Private creditors are allowing companies to take on larger amounts of debt not subject to performance tests, law firm Proskauer said recently.
The terms that allow this, called “free and clear baskets” or “incrementals”, let a borrower add obligations to a debt facility without regard for a leverage ratio or other financial performance tests. That additional capital is on top of the facility, so the borrower gets the money quickly without doing paperwork of drawing from the facility.
If the agreement did not have an incremental, a borrower might need to seek an amendment or refinance the whole facility for additional capital.
Of the free and clear baskets Proskauer’s private credit group closed the first half of the year, the average basket size was 73 percent of the company’s EBITDA, according to its mid-year report.
That’s a jump from what the firm saw last year, when the average basket size was 62 percent of the company’s EBITDA.
“Incrementals have always been popular, but this year we have seen a noticeable increase in the size of free and clear baskets,” Steve Boyko, partner and co-head of the Proskauer’s private credit group, told Private Debt Investor. “The rough rule of thumb had always been 50 percent of EBITDA, but that is clearly shifting.”
In addition, roughly 39 percent of the 73 total transactions the group completed so far this year had free and clear baskets greater than a 100 percent of the company’s EBITDA. That proportion is compared to just 14 percent of deals in 2016.
Typically, the free and clear baskets are only subject to an event of default contract provision, Boyko added, but in more aggressive deals that test may fall away or be limited to a bankruptcy filing. There is no separate EBITDA definition for a free and clear basket from the definition negotiated in the facility agreement.
Incremental provisions do not usually limit uses of the capital, and companies can use them to fund acquisitions, working capital, or other initiatives.
With covenants today in general, there are more EBITDA add-backs than three or four years ago, making it easier for companies to achieve the leverage levels necessary to access incrementals than before, he said.
So far this year, 72 percent of Proskauer’s private debt deals had incrementals, while 69 percent of such deals had incrementals last year.
“Before the financial crisis, incrementals were there but not as relevant, but now they are in virtually every deal,” said Boyko.