Mon 04/05/2021 10:57 AM
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Although the loan market continues to provide borrowers with significant flexibility to incur additional secured debt, pay dividends and transfer assets to unrestricted subsidiaries, particularly in larger, sponsored financings, we have started to see instances where lenders have been successful in pushing back against certain terms or in pushing for the inclusion of others. Continue reading for our Americas Covenants team's analysis of the leveraged loan market trends and Request a Trial for access to the linked debt documents, tear sheets, and summaries as well as our coverage of thousands of other stressed/distressed debt situations.

In this article, we provide an overview of the current leveraged loan market and highlight contentious terms that lenders have been able to successfully push back on, some terms that have been added for the lenders’ benefit and certain other terms that were once thought of as aggressive but are now becoming more common.

We want to emphasize that although the terms discussed below are favorable for lenders, they remain the exceptions to the rule and, absent substanined inclusion in loan documentation, do not reflect an overall market trend. Nevertheless, most trends start as a trickle and build up momentum over time, and what once was the exception could slowly and steadily turn into the rule.
Most Favored Nations (MFN) Protection

In credit agreements, MFN protection is meant to provide initial lenders with the benefit of better pricing should their borrower incur additional pari debt. Ideally, MFN protection requires that if a borrower incurs additional pari debt under incremental debt, incremental equivalent debt, ratio debt or acquisition debt baskets that is priced more than 50 basis points higher than the initial term loans, the pricing on the initial term loans will be adjusted so that the difference is never more than 50 basis points.

Over the past few years, sponsors have continually tried to chip away at the strength of MFN protection in three key areas: pricing difference, length and scope.

Pricing difference - Although 50-basis-point MFN protection remains the market standard, initial drafts of many sponsored bank facilities, especially the larger ones, have tried to widen MFN protection such that the difference between new pari debt and the initial term loans may not exceed 75 basis points or, in fewer deals, 100 basis points. While lenders have had some success in pushing back on the wider pricing difference, some deals we have seen in the past year have been finalized with 75-basis-point MFN protection, including the credit agreements of Bumble (Blackstone), Certara (EQT Services), Maravai LifeSciences (GTCR) and StubHub (Madrone Partners and Bessemer Venture Partners).

Length - Whereas five years ago, MFN provisions did not expire after some length of time following closing (referred to as sunset periods), more and more recent credit agreements are including sunset periods of between six months and 12 months (for finalized facilities that do include an MFN sunset, most of them include a 12-month sunset). Academy Outdoors’ (KKR), Bumble’s and Petco’s (CVC) recent credit agreements included six-month sunsets, while Maravai LifeSciences’ and Certara’s credit agreements included 12-month sunsets.

Scope - In addition to not being subject to a sunset, MFN provisions five years ago applied to all additional pari incremental term loans. Almost every draft sponsored credit agreement tries to weaken the scope of the facility’s MFN protection in one of more ways, including:

  • Where an incremental debt basket permits amounts not to exceed the greater of a fixed amount and a percentage of EBITDA or total assets (referred to as the grower basket), plus additional amounts in compliance with specified leverage or interest coverage test, by excluding pari incremental debt incurred under the grower basket or incurred as leverage-based incremental debt (but not both obviously); where debt incurred under the grower basket is excluded, the MFN protection typically applies only to leverage-based debt in excess of specified amounts.

  • Excluding incremental debt that matures more than one or two years after the initial term loans mature.

  • Excluding incremental debt that will be used to fund an acquisition or other permitted investment.

The table below summarizes the MFN protection in certain recent sponsored credit agreements and illustrates how sponsors have steadily eroded the strength of the protection.
MFN protection in recent sponsored credit agreements

While MFN protection continues to deteriorate, lenders have had some success in reducing the pricing difference (as mentioned, 50 bps MFN protection is still standard), extending or eliminating sunset periods (no sunset is still standard, although 12-month sunsets are definitely increasing) or expanding the scope of the protection (requiring MFN protection to apply to any pari incremental term loans regardless of which basket such debt was incurred under is still standard).
Anti-PetSmart Guarantor Protections

While PetSmart’s 2018 transfer of a portion of Chewy’s equity to an unrestricted subsidiary resulted in valuable collateral being released from liens, the transfer of another portion of Chewy’s equity to the company’s sponsors was arguably more deleterious to lenders.

Because PetSmart owned 100% of the equity of the unrestricted subsidiary that now owned a portion of Chewy’s equity, it still owned 100% of Chewy’s equity, albeit directly and indirectly now.

Had the transaction been limited to just the unrestricted subsidiary transfer, lenders would not have been pleased, sure. But there were no other material ramifications from that transfer, at least in the short term.

However, because PetSmart did not own its sponsors, the transfer of Chewy’s equity to the sponsors resulted in Chewy becoming PetSmart’s non-wholly-owned subsidiary and, pursuant to the definition of “Excluded Subsidiary” in the company’s debt documents, which included non-wholly-owned restricted subsidiaries, not only was Chewy released from its guarantee of PetSmart’s debt, the liens on its assets were also terminated, because Chewy was now a nonguarantor restricted subsidiary.

