurrence of acquisition debt removed.
Margin / Yield Protection	MFN changed from margin to a yield cap.
	Scope of MFN extended to other debt baskets, including incremental “free and clear” debt basket, incremental acquisition or investment debt.
	MFN sunset period extended.
	MFN de minimis threshold reduced or removed.
	MFN maturity condition removed.
	MFN cap reduced from 1% to 0.5%.
	Soft call prepayment fee protection period extended.
Asset Disposals	Disposal proceeds reinvestment period introduced or reduced.
	Introduction of a 75% cash consideration requirement in the general FMV basket.
	Excess cash flow sweep leverage levels reduced and/or percentages increased.
Transfers	Restriction on lenders holding more than specified % of total commitments deleted.
	Deemed consent period introduced.
	Reasonableness requirement introduced.
	Restriction on transfers to "net short lenders" removed.
	Advance notice requirement for transfers of the term loan removed.
Other significant changes	Portability removed.
	Stay of default grace period during litigation of defaults removed.

We consider the nature of pushback seen in each of these areas.

Pricing

Of the deals that saw pushback in 2022, 60% of those featured at least one change related to pricing.

The key changes investors sought were to limit the number of stepdowns in the margin ratchet (typically capping this at two) and to ensure that the margin ratchet holiday applies for at least 6 to 12 months from closing.

Ticking fees were also introduced in some deals, while others saw the time periods for ticking fee step ups reduced. Increased scrutiny from regulators of M&A deals worldwide may result in investors seeking greater protection of their returns through introduction of bespoke ticking fee profiles on deals.

Value Leakage

73% of deals which saw syndication pushback in 2022 featured at least one change to documentation aimed at limiting value leakage.

No specific aspect of the restricted payments and investments covenant dominated the pushback table. Instead, pushback in 2022 was a case of mitigating the risk of value leakage in various ways, including through tightening of various restricted payment and investment baskets and introduction of, or tightening of, default blockers across those baskets.

Investors’ focus on curtailing potential value leakage is unsurprising, and is likely to carry on into 2023 as they keep their eyes on credit quality in the wake of tough trading conditions.

Leverage Risk

73% of deals which saw syndication pushback in 2022 featured at least one change to the debt covenant.

Pushback related to the debt covenant was skewed towards tightening of ratio debt incurrence tests and reduction of contribution debt baskets and dividend to debt toggles from 2x to 1x.

The size of incremental “free and clear” debt baskets also faced resistance, as a result of which the basket was most often sized between 75% and 100% of EBITDA following pushback.

Calculation Flexibilities

Of the deals that saw pushback in 2022, 53% of those featured at least one change related to calculation flexibility.

Not dissimilar to what we saw with European high-yield bonds, investors rejected terms which allow borrowers to add back to EBITDA uncapped amounts for cost savings and synergies.

Whilst investors may hope for a return to clean EBITDA, the market generally settled for addbacks capped at 20% to 25% of EBITDA and with a time realization horizon of 18 to 24 months.

Investors continued to reject addbacks for revenue based synergies.

Calculation flexibilities can materially impact leverage and value leakage capacities and may be used which investors may not have intended. We expect investors to continue to focus on these provisions given the macroeconomic headwinds expected in 2023. Such pushback could take many forms, but we consider these will continue to be at the top of investors’ wishlists:

• No exclusions of revolving or working capital facilities from ratio calculations, as it can be gamed to hide true leverage.
• No super growers - these one sided provisions give borrowers unfair upside rewards, especially where performance is volatile.
• Further tightening of EBITDA adjustments, including lowering of caps on cost savings / synergies and reduction of time horizons for realization.

Transferability

When market conditions were benign, transfer provisions generally did not garner much attention from investors. With worsening market conditions, transfer provisions have come back under the spotlight.

Some pushback seen this year can be attributed to borrowers’ attempts to further restrict lenders’ ability to transfer out of their loans. The bulk of pushback in this area focused on reintroducing the traditional deemed consent period and reasonableness requirement.

Other changes sought to limit relatively newer innovations, such as transfers that would result in the transferee lender exceeding a cap on commitments.

The big question in this area is whether investors will seek to roll back innovations that have become more commonplace. The absolute prohibition on transfers to distressed investors, for instance, which are commonly prohibited unless a material (i.e. non-payment or insolvency) event of default is continuing, which could be rolled back by easing of the fallaway to any event of default (rather than a material event of default) or by the removal of this absolute prohibition entirely.

