Redrawing the lines for direct lending

Politicians, business people and even, on occasion, harassed parents talk about red lines beyond which they are not prepared to negotiate. But in the world of direct lending, most observers say that these red lines have been pushed back progressively by borrowers in recent years – to the point where terms that, at the height of the credit crunch would have been considered unacceptable, have become almost standard for certain types of sponsored deal.

It is often over terms where the negotiation is toughest, and where lenders have been forced to make the most generous concessions. “The biggest changes have been in the documentation terms, then leverage and then pricing, in that order,” says Faisal Ramzan, a London-based partner at law firm Proskauer. In other words, because funds have target internal rates of return to meet, they choose to make pricing their red line rather than documentation.

Sponsors and their lawyers are, of course, trying to push the red lines even further. Judah Frogel, partner in the New York office of Allen & Overy, the law firm, offers a useful historical perspective. “In the two years before the beginning of the credit crisis in 2007, everyone thought that the terms being sought were super-aggressive, because that was when covenant-lite deals began permeating the market. At the time people thought the terms couldn’t get more aggressive, but now they are more borrower-friendly than in 2007.”

A fall in the number of financial covenants is the aspect of loosening most commonly quoted in the media. However, the trend goes beyond this, to include important issues such as flexibility within covenants, addbacks, starter baskets and the ability to make payments to sponsors and transfer assets.

Ramzan gives an example of how key these finer details of loan documentation can be: “Borrowers often push for an increase in the percentage of headroom between the covenant numbers set out by the sponsor, based on the sponsor’s expected trajectory for the business, and the levels in the credit agreement, so if the business underperforms there isn’t a breach of the covenant. In Europe, historically that headroom has tended to be around 30 or 35 percent, but in recent years headroom has been as high as 40 percent, and we see 45 percent as well from time to time.”

Setting limits

To return to the general market trend, worried limited partners might wonder whether, given the progressive market loosening, there are any red lines left at all. When asked if she is ever surprised by what particular term borrowers try to push forward on, Annette Kurdian, partner at law firm Linklaters, in London, replies: “No. Nothing surprises me at this stage.”

But there is ground on which she will recommend that lenders not give way. “My red line is that you have to have your single point of enforcement security that works, because the best covenants in the world won’t protect you if somebody breaches those covenants and you need to take control of the borrowing group by enforcing that,” says Kurdian.

A single point of enforcement is the ability of lenders to take control of the borrowing group, by enforcing share and receivables security at the top of the borrowing group in the event of a covenant breach.

Kurdian notes that even the effectiveness of the single point of enforcement security “is up for grabs” in the market, though she personally will heavily recommend to lenders that they hold firm. “There are some transactions where the covenant flexibility is such that we have to say to people, ‘There is a possibility that your single point of enforcement may be prejudiced in certain situations.’ We advise lenders to push back quite heavily on anything that could potentially impact that.”

“In the lower mid-market, the packages tend to be more robust, the conditions tend to be more restrictive, and ebitda definitions tend to be stricter”

Stephen Boyko

But even in these looser times, most observers are reluctant to say that the market has passed “peak looseness” when it comes to acceptable terms. On the one hand, Frogel of Allen & Overy has noticed “some tightening of some terms” because of the recent volatility across financial markets, which has triggered outflows from debt funds. On the other, he thinks that not too much should be read into this.

“The last two or three years have shown that the minute markets come back, and the minute the supply-demand dynamic turns in favour of the borrowers, there is a push for more borrower-friendly terms. And then the trajectory towards looser terms starts again,” he says.

An important aspect of this trend is the size dimension. In Europe, “as lenders swim downstream to deals with a debt value of less than €25 million or €30 million, or a similar value in sterling, they tend to get progressively stronger covenant protection”, says Ramzan.

“There are many reasons for this. There are fewer private debt fund lenders, the paper is highly illiquid, and the sponsor tends to be less well-known.”

If the lender has never previously dealt with the sponsor, they are more reluctant to take matters on trust. Stephen Boyko, Ramzan’s colleague in New York, sees much the same in the US market. “In the lower mid-market, the packages tend to be more robust, the conditions tend to be more restrictive, and EBITDA definitions tend to be stricter.” Pierre Maugüé, a partner at Debevoise & Plimpton, the law firm, notes that in Europe, where terms always used to be tighter than the US, in certain respects they can now be more flexible. Maugüé is involved in deals on both sides of the Atlantic. He gives the example of “most-favoured-nation” (MFN) status, which can sometimes favour the borrower more in Europe these days.