Almost all credit agreements prior to PetSmart’s Chewy equity transfers treated, and most afterward treat, non-wholly-owned restricted subsidiaries similarly. However, the transaction highlighted how easily guarantors and liens on assets could be released (although PetSmart transferred 20% of Chewy’s equity to its sponsors, the same result would have happened had it transferred 1% of its equity).

In response, some credit agreements started including provisions that, under certain circumstances, block the release of guarantors from their guarantees should they become non wholly owned. We have seen these anti-PetSmart guarantee protection provisions in a decent amount of private loan agreements, and their inclusion is steadily increasing.

Although the provisions vary slightly from credit agreement to credit agreement, in general they provide that guarantors that become non-wholly-owned restricted subsidiaries will not be released from their guarantees if a portion of guarantor’s equity following the subject transaction is owned by an affiliate of the borrower and the underlying transaction that resulted in it becoming non-wholly-owned was not for a bona fide business purpose.
Anti-PetSmart guarantor protections in recent sponsored credit agreements

Slight variations and additional conditions in some credit agreements include:

  • The guarantor can no longer constitute a subsidiary of the borrower (in most cases, this would require that the borrower owns less than 50% of such subsidiary’s equity).

  • The borrower must have sufficient investment capacity and will be deemed to have utilized such cash, equal to the fair market value of the assets of such subsidiary that are attributable to the borrowers’ or the borrowers’ holding companies’ ownership interest in such subsidiary.

Lien Subordination Amendments

The most controversial transactions taken in 2020 by borrowers looking to strengthen their liquidity were the superpriority uptier exchanges consummated by Serta Simmons, Boardriders and TriMark in mid to late 2020.

The transactions involved amendments to the company’s credit agreements that resulted in lenders’ liens being subordinated by newly permitted superpriority debt provided by the amendments. The controversy revolved around the fact that, because amendments that resulted in lenders’ liens being subordinated were not included in the list of amendments requiring all lenders to consent, such amendments likely only required the consent of a majority of lenders.

Rather than simply require that lien subordination amendment require the consent of all lenders, some 2021 credit agreements have included language requiring that all lenders have to consent to any amendment that subordinated lenders’ liens for new debt, but that threshold will be reduced to majority consent if all lenders have been offered the opportunity to participate in the senior lien debt.

Had Serta, Boardriders or TriMark been required to offer all lenders, or even 66.67% of lenders, the opportunity to roll up their first lien debt into superpriority debt, the appeal of the transaction, and in Serta’s case the willingness to lock in the losses caused by the distressed exchange, would be reduced. If all lenders exchange their first lien debt for superpriority debt, none of them are in a better position than they were prior to the exchange.

Although this new amendment provision would not prohibit a borrower from incurring superpriority debt, it seemingly eliminates the biggest risk of these Serta transactions, namely that the majority lenders benefit to the detriment of the minority lenders.

However, imagine this scenario:

  • A company’s term loans are trading at 70, its liquidity is drying up, and it wants to pursue a superpriority uptier transaction but is subject to this new amendment provision.

  • The company’s term loan permits it to purchase its term loans in the open market.

  • The company goes to a majority of its lenders and tells them that it wants to pursue a superpriority transaction, but in order for the necessary amendment to be effectuated, either all lenders have to consent or a majority can consent but only if the company offers all lenders an opportunity to participate in the superpriority debt.

  • The company tells the majority lenders that it is going to offer all lenders the opportunity to participate, but only if they agree to exchange their term loans at 50, well below the current trading price of 70.

  • The company also tells the majority lenders that if they consent to the exchange, it will also purchase an additional amount of their term loans, but not the term loans of any other lenders, at par in the open market.

  • The company then announces to all lenders that it wants to pursue the superpriority uptier exchange under which they would need to exchange their term loans at 50.

  • The minority lenders, unsurprisingly, balk at the offer, just as the company expected.

  • Now, however, the necessary amendment only requires consent from the majority of lenders who have already consented to the exchange with the understanding that the company will also purchase an additional amount of their term loans in the open market at par.

  • The amendment and the exchange are consummated with majority term loan lender consent.

In this scenario, the company would almost assuredly find itself in litigation over the transaction, and the “side room” deal with the majority lenders would likely face significant judicial scrutiny. However, this scenario could be possible and could allow borrowers to continue to pursue Serta transactions.

Nevertheless, credit agreements with this provision provide lenders with more protection than credit agreements without it, and although most new sponsored credit agreements still permit lien subordination amendments with consent from a majority of lenders, these new provisions have begun appearing in some recent sponsored financings.