Margin / Yield Protection

40% of deals in 2022 which saw pushback featured at least one change to margin and yield protection related provisions.

We previously considered the MFN provision and the many ways in which its applicability has been limited. As we saw for 2021, investors continue to push back against these carve outs.

 
As illustrated in the chart below, we have used Reorg’s Flexibility Scale to show how capacities for additional senior secured debt and structurally senior debt contracted over the course of the year.

It is interesting to note that capacities for shareholder payments remained the same in the second half of the year compared to the first half of the year while capacities for investments in restricted subsidiaries increased marginally.

Also of interest is the comparison to European high yield bonds, with “day 1” general capacities being higher across the board for loans. Debt capacity is notably much higher, with differences in the way the dividend-to-debt toggle operates in loans and bonds appearing to be the key reason for the difference (see below titled “Dividend-to-Debt Toggles More Than Double In Prevalence, the Risk of This Debt Incurrence Flexibility is Under-Appreciated”, and our prior analysis here for more detail).


 

 
Are Multiple Builder Baskets Now Market Standard?

End of year figures confirmed the trend we saw for the first half of the year with regard to the inclusion of multiple builder baskets. 65% of 2022 Deals had both a 50% CNI builder basket and an “available amount” basket based on retained excess cashflow, up from prior years, arguably driving presence of both baskets more into the “market standard” territory.
 
If the market continues to accept the presence of both baskets, it will be important for investors to ensure that certain key protections remain in place.
 

• The first is that there should be no double counting of components that build both baskets, i.e. if one component is used to make a payment under one basket, it should not also still be available to make a payment under the other basket.

• Second, the use of the “available amount” basket should be subject to a leverage condition, set at or just slightly above the ratio for the leverage-based restricted payment basket. Most deals in 2022 included such a leverage condition, however, a sizable minority of 2022 Deals (19%) did not.

• Finally, permitted debt should not be included in the “available amount” when used for making restricted payments. If included, this effectively gives the company a free route to a dividend recapitalization whilst still preserving full restricted payments capacity under other baskets.

The “available amount” can also be used to fund permitted investments, with borrowers sometimes proposing that these baskets can be accessed for investments without complying with a leverage ratio condition (or subject only to a loose leverage condition). Investors could push back by removing this standalone ability to use the “available amount” for investments without any conditions, as was seen in 2022.

Protective CNI Builder Basket Conditions Continue to be Chipped Away

The CNI builder basket in European leveraged loans was present in 92% of 2022 Deals, continuing the trend identified in prior years.

Zero floors, which help issuers maintain upside from periods of good performance whilst curtailing the downside from leaner years, remained in line with prior years.
 

Whilst the standard 50% of CNI was seen in all deals with a CNI builder basket in 2020 and 2021, a couple of 2022 Deals set the builder lower, at 25% of CNI.

81% of 2022 Deals had a CNI builder basket starter amount. The size of the starter ranged between 15% and 50% of EBITDA, with an average of 28% of EBITDA.

The ratio debt test condition continues to be an important condition for use of this basket, as our analysis on United Group’s ability to use the builder basket demonstrates. Helpfully for investors, the ratio condition continued to be prevalent, with only a very small minority of 2022 Deals omitting this condition. Requiring compliance with a ratio test on a pro forma basis protects creditors from shareholders extracting cash or assets through use of the builder basket when the company is in poor financial health - investors should always require a ratio test condition.

Where a ratio condition is present, the 2x FCCR test continues to be the most common. However, this is being eroded by (i) use of the alternative “not made worse” conditions and (ii) exclusion of the condition if the starter basket is being used or if used for making investments. We expect borrowers will continue to attempt to chip away at the ratio condition in 2023.

Traditionally, the absence of a both a default (i.e. any events that would become an event of default after expiry of a grace period, the giving of notice or the making of a determination) or an event of default is also a condition to use of the CNI builder basket. The erosion of this standard to a “material event of default” (i.e. payment or insolvency of default) only was included in a sizable minority of 2022 Deals.
 

In a small number of 2022 Deals, the default blocker did not apply at all where the basket is used to make investments. Such investment flexibility could allow a borrower to transfer assets into an unrestricted subsidiary to raise priming debt, even after it had defaulted. As shares of an unrestricted subsidiary can often be freely distributed, the absence of the default blocker solely for purposes of investments leaves a loophole for payment of dividends or distributions even when in default.

