Banking Newsletter
Market trends in LBO credit documentation in France
Driven by the influence of the US market on European leveraged transactions in an environment increasingly dominated by sponsors due to high liquidity, the French LBO market has seen significant changes in credit documentation over the last couple of years. Not only have borrowers benefited from looser covenants and increased structural flexibility, but the "buy and build" strategies which sponsors have continued to advocate as the fast-track to EBITDA accretion, have paved the road for provisions allowing additional debt to be incurred by way of incremental facilities and sponsor-friendly provisions relating to permitted acquisitions and baskets, with lenders' primary protection in many cases being a soft-cap leverage level. The extent of the impact of the US market has depended to a large extent on the size of the transaction, with large-cap transactions being closer to US "Term loan B" structures, while mid-cap deals have tended to incorporate only some of the features of such loans.
Extend, increase and/or refinance without starting over: "evergreen" debt structures
In terms of debt structure, in addition to the initial facilities, provision is made for additional, uncommitted facilities, called incremental facilities, which may be made available to the borrower without any further consent of the syndicate. These facilities can be structured as an additional commitment under an existing tranche or as a new tranche, in each case usually under the existing credit documentation (although on large-cap deals, incremental facilities can sometimes be seen under a separate facility agreement alongside the existing facility agreement). They are primarily intended to be used to finance permitted acquisitions and/or refinance indebtedness of the target companies being acquired, but some more aggressive agreements do not restrict their purpose. Although occasionally junior in ranking, they generally rank pari passu with the initial facilities under the intercreditor arrangements and share security granted to the existing lenders where possible, but if the incremental borrower is below the principal existing borrowers in the group, initial lenders can find themselves structurally subordinated to the incremental lenders.
Alongside provisions relating to such incremental facilities, there can be "permitted refinancing" clauses. Their purpose is to enable the borrower to achieve the economic benefits of a refinancing, such as improving pricing or extending its maturities, without further lender consent, through pre-baked permitted refinancing provisions which provide for the refinancing of all or part of the the existing facilities (and potentially any incremental facilities already made available at that time). Such refinancing debt can be structured as an additional tranche under the existing credit documentation or made available under separate terms by way of a new credit facility, notes or bonds, but cannot mature earlier than existing facilities.
An important aspect of the "evergreen" approach is that the transaction documents are designed to remain in place with little or no need for amendment, which is a significant advantage for the borrower group. Under the intercreditor arrangements, for example, such facilities will usually be treated pari passu with the existing facilities and benefit from existing security, although they can also be junior (but not senior) to them and have only limited security. In the event that incremental or permitted refinancing facilities can either be borrowed as a loan or issued through notes or bonds, lenders should think about the potential structural consequences of potentially having different groups of creditors which vote separately in a restructuring scenario when agreeing to the refinancing terms.
Hard cap or "incurrence"-based soft cap?
Refinancing facilities replace existing facilities, so they do not create additional leverage. Incremental facilities, on the other hand, involve additional debt being incurred by the borrower group and therefore increase leverage. The overall amount of such facilities was initially capped by reference to a fixed amount, but the tendency has moved towards an "incurrencebased soft cap" by reference to leverage, which means that additional debt can be incurred up to an amount which would bring the overall leverage level up to the agreed leverage cap (usually the opening leverage level). Therefore, providing that EBITDA increases, there is no finite limit on the overall amount of debt which can be incurred. Where an "incurrence" cap is used, it often comes with an aggregate "freebie''amount which can be used regardless of the leverage ratio at that time.
"MFN" protection for initial lenders
The "quid pro quo" of this structural flexibility for the initial lenders is twofold. Firstly, the initial lenders request the benefit during a limited period (usually 18 months) of a "most favoured nation" pricing clause, under which, if incremental or refinancing lenders are offered more favourable pricing terms (over and above a fixed annual "effective yield" buffer), the borrower must increase the remuneration of the existing lenders by an equivalent amount. This "pricing MFN requirement" is often accompanied by a conceptually similar "contractual MFN", which obliges the borrower to bring the initial credit documentation in line with more favourable contractual terms from which incremental or refinancing lenders may benefit in other areas (covenants, events of default, prepayment event, etc.). The alternative approach on this issue is only to allow the incremental or refinancing facilities if they are on terms which are not substantially more favourable than those of the initial lenders.