According to this concept, if a borrower takes a loan from Lender B at a higher interest rate within a specified period after closing its original deal with Lender A, Lender A can hike its interest rate to bring it to within a certain number of basis points of Lender B’s level. Negotiations often take place, when inking the original deal, over how long Lender A will enjoy its MFN protection, and what the maximum differential can be between the rates of the original and the new loan.

Observers also note that in the non-sponsored market, where competitive bidding among lenders is much less fierce, one is less likely to see loose terms. However, borrowers are not universally winning their battle over red lines, or even finding it progressively easier to do so with every passing month. The situation is more complex than that.

Addback complexities

David Leland, who as head of capital markets at BC Partners, the private equity firm, in New York, raises debt for acquisitions, differs from the consensus by describing the long-term trend of looser documentation as “minor”, and limited to specific areas. He lists these as the ability to take on incremental debt, EBITDA definitions and addbacks, restrictions on permitted payments, and restrictions on investments.

“These terms loosen or tighten based on conditions in the market”, with negotiations favouring the lender more “during periods of volatility in the marketplace”. Asked whether he has more negotiating power over these specific issues than he would have three or four years ago, he replies: “No. Substantially similar.”

Leland also makes a point mentioned almost universally by interviewees, including those who act for lenders: that the interests of lender and borrower are usually aligned, and that flexibility can serve the interests of both. In other words, if well-crafted, terms can be not only acceptable but desirable for both parties.

Leland gives the example of addbacks: “There are times when we might take a strategic action that has a very long-term benefit for a company in perpetuity, such as consolidating manufacturing capacity in a smaller number of factories to reduce inefficient spare capacity. A company wouldn’t want to be prevented from taking an action that positively impacts the credit in the long term for the benefit of lenders and equity investors, just because it would create negative covenant implications for you.”

It might, for example, entail redundancy costs that would hit EBITDA. If addback provisions prevented the sponsor from adding back to EBITDA to counteract this, it might not be able to take the action without breaching its leverage covenant.

But although lenders agree that they do not want to create perverse disincentives to make businesses more profitable for the long term, many are also starting to express qualms about the acceptability of particular document terms.

“A favourite subject of pushback at the moment is addbacks to EBITDA”, says Alan Davies, partner at Debevoise & Plimpton.

He says the historical practice of adding back projected earnings from acquisitions to existing EBITDA “has morphed into something even more flexible. You don’t even have to make an acquisition – sometimes you can just make an operational change to the business”.

An example: “You make widgets on one type of machine and say, ‘I’m going to make widgets on another type of machine, and realise cost savings from that, that I want to add back into EBITDA now, even though I haven’t actually made those savings yet.’”

Pushing for caps

Lenders are prepared to accept such reasoning up to a point, he says, but “the thing that lenders particularly don’t like is for addbacks to be uncapped in amount or percentage terms. Lenders are therefore pushing for caps, and we are increasingly seeing them”.
Lenders are also tending, he says, to demand third-party verification that addback estimates above a certain amount, such as 10 percent of existing EBITDA, are reasonable.

Another current area of pushback is over the transfer of assets to unrestricted subsidiaries: subsidiaries of the company that are not covered by the credit agreement, and are therefore not constrained by the credit agreement from borrowing as much as they can, or paying as much in dividends as their owners want. Such transfers also reduce the value of assets that can be seized if the borrower goes bust, as usually the creditors of relevant unrestricted subsidiaries will have first call on these assets.

The issue of unrestricted subsidiaries has been catapulted to the forefront of lenders’ minds by the cases of the US retailers Neiman Marcus and J Crew. “Once something goes wrong with a particular practice, such as the transfer to unrestricted subsidiaries by Neiman Marcus and J Crew, then every lender is focused on it in initial loan negotiations,” says Kurdian of Linklaters.

It is instructive, however, that both cases have produced extensive legal arguments about who had the right to do what, with what, and to whom (J Crew won its legal battle, while the newer case of Neiman Marcus is unresolved). This is itself a symptom of the trend for looser documentation, which has produced less clarity about lenders’ rights. For this reason, lenders can end up ceding more ground than they know, by giving way on what appear to be unimportant technical details, but prove to be vitally important when something goes wrong.

Jeffrey Griffiths, principal at Campbell Lutyens, the placement agent, in London, notes: “Most direct lenders for sponsor-backed, mid-market deals will say, ‘We’re very selective, and disciplined on covenants.’ Private equity sponsors will say, ‘It’s an amazing private debt market: we can get what terms we want, and we can remove covenants.’ So there’s a disconnect.”

Which side, ultimately, is nearer the truth? “More often, the private equity guys,” replies Griffiths. “I’m not saying the private debt guys are being dishonest, because there’s so much ambiguity, and the terminology can be used to obfuscate.” In other words, there may still be red lines, but there is also an increasing number of grey areas.