For borrowers looking to finance deals below the minimum size for high yield at the moment, they have to choose between a traditional lender – most of whom are constrained to some degree, are only funding the best transactions and who are offering relative conservative leverage and terms – or one of the newer funds or direct lenders who are increasingly providing liquidity in the market.
Pricing by funds and direct lenders is not cheap (although helped by still historically low interest rates), but the new breed of lenders can entice borrowers with increased leverage, limited or no amortisation and even covenant-lite terms in the early years of a loan.
Often what emerges is a single tranche of five to eight year term debt – a unitranche facility – with bespoke covenants and with or without an equity participation to reflect the risk being taken by the lender.
For traditional lenders this seems to be a significant threat, and traditional lenders have an instinctive distrust for the new lenders and how they will behave in a default scenario. However, the new breed of lenders struggle to provide working capital, payment facilities (cheques, BACS, CHAPS and overdrafts), and derivatives. And they will not be acceptable parties for bank guarantees or letters of credit which borrowers need to enhance their trade and other obligations. Accordingly, in addition to the unitranche facility, borrowers need to access these facilities from traditional lenders.
This means that, in order to make the financing structure work, the new lender will need to team up with a traditional lender, the only alternative being that working capital facilities are provided on a cash secured basis without going overdrawn, with is very inefficient.
The need for working capital facilities and derivatives provides traditional lenders with a bargaining tool and the cost of providing these facilities means that they have to be provided super-priority. In some cases traditional lenders who are providing interest rate hedging in respect of the senior facilities have even managed to get this exposure treated as a super-priority debt.
Super-priority means that working capital providers require their facilities to be repaid first out of the proceeds of enforcement or on maturity. They also typically require at least minimal financial covenant protection and protection against disposals or other transactions reducing the business below a suitable coverage level for the facilities they are providing.
Where the super priority lender is given rights they obviously also need the ability to take action if those rights are not respected. This means that the super-priority lender needs to be able to enforce their claims, without the normal senior lenders being able to block that enforcement. Enforcement rights for super-priority debt will be narrowly defined, but typically include circumstances where amounts in respect of the super-priority debt are not paid or the super-priority borrower becomes insolvent.
Otherwise the super-priority lender will typically count towards the normal majority or all-lender votes, and so will be able to block increases or extensions in commitment and reductions in margin or interest. Super-majority voting provisions, typically reserved for release of security and guarantees, will need to be disapplied, as the super-priority lenders will need individual right to veto these as they are the source of repayment of the super priority debt.
So, ultimately, despite the level of distrust between the two camps, the traditional lenders and the new lenders can come to terms on the intercreditor points. However, whilst this superficially looks like a good result for the traditional lenders and a potential model for the future of mid-market leveraged financing, reports are that the capital requirements of working capital facilities and derivatives mean that traditional lenders cannot necessarily make money out of this model and may rely on the amortising debt to generate an overall return.
And so we are left with either an uncomfortable compromise between unfamiliar bedfellows, or working capital being provided on a rather inefficient cash basis.
Ian Borman is a partner and head of the financial institutions group at law firm SJBerwin in London, and an expert in leveraged finance and syndicated bank lending.