Equity repayment, exit terms and control over lender pool
Sponsors have also made the most of the buoyant liquidity in the market by negotiating more aggressive equity repayment and exit terms. For example, it has become quite common to see a fixed amount of repayments of junior debt or shareholder debt permitted during the life of the facilities regardless of leverage, plus an additional amount which can distributed subject to leverage. The latter is not innovative per se, but the level of leverage has been on the increase, especially in large-cap deals.
Increased flexibility has also been introduced within sponsor exit terms, with a couple of noteworthy examples being the relaxing of: (i) "Qualified Public Offering" (QPO) clauses, and of (ii) "change of control" provisions.
QPO provisions, as they are commonly known, allow the sponsor to exit via a public offering without triggering the change of control clause and therefore without having to prepay the entire facilities. Historically, this has been possible in some transactions, but only where, at the time of the listing, the leverage more or less is at crossover/investmentgrade level (or can be reduced to that level by a partial prepayment using the proceeds of the listing). However, in many transactions, the leverage test is disappearing, allowing (in theory at least) a listing without repaying/refinancing the facilities in full, regardless of the leverage at that time (although the QPO proceeds will still be required to be applied in partial prepayment of the facilities according to a leverage grid).
In a similar vein, change of control provisions have also seen increasingly flexible terms, under the influence of the US bond market, such as prepayment "à la carte" provisions. This is where, upon a change of control, each lender can opt to stay in the debt or be refinanced. While this appears to be a more flexible option for the sponsor, it reintroduces the burden for the purchaser of potentially refinancing some of the debt; however, this may not be an issue if the documentation allows the sponsor to raise additional debt to refinance the facilities, because the commitments of those lenders which "opt out" upon the occurrence of a change of control can be replaced by additional commitments of new or existing lenders under the "evergreen" refinancing provisions. Consequently, the sponsor can still exit the deal and a new purchaser come into the transaction while keeping the existing documentation structure in place.
Lastly, sponsors have obtained increased control over the lender pool by imposing more stringent conditions on transferability, with a "white list" of acceptable lenders (except in a default scenario) and full restrictions on transfers to competitors becoming the norm, and by improving their rights with respect to non-consenting lender using reinforced "yank-thebank" rights.
Loosening of financial covenants
The influence of the US market has seen the return of a general weakening of financial covenant tests. In Europe, most transactions have been "cov-loose", with the disappearance of interest cover and capex covenants, and some "cov-lite", with no maintenance covenant testing at all, except where the facilities include an RCF facility, in which case they usually include a "springing covenant" leverage test. This test applies only to revolving facility lenders, and relies on a leverage covenant which is tested only if, and for so long as, the revolving facility is drawn above a defined threshold. It can be waived by the majority of the revolving facility lenders, usually on a 66 per cent majority basis, but sometimes only 50 per cent.
If the revolving facility lenders cancel their facility or accelerate as a result of breach of the springing covenant, the term lenders get the benefit of a "crossacceleration"; this can be subject to further qualifying items, such as a de minimis threshold or a standstill period, following which, providing the revolving loans have been repaid or terminated, there will be no cross-acceleration into the term loans.
"Buy and build" – sponsors seek a free rein
In order to obtain a free rein with respect to their "buy and build" strategy, as well as negotiating flexibility on financing for build-ups, sponsors also have focused their efforts on negotiating significantly more flexible terms for permitted acquisitions. The most significant shift has been the lack of cap of the aggregate value of acquisitions that may be made. Consequently, in terms of consideration, the sponsor is often limited only by its capacity to raise financing.Other changes include the scope of the acquisition itself. For example, permitted acquisitions can include the acquisition of minority interests and top-up acquisitions (in addition to the more traditional majority stakes), as well as the acquisition of businesses "related" to the existing business of the group (a rather looser term than the previously common requirement of being "similar or complementary" to it) and which can be located in an extensive list of agreed jurisdictions, potentially with negative EBITDA (subject to a hard cap).
