Special situations lending has always included heightened focus on legal issues, including:
Credit and structuring issues: From a credit and structuring perspective, special situations lenders want the best possible recourse within the constraints of existing documentation and applicable laws (i.e. those relating to the provision of guarantees and security and relating to bankruptcy), and then price that risk accordingly. Optimising recourse involves determining which companies can be borrowers and guarantors and whether security is available and, if so, whether it is shared and how it ranks.
Debt and guarantee claims: Structural seniority can play a very important role in special situations lending. A typical acquisition financing may rely on upstream guarantees for its credit support from operating companies. Those upstream guarantees may be limited in value in many jurisdictions due to local corporate benefit rules, whereas a third party that lends directly to an operating company will have a direct claim which would not be so limited. Therefore, a special situations lender may be able to maximize the value of its claims by lending directly to one of the principal operating asset owning vehicles.
Alternatively, a special situations lender that is providing an acquisition financing may want to contractually limit the ability of future lenders to lend directly to the asset owning vehicles, even though such flexibility might have been permitted in more broadly syndicated debt documentation.
Security: The extent of unencumbered and available security in borrower groups can vary significantly. Guarantor coverage tests and agreed security principles in loan documentation mean that security over particular types of assets, which is impracticable and/or expensive to secure, such as equipment and real estate, may have been omitted as part of the main deal financing and so may be available as security for a new loan. As a rule of thumb, this omission creates potential opportunities for special situations lenders to create security over assets not subject to the main deal security package.
Furthermore, European guarantor coverage tests can range between 70-90 percent of EBITDA and gross assets, which may leave some value in group companies outside the guarantee and security net (although individual material companies contributing more than 5 percent of such amounts are likely to have been required to have been part of the existing guarantee and security package). In many cases, the shares of subsidiaries which are not defined as material will not be subject to existing deal security.
There may even be flexibility to reorganize a group so that there is a standalone subgroup available against which specific financing can be raised. Alternatively, a special situations lender may want to obtain security over types of assets that are often excluded in broadly syndicated debt financings. Such lenders may also want to contractually limit the ability of future lenders to obtain security over non-collateral or to lend to non-guarantor subsidiaries, even though such flexibility might have been permitted in more broadly syndicated debt documentation.
Security avoidance risk: Insolvency related hardening periods can be key considerations for loans made when companies are in financial difficulties – if security is likely to be exposed to bankruptcy avoidance risk for a certain period following execution, lenders should consider this additional risk when structuring the deal.
Security enforcement and bankruptcy issues: In special situations lending, the ease with which security can be enforced may be relevant (particularly if a lender expects to become the owner of the business in the event of a default, in which case it’s better to have a single point of enforcement and share security in a jurisdiction with an efficient enforcement regime such as the UK, the Netherlands or Luxembourg). Understanding what priority and/or preferred claims, expenses and creditors can arise locally, the relevance of retention of title, applicable bankruptcy processes (including any mandatory stay regime) and more detailed legal diligence may also be necessary.
Alternatives to loans: There may be other ways for corporates to raise new finance. Selling receivables and entering into sales and leasebacks are common examples but more structured and ingenious ways may be found to raise finance within the constraints of covenant limitations.
NEW MARKET FLEXIBILITY
Over the last year or so significant flexibility from both the US term loan B and the European high yield markets has penetrated the European loan market to a large extent, which has led to a broader range of specific basket exemptions (including a general basket for ratio debt which may be linked to either a leverage test or a fixed charge coverage test).
Debt raising flexibility includes accordion features (incremental facilities) are now very frequently included in credit agreements which can allow third-party creditors to lend alongside lenders under an existing credit agreement. There may also be flexibility for separate loans to be made which share in the existing guarantee and security package on a super senior, pari passu or subordinated basis.
- Accordion features – These may be limited in absolute terms or by ratio tests but have developed to allow significant financing to be raised under the framework of the main credit agreement. Typically, provisions relating to this new incremental tranche cannot be more onerous than the existing documentation, with a cap on any increase in pricing, consistent or later maturities required and no more onerous covenants and events of default.
- Separate third-party debt sharing in guarantee and collateral package – This may have similar conditions to the accordion debt or may be more flexible.
Because this flexibility is relatively new in the European market, negotiated positions are variable and the loan, bond and intercreditor documentation need to be studied extremely carefully to determine what is possible. Some financings may restrict which entities can borrow new money, picking up on the concerns about structural seniority outlined above. Some will require new third-party lenders to become party to an existing intercreditor agreement, whether the facilities are guaranteed and secured on a similar basis with that original deal, or, in some cases, when unsecured. In this increasingly flexible landscape, the issues posed by the intercreditor agreement can vary significantly. There is an increasing trend for significant unsecured debt facilities to be required to become party to the intercreditor agreement, often for the purpose of ensuring that the pre-existing senior secured debt cannot be frustrated in its enforcement strategy by other classes of structurally senior third-party debt.
One disadvantage of sharing in an existing security package may be that the covenants on offer are the same, which may not be as restrictive as a special situations lender requires.
While special situations lending often involves financially distressed or near distressed situations, which are not as prevalent in the current market environment, market documentation is giving rise to more and more opportunities for specialist lenders to offer structured debt products to borrowers where, for whatever reason, the mainstream syndicated loan or bond markets are unwilling to provide funds through increased loans / bond tap issues or the borrower does not want to utilise those markets.
This lack of mainstream market availability may be related to credit issues or it could be that terms on offer are more flexible in the private debt or credit fund market. Non-bank lenders can support a number of situations or deal types including non-amortizing long-term debt, relaxation of covenants; unitranche or subordinated debt, increased confidentiality or situations where US regulated lenders have been forced to limit the quantum of total debt offered due to the Fed’s leveraged lending guidelines.
As the leveraged loan and high yield bond markets continue to mature and develop, in the absence of any tightening of market documentation, more and more companies will have capital structures for which these solutions may be relevant, and in these complex capital structures, mastering the applicable documentation, credit and bankruptcy issues will be key.