The only publicly available credit agreement to include these provisions that we have found is Owens & Minor’s new credit agreement, dated March 10, 2021. Pursuant to the agreement, no amendment will:
“[O]ther than in connection with a debtor-in-possession financing … or except as otherwise expressly permitted by this Agreement or the other Loan Documents, subordinate the Liens on all or a material portion of the Collateral securing the Obligations or the payment of the Obligations to other Indebtedness (unless the opportunity to participate in the priming debt giving rise to such subordination is offered to all of the Lenders on a pro rata basis), without the written consent of each Lender directly and adversely affected thereby” (emphasis added).

Erroneous Payments

On March 8, we wrote about new language that had begun to appear in credit agreements, public and private, following the U.S. District Court for the Southern District of New York ruling that Revlon’s lenders who received mistaken transfers from Citibank last August were protected by New York’s “discharge-for-value” rule and, as a result, were entitled to keep the money.

Pursuant to these so-called “Erroneous Payment” provisions:

  • The agent has the sole discretion to determine whether a payment was made in error.

  • The agent can claw back any erroneous payments, regardless of whether the error was known to the receiving lenders.

  • Once it determines that a payment was made in error, the agent is entitled to recover the amounts erroneously paid.

  • Not only must lenders repay the erroneous amounts (which amounts must be provided by the agent in reasonably detailed calculations), they must also pay accrued interest for each day the payment remains outstanding, including from the date of the initial erroneous payment.

  • In becoming a signatory to the facility, each lender waives its claim of discharge for value or any other claim of entitlement to the erroneous payment.

Although, when we wrote that article on March 8, we could find only four publicly filed credit agreements that included the Erroneous Payment provisions, by the beginning of April there are countless credit agreements that now include them.

Because these provisions, which are substantially similar in all cases, appear to allow the agent to determine that an erroneous payment was made at any time in the past, absent the agent notifying lenders that a payment was not erroneous, it is not clear how lenders could ever be certain that payments (or any portion of any payment) they receive would not be clawed back at some time in the future should the agent determine that an error was made.

In addition, under these provisions, to the extent the agent exercises its clawback rights, lenders must return the erroneous payments, together with accrued interest equal to the overnight rate from the date the payment was sent.

Viewed in a different light, all payments made to lenders from the agent effectively become a debt owed by lenders to the agent (together with accrued interest) until the agent determines that such payments were not erroneous and, therefore, need not be returned.
Transfers to Unrestricted Subsidiaries

Although far more attention is paid to borrowers’ ability to transfer assets to unrestricted subsidiaries, unfortunately, most of the larger private sponsored credit agreements continue to lack any lender protections that prohibit, or reduce, borrowers’ ability to shift value to unrestricted subsidiaries.

While we have seen a few recent agreements that either prohibit or impose a cap on the amount of value that can be shifted to unrestricted subsidiaries, those limitations are typically reserved for lower-middle-market and small-cap financings.
unrestricted subsidiary transfer restrictions

Nevertheless, as illustrated below, some recent sponsored credit agreements that have been publicly filed have included limitations and prohibitions on certain transfers of assets to unrestricted subsidiaries. However, despite the focus paid to borrowers’ flexibility to transfer assets to unrestricted subsidiaries, these examples are outliers and are not indicative of a new trend.
Other Provisions That Are Becoming More Common

Certain terms that had begun appearing in private sponsored credit agreements a few years ago have now become more common. Although not in every agreement, to the extent these terms appear in initial draft credit agreements, they usually remain in the final versions.

Earlier maturing debt - Many credit agreements allow borrowers to incur a specified amount of debt (typically between 50% and 100% of the incremental grower basket) that is permitted to mature ahead of the initial term loans.

Although this debt is secured on a pari basis with the initial term loans, because it matures first and, as a result, could be subject to accelerated amortization payments, it is, effectively, quasi-senior pari debt.

Proceeds subject to asset sale sweep based on pro forma leverage - Asset sale proceeds that are subject to the asset sale sweep and must be used to either repay debt or reinvest in the business are based on the borrower’s pro forma first lien or total leverage.

Although these provisions have been appearing in draft credit agreements for many years, their inclusion in the final versions of the agreements has been steadily increasing.

Debt using restricted payment capacity - For the past few years, many credit agreements have allowed borrowers to use available restricted payment capacity to alternatively incur additional debt. For investors who view dividends as a larger risk than increased outstanding debt, these types of baskets are not particularly troubling (for those who view increased debt as a bigger risk, they are far more troubling).

However, in some larger sponsored financings, these credit agreements also include a corresponding liens basket that allows all such debt using restricted payment capacity to be secured, and some allow for debt equal to twice the amount of permitted restricted payments (relatedly, some agreements also permit borrowers to incur debt equal to twice the amount of cash contributions and proceeds from equity issuances received since closing, and some of these agreements also include a corresponding liens basket allowing all such debt to be secured).

Although there have been a few examples of lenders successfully pushing back on this debt basket’s inclusion in the final documents (there are also a few examples of lenders successfully eliminating the corresponding liens basket and reducing capacity to a one-to-one basis), where drafts include a debt basket using restricted payment capacity, the final versions do as well.
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