Nearly Quarter of Deals Allow Permitted Investments If Ratio Test is Not Made Worse

In recent years, a separate ratio based basket for the making of permitted investments started to appear alongside the restricted payments ratio based basket. The key difference between the two has been that the ratio test for permitted investments only is generally set higher.

Confirming the trend we identified in September 2022, 61% of 2022 Deals had permitted investment ratio baskets set at levels that included headroom on closing. Most of those deals had available headroom of up to 0.5x leverage, although there was considerable variation.

Some deals included alternative 2x FCCR tests that are, generally speaking, easier to meet. This alternative was present in 12% of 2022 Deals, representing a small but perceptible uptick from prior years (6% in 2021, 5% in 2020). Critically, it has not been included in deals in the second half of 2022, and where it was proposed was rejected by investors during that period.

In a further weakening of the conditions, some 2022 Deals allow for use of this basket so long as there is no deterioration of the applicable ratio (for more on why this provision is problematic, see HERE). There was an increase in the prevalence of the alternative “not made worse” condition in 2022 Deals compared to 2021 Deals, with most of these being seen in the first half of 2022.
 

We expect investors will continue to pushback against any such provisions if brought to market in 2023.

Protective J Crew Blockers Increase In Usage

Dropdown transactions continue to feature in the US market as a means of liability management, as seen with Envision early last year. Although, we have not seen such transactions effected in a European context, investors will remain alert for its possibility in the right circumstances, as we considered in the context of GenesisCare.

Investor concerns have not translated into action at the primary end of the market, however, with inclusion of a “J Crew” blocker only coming in slightly higher in 2022 (19%) compared to 2021 (10%). A “J Crew” blocker helps limit the risk of material assets being transferred to an unrestricted subsidiary which can then be used for various transactions, such as incurrence of priming debt (for more on the blocker, see here).

 
Dividend-to-Debt Toggles More Than Double In Prevalence; the Risk of This Debt Incurrence Flexibility is Under-Appreciated

The percentage of 2022 Deals that included a dividend-to-debt toggle (or “pick-your-poison” provisions) soared compared to prior years. This is somewhat incongruous given market conditions. It should be noted that the bulk of deals featuring this provision were seen in the first half of 2022, at a time when the market was still adapting to the change in market conditions.

Additionally, it could be that only issuers with more solid fundamentals and better credit quality cleared the market, and so a dividend-to-debt toggle may have been more palatable as part of the package provided it is not of the most egregious 2x formulation. No deal featuring a 2x dividend-to-debt toggle was seen, and were flexed out of deals where initially proposed.
 

The provision was further weakened in another respect. A sizable majority of the deals that included the toggle allowed for ALL restricted payment baskets to be converted, whereas previously it was more common that only selected material baskets can be used.

As we noted previously, conversion of specific purpose restricted payment baskets and permitted investment baskets expands the leverage risk of this toggle.

Updating the figures in our prior analysis for year end, on average, dividend-to-debt toggles contributed “day 1” additional debt capacity equivalent to 169% of EBITDA.

If the toggle were limited only to general purpose restricted payment baskets (i.e. did not include specific purpose RP baskets such as the sponsor fees or holding company expenses basket), that average would be reduced to 112% of EBITDA. Removing the ability to convert investment baskets further reduces the average to 71% of EBITDA.

If the dividend to debt toggle were limited in the manner described above, the average “day 1” debt capacities (see “Reorg’s Flexibility Scale” above) will reduce to:

• for additional senior secured debt capacity, approximately 242% of EBITDA, and
• for additional structurally senior debt capacity, approximately 105% of EBITDA.

These figures would then be more in line with “day 1” debt capacity we see for European high yield bonds. That conclusion is unsurprising, as high yield bonds typically do not allow for conversion of specific purpose restricted payment baskets and permitted investment baskets.
 

Deleting the toggle entirely would be the easiest way for investors to limit leverage risk. However, if not possible investors could alternatively seek to mitigate the risks presented by this toggle by limiting the toggle to general use restricted payment baskets only, and excluding the ability to convert permitted investments capacity.

