Deal documentation: What borrowers may be hiding from lenders

The Thinking Outside the Box report from the European Leveraged Finance Association and law firm Akin Gump finds that borrowers are not always obliged to share key information, creating so-called “blind spots” with potentially serious consequences.

The report highlights several examples including excessive debt at Rallye, the parent company of French retailer Casino, which led to “years of large dividend pay-outs and underinvestment in the restricted group”; and a cash requirement at UK retailer Very Group that arose from the collapse of Greensill, lender to its parent company Shop Direct, which did not have to be disclosed to lenders in the restricted group.

The report urges lenders to make use of amendment and waiver requests from borrowers to ask for additional information in relation to such things as the details of used and unused basket capacity and the identity of any unrestricted subsidiaries and indebtedness at those entities.

“As recent examples have demonstrated, the consequences of being left in the dark about what lies ‘outside of the box’ can be serious,” says Sabrina Fox, chief executive officer of ELFA. “Asking the right questions and holding firm to such requests is key.”

Information disclosures are not the only source of angst between borrowers and lenders. ELFA also flags so-called reverse factoring.

Reverse factoring is used to allow sellers of goods and services to post receivables for an earlier cash payment, while permitting businesses to extend the timing of these payables to their suppliers. Such arrangements increase cash on the company’s balance sheet and the liabilities to the financial institution providing the facility is accounted for as payables rather than as debt.

‘Blind spot’

ELFA warns this may create a “blind spot” for investors due to under-reported financial debt, “raising the risk of investors mispricing credit risk and overvaluing stocks”. Such arrangements are also short-term in nature and can be pulled at short notice, creating the potential for working capital shocks and increasing default risk.

“The disclosure gap under current accounting standards raises the risk that companies may understate the quantum of their debt obligations by classifying this form of borrowing as trade payables,” says ELFA’s Fox. “As there is currently no obligation for companies to inform investors that they are doing so, we have lobbied the IASB [International Accounting Standards Board] and IFRS for improved disclosure.”

Amid the pandemic, inflation and rate concerns, and now the conflict in Ukraine, it’s easy to forget that the big talking point – at least in a private debt context – used to be the unfavourable terms and conditions being signed up to by lenders in the leveraged finance market.

But such concerns have clearly resurfaced, with ELFA calling out the Advent International-sponsored buyout of Dutch speciality chemicals firm Caldic for what appears to be an aggressive cap on creditor voting rights.

The agreement limits individual creditor voting rights to 15 percent of total commitments or, if a vote relates to a specific facility or tranche, to 15 percent of the commitment under that facility/tranche.

ELFA concedes the possibility that investor groups may be able to band together to meet the threshold but maintains that “no single investor would be able to enforce contractual covenant protections, even in the event of a default”.

ELFA described the terms as “the first instance of an aggressive voting cap provision entering a European leveraged loan” and said that they “severely undermine the notion of equal contractual rights and pro rata principles for creditors”.

Heated debates around terms and conditions are back on the agenda, it seems.