Thu 04/22/2021 12:11 PM
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Relevant Items:
Covenants Tear Sheet, Debt Document Summaries
Surgery Partners

On April 20, Surgery Partners announced that it is seeking to raise $125 million of incremental term loans to refinance $119 million of outstanding incremental debt the company incurred in April 2020, including paying “the fees and expenses associated with this refinancing.”

At the time Surgery Partners incurred the incremental term loans in April 2020, the global economy had effectively been shut down due to the Covid-19 pandemic and a multitude of borrowers were seeking covenant relief amendments under their credit agreements due to steep EBITDA declines, looking to raise new debt to fortify liquidity or both.

In that light, it is hardly surprising that pricing on Surgery Partners’ incremental debt was L+8%, compared with the L+3.25% pricing on its $1.29 billion tranche of initial term loans.

The differences between the new incremental tranche and the initial tranche of term loans were not limited to pricing. Whereas the initial term loans had been subject to a six-month 1% soft call protection, the incremental term loans were subject to a two-year call protection, including a make whole, plus a 2% premium in the first year and 2% in the second, for all voluntary prepayments and mandatory prepayments with debt proceeds.

Given the 2020 incremental term loans’ call protection schedule and the fact that Surgery Partners incurred the loans on April 22, 2020, it is also hardly surprising that Surgery Partners is now looking to refinance the 2020 incremental term loans as the one-year make whole period is set to expire.

The incurrence of the 2020 incremental term loans and their repayment, which will include a 2% call protection premium, highlight the potential risks to lenders that have invested in bank debt, the documentation of which includes weak most favored nations, or MFN, protection.

For initial term loan lenders under Surgery Partners’ senior secured term loan and revolving credit facility, not only did they not benefit from the significantly higher pricing of the 2020 incremental term loans, despite their term loans being secured on a pari basis with the new loans, but they will now also not receive the benefit of the 2% call protection premium that the 2020 incremental term loan lenders will receive.

In this article, we provide a brief overview of MFN mechanics in credit agreements and discuss how weak MFN protection was exploited by some borrowers at the height of the Covid-19 pandemic in the first half of 2020 to the detriment of existing term loan lenders.
MFN Protection

Almost all credit agreements permit borrowers to incur additional pari debt in the form of incremental debt and incremental equivalent debt, and many credit agreements also permit pari ratio debt.

Incremental equivalent debt and ratio debt usually can be in the form of bank or capital markets debt and, to the extent it takes the form of bank debt, is usually documented under a separate credit facility.

Incremental debt and incremental equivalent debt share capacity and, in the current market, typically permit debt under a so-called free-and-clear basket, which is based on the greater of a fixed amount and a percentage of EBITDA or total assets and permits additional debt, subject to meeting a specified first lien leverage test if the debt is first lien debt, a specified secured leverage test if the debt is junior lien, and a total leverage ratio (or an interest coverage test, or both) if the debt is unsecured.

Ratio debt typically permits leverage-based debt, subject to the same leverage tests as are required to incur incremental debt and incremental equivalent debt.

Five years ago, most credit agreements included MFN protection pursuant to which any pari incremental debt, incremental equivalent debt and ratio debt could not be priced more than 0.5% higher than the initial term loans unless the initial term loans’ pricing was increased to ensure the difference was never greater than 0.5%.

We recently discussed how, over the past five years, sponsors have continually tried to chip away at the strength of MFN protection in three key areas: pricing difference (MFN protection currently ranges from 0.5% to 1%, although 0.5% is still the most common), length (more and more credit agreements include MFN sunsets under which the protection expires between six and 12 months after closing) and scope (some deals only provide MFN protection from pari leverage-based incremental debt or incremental debt incurred under the free-and-clear basket).

Importantly, borrowers can always circumvent the MFN protection by issuing pari high-yield bonds instead of pari term loans. Because bonds are typically fixed-rate debt instruments and bank debt is a floating-rate instrument, requiring MFN protection would not be practical.
MFN Protection Under Surgery Partners’ Credit Agreement

Surgery Partners’ credit agreement permits incremental and incremental equivalent debt not to exceed $346 million, plus additional amounts in compliance with a (i) 3.9x first lien leverage ratio if such debt is pari debt and (ii) 3.9x secured leverage ratio if such debt is junior lien.

The credit agreement was entered into on Aug. 31, 2017, and the MFN protection included in the credit agreement reflects the steady weakening of the MFN mechanics.

Under the credit agreement, initial lenders received 50 bps of MFN protection for 18 months after closing for any pari incremental or incremental equivalent term loans incurred as leverage-based debt only.

Although the amendment that documented the 2020 incremental term loan explicitly stated that the loans were incurred under the $346 million basket, even if they had been incurred as leverage-based incremental debt, the MFN protection had already expired by April 2020.

As a result, although the margin on the 2020 incremental term loan is 4.75% higher than the margin on the initial term loans, initial term loan lenders did not receive any benefit from that higher pricing.

Had the MFN protection not expired and had it applied to the 2020 incremental term loans, pricing on the initial term loans likely would have been required to increase from 3.25% to 7.5%, which is 0.5% less than the pricing on the 2020 incremental term loans.

The following table highlights other companies that have incurred incremental debt since the Covid-19 pandemic began and that have not had to provide initial lenders with MFN protection.

Whereas the MFN protection under Bally’s and StubHub’s credit agreement had expired, the MFN protection under PlayAGS’ credit agreement was not subject to a sunset.

However, because amendments to the MFN protection require only the consent of a majority of lenders, the lenders that provided the incremental debt and that, presumably, constitute a majority of lenders amended the credit agreement’s MFN protection such that PlayAGS was not required to increase the pricing of the initial term loans.
Call Protection

As mentioned above, not only did Surgery Partners’ initial term loan lenders not receive the benefit of the 2020 incremental term loans’ higher pricing, but they will also miss out on the 2% call protection the company will pay to refinance the debt.

Because these incremental term loans carry significantly higher pricing than the initial term loans, as stability returns to the markets, these borrowers could be highly incentivized to repay the incremental debt, even with a prepayment premium.

In its press release announcing the refinancing of the 2020 incremental term loans, Surgery Partners stated that:

“At prevailing market rates, the Company expects that this refinancing transaction would save the Company in excess of $5 million in interest expense annually.”

As illustrated below, both Bally’s and PlayAGS’ incremental term loans are subject to two-year make whole periods, with an additional year during which the borrowers would be required to pay a call premium to take out the debt.
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