Investors Stand Firm Against 2x Contribution Debt Baskets

None of the deals seen in 2022 allowed for incurrence of contribution debt at 2x and where it was proposed by borrowers, it was successfully resisted by investors. Broadly, a contribution debt basket allows a company to borrow additional secured debt against the amount of equity its shareholders inject on either a £1 to £1 (1x) or £1 of equity to £2 debt basis (2x).

This confirms the trend we observed at the half year mark and is consistent with our findings on the dividend-to-debt toggle. With market conditions expected to remain tough in 2023, we anticipate that investors will continue to resist the inclusion of 2x contribution debt baskets.

Use of Acquired / Acquisition Debt Freebie Baskets Soar

Tough market conditions can also present opportunities for bolt-on acquisitions.

Perhaps with this in mind, borrowers continued pushing for and getting a capped freebie acquired / acquisition debt basket, in addition to the standard ratio based basket for funding acquisitions. This basket had already been popular in prior years, and only became more prevalent in 2022.
 

In addition to the inclusion of the freebie, the ratio debt test for incurrence of acquired / acquisition debt also weakened slightly in 2022. Instead of, or as an alternative to, a leverage test, the easier to meet 2x FCCR test was present in a minority of 2022 Deals.

Even if the ratio test itself cannot be met, some deals would still allow acquired / acquisition debt to be incurred provided the ratio does not worsen (i.e. the “not made worse” test). While this “not made worse” option is entirely common in the high yield bond market, this provision has always been harder for loan investors to accept. This resistance was evident in 2022, as the prevalence of this alternative condition saw a decline, and pushback in syndication.

A small number of outlier 2022 Deals allow for senior secured acquired / acquisition debt to be incurred subject to the 2x FCCR test alone, without also requiring a senior secured leverage ratio to be met. This potentially allows a significant amount of acquired / acquisition debt to share in the collateral for the existing TLB, given a 2x FCCR test is generally easier to meet compared to leverage ratio tests.

 

Innocuous-Looking “Ordinary Course” and “Consistent with Past Practice” Exceptions Present An Unquantified Amount of Dilution / Priming Risk

An increasing number of deals allow for incurrence of uncapped capitalized lease obligations and purchase money obligations (“CLO/PMO basket”) provided it is incurred in the ordinary course of business, or is consistent with past practice. This allows additional amounts of such debt to be incurred in excess of any cap provided it can be said to be incurred in the ordinary course of business.

This presents a significant risk of additional debt being incurred beyond lenders’ expectations. The phrase “ordinary course of business” does not present a bright line test. The risk for lenders is compounded by divergence in interpretation under New York law and English law.

Where the “consistent with past practice” exception is present, the risk for lenders is greater. With loans, disclosure is not as fulsome as for a bond and so it is hard for lenders to understand what type and size of transactions might be considered consistent with the borrower’s past practice.

With respect to the CLO/PMO basket, 54% of 2022 Deals included the ordinary course of business exception, and 31% of 2022 Deals included the consistent with past practice exception.

These exceptions have also started to creep into other key material baskets that otherwise are capped by grower baskets. For example, we have seen this with the factoring / securitization basket and local lines basket.

   

Uncapped synergies

Often a bugbear of investors, 19% of 2022 Deals allowed for uncapped amounts of cost savings and synergies to be added back to EBITDA. This represents a reduction compared to previous years, helped on by investors pushing back during syndication and requiring a cap to be imposed.

The majority of 2022 Deals that allowed for uncapped cost savings and synergies required third party certification as to the amount of cost savings and synergies added back. Where such certification is not provided, a cap would apply.

The cap on cost savings and synergies seen in 2022 ranged between 10% and 30% of EBITDA, with the median cap being 25% of EBITDA, in line with the range and median seen in 2021.

More than a Third of 2022 Deals Allowed Revolving Debt to Be Excluded When Calculating Leverage

2022 saw an increase in the percentage of loans which allowed revolving or working capital debt to be excluded from ratio calculations to 36%. Such an exclusion effectively allows uncapped revolving debt, because revolving debt incurred under the ratio debt basket would not result in an increase in the ratio.

Only about half of 2022 Deals which had this calculation flexibility limited the exclusion to revolving debt incurred for working capital purposes only.

Where the exclusion extends to all forms of revolving debt (i.e. whether for working capital purposes or not), a borrower may be able to game the exclusion by incurring what is intended to be longer term debt in the guise of revolving debt. Clean down provisions in revolving facilities are rarely (if ever) included, so there is often no requirement for revolvers to be left undrawn any period of time, increasing the risk of revolving debt remaining outstanding as if it were term debt.