The financial covenant compliance tests can also be the topic of lengthy discussions, with "look-forward" tests being increasingly absent, and the integration of cost savings and synergies into covenant calculations increasingly present. Cost savings can be more easily identified and supported by due diligence prepared by an independent accounting firm, whereas the calculation of revenue synergies is more difficult for lenders to control. They are usually certified by the CFO, and capped, for example, by a hard cap per acquisition, a soft cap based on a EBITDA percentage in that financial year, and/or an aggregate hard cap over the life of the facilities. Above a certain threshold, they are usually validated by an independent third party.
Grower baskets: a key feature of increased contractual flexibility
A "buy and build" strategy which holds the promise of substantial EBITDA increase will inevitably see growth in assets but also liabilities. The "grower basket" concept is based on the premise that, with increased EBITDA and/or assets, the borrower group can sustain increased liabilities and outgoings without increasing the lenders' credit risk.
US baskets tend to be purely EBITDA-based, i.e. the basket amount is simply indexed on the EBITDA of the group at the relevant time. European transactions have mostly maintained initial basket fixed amounts, which can grow over time, i.e. provided that a minimum threshold of percentage of EBITDA (or sometimes asset value) increase is triggered, some baskets increase in line with such percentage increase.
These baskets can include, for example, permitted financial indebtedness, permitted loans, permitted guarantees and security and permitted disposals. A distinction can be made between acquisitive EBITDA growth (i.e. increased EBITDA generated as a result of permitted acquisitions) and non-acquisitive EBITDA growth (i.e. EBITDA generated through organic growth of the business). Some lenders argue that nonacquisition growth should not give rise to basket increases, as this is accounted for in the initial business plan on which the baskets have been calibrated. When accepted, non-acquisitive basket growth tends to be capped by lenders at a maximum aggregate percentage increase over the life of the facilities, whereas acquisitive basket increase are more likely to be uncapped, although sometimes the lenders may insist on a maximum number of increases during the life of facilities and/or a general cap on increase. The correlation of increased baskets when EBITDA increases as a result of a permitted acquisition will be for the basket amounts to decrease where EBITDA decreases as a result of a disposal.
Other trends
These are some of the main trends that we have seen over the last couple of years, but there are a whole host of others. Other notable trends include structural change provisions with increased flexibility on extensions of maturities, the right to prepay earlier maturities, and the introduction of repricing clauses allowing lenders to reprice on an individual decision basis – and the list goes on …
And the trend for 2016?
2015 in particular was a boom time for sponsors, but with recent tremors in the market and pricing on the increase, it is possible that the pressure to find sufficient liquidity at attractive pricing might start to push the pendulum in the other direction in 2016. But it is just as possible that the sponsor-friendly trend will continue, and that this year will see the European market continue its alignment with the US market. Time will tell …
Market trends in LBO credit documentation in France
Driven by the influence of the US market on European leveraged transactions in an environment increasingly dominated by sponsors due to high liquidity, the French LBO market has seen significant changes in credit documentation over the last couple of years. Not only have borrowers benefited from looser covenants and increased structural flexibility, but the "buy and build" strategies which sponsors have continued to advocate as the fast-track to EBITDA accretion, have paved the road for provisions allowing additional debt to be incurred by way of incremental facilities and sponsor-friendly provisions relating to permitted acquisitions and baskets, with lenders' primary protection in many cases being a soft-cap leverage level. The extent of the impact of the US market has depended to a large extent on the size of the transaction, with large-cap transactions being closer to US "Term loan B" structures, while mid-cap deals have tended to incorporate only some of the features of such loans.
