EMEA Leveraged Loans Wrap 2023

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2023 Covenants Less Permissive Compared With 2022, but Slight Loosening at Year-End Gives Borrowers Cause for Optimism in 2024

Key Takeaways:

• A&E and refinancing transactions dominated 2023. However, a number of LBOs reinvigorated the market, and dividend recaps gave sponsors a route to extract returns where other exit options were not available.
• Our predictions at the start of the year have largely hit the mark. In A&E deals, covenant terms were mostly recycled, leading to improved overall covenant quality compared with 2022. There were few new money deals for investors to choose from though, leading to relatively looser terms on those deals. Nevertheless, the overall picture shows covenants in 2023 being less permissive for borrowers relative to 2022.
• Investor pushback frequency far exceeds 2022 levels if add-ons are excluded (67%), and even more so if A&Es are also excluded (81%). Investors focused on value leakage, pricing and yield protection, and leverage risk-related covenant terms for pushback.
• Our Flexibility Scale shows decline in “day 1” general purpose debt, restricted payments, and investments capacity compared with 2022. However, increases were seen across the board in Q4 2023 compared with earlier quarters, and we expect this trend to continue if the market for new money deals becomes more active.
• Qualitatively, covenants were more protective for lenders across the board in 2023 compared with 2022. A minority of terms have trended toward being more borrower-friendly, or remained at least unchanged, giving borrowers some scope for optimism going into 2024. We discuss how specific covenant terms have evolved in 2023 in greater detail in part 2.
• A&Es and refinancings will continue to make up a significant portion of the market, with 2025 and 2026 maturities coming into view. Covenants for those deals are likely to look similar to prior years. In 2024, reductions in interest rates may bring a rush of supply of new money deals to the market, but demand for quality deals and competition from direct lending may lead to weaker covenant terms. However, if rates remain elevated, 2024 may very well be 2023 all over again.
• Controls around value leakage became more restrictive in 2023: As the presence of multiple restricted payment builder baskets declined, permitted investments ratio baskets were less permissive and use of protective “J. Crew” blockers markedly increased.
• Borrowers as a whole had less room for gaming ratio and EBITDA calculations in 2023. The ability to add back uncapped cost savings and synergies, exclusions of revolving debt from ratio calculations, and use of “super-grower” baskets all declined compared with 2022.
• Pricing and yield protection: In a rising interest rate environment and general market volatility, investors were keenly focused on protecting their yields. 101 soft call protection was frequently included, with sunset periods of between six and 12 months. There were longer MFN sunsets in 2023, with other carve-outs and limitations to MFN largely scaled back.
• 2023 arguably marks the year when Chewy protection established itself in a firm minority of leveraged loan deals. Of 2023 deals that exempted non-wholly owned subsidiaries from granting credit support, 25% included Chewy protection to prevent the erosion of credit support.

Reorg’s Proprietary Flexibility Scale

Our Flexibility Scale measures capacities available for general debt incurrence and value leakage on “day 1,” that is, immediately upon closing of the transaction. The chart below shows how capacities for additional senior secured debt, additional structurally senior debt, value leakage to unrestricted subsidiaries and dividends have declined in 2023 when compared with 2022.

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