To limit risk of such gaming, some deals in 2021 imposed a cap on the amount of revolving debt that can be excluded from the ratio calculation. That cap was not seen in deals in the first half of 2022. However, in a sign that investors are uncomfortable with the risk, pushback was seen in the second half of 2022 resulting in a cap being introduced.

Super Grower Baskets

At the half year mark, the prevalence of super grower baskets (also known as “high watermark” baskets) matched that seen in previous years, albeit with some pushback being seen in that period.

However, the provision was seen more frequently in the second half of 2022, leading to the full year figure for 2022 being higher than previous years, at 27% of 2022 Deals.

 
Leverage Grid Step-Downs

The requirement for asset sale proceeds to be applied to deleverage continued to be weakened with 54% of 2022 Deals including a leveraged based grid for the reduction of the proceeds required to be applied in prepayment. This was in line with 48% of 2021 Deals and up from 32% of 2020 Deals.

If the leverage test can be met, asset sale proceeds can be retained by the group and could be used for any purposes, including the making of restricted payments. The risk is compounded if a dedicated restricted payment basket allows those proceeds to be leaked out directly without the borrower having to use capacity under other restricted payment baskets.

Specified Asset Disposals

35% of 2022 Deals included a carve-out for disposal of specified assets or assets not exceeding a specified threshold of EBITDA from the asset sale mandatory prepayment regime. The basket was sized between 10% and 25% of EBITDA, with 20% of EBITDA being the median basket size. The proceeds of such sales typically can be used for any purpose, including the making of restricted payments.

Each of the loans in 2022 that included a specified asset disposals basket also allowed proceeds of such specified disposals to be paid out as a permitted payment under a dedicated restricted payments basket, compared to just 7% of 2021 Deals. Use of such dedicated baskets are commonly subject to compliance with leverage ratio-based conditions.

 
MFN protection continued to be offered in documentation, typically with a 1% margin / yield cap. However, a greater proportion of loans in 2022 measured the cap by margin only, instead of the more protective yield cap. A margin cap is susceptible to being circumvented through use of greater OID or an increased base rate floor. For example, OID of 94 equates to 2% per annum margin (on a three-year convention which is typical for European deals, or 1.5% per annum on a four-year convention).
 

Where present, MFN protection is often weakened by the inclusion of extensive restrictions and carve-outs, so the circumstances in which it will apply are very limited.

Short sunset periods mean that the MFN protection applies only for a limited period of time post closing.

Save in the case of certain loan add-ons which did not provide for renewed MFN protection for the add-on lenders, all loans seen in 2022 had an MFN sunset period. 6 month sunsets remained popular, although investors had some success in pressing for a preferable 12 month period, while 18 month sunset periods were also seen in a very small minority of deals.

 

Other carve-outs to application of the MFN gained significant ground:
 

• Monetary carve-outs exploded over the last two years, meaning that a “free and clear” amount of debt can be incurred during the sunset period with margin / yield significantly higher than the existing TLB.
• Maturity condition exclusion: Carve-outs for debt that have maturity greater than 12 months after final maturity of the existing TLB also continued its upward march in 2022.
• Sidecar exclusions: For the first time in recent years, MFN protection will not apply to debt incurred outside of the existing SFA for the majority of loans.
• Inside maturity baskets: Not only do inside maturity baskets allow for pari passu ranking debt to be incurred with an earlier maturity date (i.e. it is temporally senior), a number of loans also exempted such inside maturing debt from the margin / yield MFN protection.

MFN Snooze You Lose: Unaware Lenders Could Leave Money On The Table

One new innovation seen in 2021 and carried over into 2022, is the lender MFN “snooze you lose”. This provision was seen in 23% of 2022 Deals.

Under the standard drafting, if the margin / yield MFN is triggered, the margin uplift for lenders applies automatically. However, if the “snooze you lose” is present, a lender would have to expressly confirm that it wishes to receive the margin uplift. If it does not respond within the snooze period (typically between 3 and 10 business days), it will not be entitled to that margin uplift. It is improbable that a lender would not want the margin uplift if it was available, and so this provision appears intended to catch out lenders who aren’t paying full attention to their data sites.