Extend, increase and/or refinance without starting over: "evergreen" debt structures
In terms of debt structure, in addition to the initial facilities, provision is made for additional, uncommitted facilities, called incremental facilities, which may be made available to the borrower without any further consent of the syndicate. These facilities can be structured as an additional commitment under an existing tranche or as a new tranche, in each case usually under the existing credit documentation (although on large-cap deals, incremental facilities can sometimes be seen under a separate facility agreement alongside the existing facility agreement). They are primarily intended to be used to finance permitted acquisitions and/or refinance indebtedness of the target companies being acquired, but some more aggressive agreements do not restrict their purpose. Although occasionally junior in ranking, they generally rank pari passu with the initial facilities under the intercreditor arrangements and share security granted to the existing lenders where possible, but if the incremental borrower is below the principal existing borrowers in the group, initial lenders can find themselves structurally subordinated to the incremental lenders.
Alongside provisions relating to such incremental facilities, there can be "permitted refinancing" clauses. Their purpose is to enable the borrower to achieve the economic benefits of a refinancing, such as improving pricing or extending its maturities, without further lender consent, through pre-baked permitted refinancing provisions which provide for the refinancing of all or part of the the existing facilities (and potentially any incremental facilities already made available at that time). Such refinancing debt can be structured as an additional tranche under the existing credit documentation or made available under separate terms by way of a new credit facility, notes or bonds, but cannot mature earlier than existing facilities.
An important aspect of the "evergreen" approach is that the transaction documents are designed to remain in place with little or no need for amendment, which is a significant advantage for the borrower group. Under the intercreditor arrangements, for example, such facilities will usually be treated pari passu with the existing facilities and benefit from existing security, although they can also be junior (but not senior) to them and have only limited security. In the event that incremental or permitted refinancing facilities can either be borrowed as a loan or issued through notes or bonds, lenders should think about the potential structural consequences of potentially having different groups of creditors which vote separately in a restructuring scenario when agreeing to the refinancing terms.
Hard cap or "incurrence"-based soft cap?
Refinancing facilities replace existing facilities, so they do not create additional leverage. Incremental facilities, on the other hand, involve additional debt being incurred by the borrower group and therefore increase leverage. The overall amount of such facilities was initially capped by reference to a fixed amount, but the tendency has moved towards an "incurrencebased soft cap" by reference to leverage, which means that additional debt can be incurred up to an amount which would bring the overall leverage level up to the agreed leverage cap (usually the opening leverage level). Therefore, providing that EBITDA increases, there is no finite limit on the overall amount of debt which can be incurred. Where an "incurrence" cap is used, it often comes with an aggregate "freebie''amount which can be used regardless of the leverage ratio at that time.
"MFN" protection for initial lenders
The "quid pro quo" of this structural flexibility for the initial lenders is twofold. Firstly, the initial lenders request the benefit during a limited period (usually 18 months) of a "most favoured nation" pricing clause, under which, if incremental or refinancing lenders are offered more favourable pricing terms (over and above a fixed annual "effective yield" buffer), the borrower must increase the remuneration of the existing lenders by an equivalent amount. This "pricing MFN requirement" is often accompanied by a conceptually similar "contractual MFN", which obliges the borrower to bring the initial credit documentation in line with more favourable contractual terms from which incremental or refinancing lenders may benefit in other areas (covenants, events of default, prepayment event, etc.). The alternative approach on this issue is only to allow the incremental or refinancing facilities if they are on terms which are not substantially more favourable than those of the initial lenders.
Equity repayment, exit terms and control over lender pool
Sponsors have also made the most of the buoyant liquidity in the market by negotiating more aggressive equity repayment and exit terms. For example, it has become quite common to see a fixed amount of repayments of junior debt or shareholder debt permitted during the life of the facilities regardless of leverage, plus an additional amount which can distributed subject to leverage. The latter is not innovative per se, but the level of leverage has been on the increase, especially in large-cap deals.