If inflation remains persistently high and the expectation is for rate rises over a longer duration, we may see MFN protections becoming more of a battleground between borrowers and lenders in 2023, as the risk that a borrower may be required to pay more for additional debt soon after closing becomes a greater threat.

 
Rising Use of Sunsets on Lenders Calling Defaults

The sunset on calling defaults provision effectively sets a deadline by which lenders can accelerate the loan as a result of a particular default. The sunset period we have seen in all cases is 2 years.

For example, if a default occurs on 15 December 2020, the lenders may no longer accelerate the loan as a result of that default after 15 December 2022 (assuming a 2 year sunset).

Prevalence of this provision has proliferated in 2022, with 35% of loans including this provision (compared to 13% in 2021).

The language of this provision has been evolving to the significant detriment of lenders.

As we discussed previously, it is arguable that it would be more reasonable if the 2 year period begins once all lenders are aware of the default.

However, as we observed previously, some deals allow the clock to start even if none of the agent nor the lenders is aware of the default. This introduces the risk that the borrower could simply bury the default in the hope that it would not be uncovered prior to the end of the sunset period, and is a real risk in the context of incurrence covenants. Since we last discussed this provision, this most aggressive formulation has continued to clear the market.

Transferability: Lenders’ Exit Rights Remain Highly Limited

Despite greater focus from lenders on the transfer provisions in 2022, borrowers and sponsors have been increasingly successful in constraining the rights of lenders to trade out of their loans.
 

Caps on Commitments

More aggressive innovations of recent years were pared back. One example of this is the cap on commitments of a transferee lender. Such a cap was included in 8% of loans in 2022, down from 13% in 2021.

Where present, the typical cap remains at 15% of total commitments under the relevant facility or in some cases, also across all facilities. For our article on commitment caps on transfers and voting, see HERE.

Reasonableness and Deemed Consent

More standard lender protections, however, continue to be eroded.

Most notably, the requirement that borrowers act reasonably in withholding their consent to transfers was absent in a significant number of deals in 2022 (38%), marking a significant jump from prior years.

The deemed consent provision suffered a similar hammering in 2022, being absent from 31% of leveraged loans in 2022.

Advance Transfer Notices

One fairly recent innovation is the requirement for lenders to give notice of a transfer to the borrower, even if the transfer is permitted without the need for borrower consent. This will allow borrowers to monitor and maintain greater control over the make up of their lending syndicate. From the lenders’ perspective, however, it will result in delay to an otherwise entirely legitimate transfer.

We previously discussed this provision HERE and noted its prevalence in loans seen in the first half of 2022.

38% of 2022 Deals include a requirement for an advance transfer notice, the notice period for which was typically ranged from 5 to 10 business days’.

In a number of deals, the need to give such notice is either watered down (from a 10 business day notice period to 5 business days’) or is disapplied entirely where a material event of default (i.e. payment or insolvency event of default) is continuing.

 
To try and forecast 2023, we would look to the outlook for the broader market.

Activity in the leveraged loan market in the first half of the year is expected to be confined to refinancing of debt with impending maturities, amend and extends and small add-ons. It is anticipated that few new money deals will be brought to market until at least the second half of the year.

Borrowers typically recycle their covenants for refinancings and we would expect to see covenant packages in the first half of the year remain relatively consistent with what we have seen in the last few years. However, investors could push back, even with recycled covenant packages, for more challenging credits.

As the market for new money opens up again in due course, we expect investors to be more discerning as to the credits in which they choose to invest. This will heighten demand for good quality credits with the result that those borrowers will continue to push for and to get aggressive borrower-friendly terms.

For more challenging credits, the environment is likely to be more uninviting. However, we do not expect that there will be a material reset of covenants. There is still a lot of capital available in the market, both on the private equity side and among loan investors. There will be deals to be done on the right terms and investors will accept risks on deals provided they are reflected in the pricing.

There will be some retrenchment of capacities with greater focus from investors on leverage, value leakage and calculation flexibilities. Borrowers are likely to seek more creative ways in which capacities can be used and we expect to see more deals allowing capacities to be moved from one covenant to another.

If default rates increase, we are likely to see an increasing number of borrowers using liability management techniques imported from the US. Investors will become more cognizant of the vulnerabilities that allow for potential uptiering and drop down transactions and will seek to mitigate against those risks on new deals. In a similar vein, an increase in distressed credits will focus attention on the restrictions in the transfer provisions as investors seek to manage their exposure and rebalance their portfolios.