Increased flexibility has also been introduced within sponsor exit terms, with a couple of noteworthy examples being the relaxing of: (i) "Qualified Public Offering" (QPO) clauses, and of (ii) "change of control" provisions.
QPO provisions, as they are commonly known, allow the sponsor to exit via a public offering without triggering the change of control clause and therefore without having to prepay the entire facilities. Historically, this has been possible in some transactions, but only where, at the time of the listing, the leverage more or less is at crossover/investmentgrade level (or can be reduced to that level by a partial prepayment using the proceeds of the listing). However, in many transactions, the leverage test is disappearing, allowing (in theory at least) a listing without repaying/refinancing the facilities in full, regardless of the leverage at that time (although the QPO proceeds will still be required to be applied in partial prepayment of the facilities according to a leverage grid).
In a similar vein, change of control provisions have also seen increasingly flexible terms, under the influence of the US bond market, such as prepayment "à la carte" provisions. This is where, upon a change of control, each lender can opt to stay in the debt or be refinanced. While this appears to be a more flexible option for the sponsor, it reintroduces the burden for the purchaser of potentially refinancing some of the debt; however, this may not be an issue if the documentation allows the sponsor to raise additional debt to refinance the facilities, because the commitments of those lenders which "opt out" upon the occurrence of a change of control can be replaced by additional commitments of new or existing lenders under the "evergreen" refinancing provisions. Consequently, the sponsor can still exit the deal and a new purchaser come into the transaction while keeping the existing documentation structure in place.
Lastly, sponsors have obtained increased control over the lender pool by imposing more stringent conditions on transferability, with a "white list" of acceptable lenders (except in a default scenario) and full restrictions on transfers to competitors becoming the norm, and by improving their rights with respect to non-consenting lender using reinforced "yank-thebank" rights.
Loosening of financial covenants
The influence of the US market has seen the return of a general weakening of financial covenant tests. In Europe, most transactions have been "cov-loose", with the disappearance of interest cover and capex covenants, and some "cov-lite", with no maintenance covenant testing at all, except where the facilities include an RCF facility, in which case they usually include a "springing covenant" leverage test. This test applies only to revolving facility lenders, and relies on a leverage covenant which is tested only if, and for so long as, the revolving facility is drawn above a defined threshold. It can be waived by the majority of the revolving facility lenders, usually on a 66 per cent majority basis, but sometimes only 50 per cent.
If the revolving facility lenders cancel their facility or accelerate as a result of breach of the springing covenant, the term lenders get the benefit of a "crossacceleration"; this can be subject to further qualifying items, such as a de minimis threshold or a standstill period, following which, providing the revolving loans have been repaid or terminated, there will be no cross-acceleration into the term loans.
"Buy and build" – sponsors seek a free rein
In order to obtain a free rein with respect to their "buy and build" strategy, as well as negotiating flexibility on financing for build-ups, sponsors also have focused their efforts on negotiating significantly more flexible terms for permitted acquisitions. The most significant shift has been the lack of cap of the aggregate value of acquisitions that may be made. Consequently, in terms of consideration, the sponsor is often limited only by its capacity to raise financing.
Other changes include the scope of the acquisition itself. For example, permitted acquisitions can include the acquisition of minority interests and top-up acquisitions (in addition to the more traditional majority stakes), as well as the acquisition of businesses "related" to the existing business of the group (a rather looser term than the previously common requirement of being "similar or complementary" to it) and which can be located in an extensive list of agreed jurisdictions, potentially with negative EBITDA (subject to a hard cap).
The financial covenant compliance tests can also be the topic of lengthy discussions, with "look-forward" tests being increasingly absent, and the integration of cost savings and synergies into covenant calculations increasingly present. Cost savings can be more easily identified and supported by due diligence prepared by an independent accounting firm, whereas the calculation of revenue synergies is more difficult for lenders to control. They are usually certified by the CFO, and capped, for example, by a hard cap per acquisition, a soft cap based on a EBITDA percentage in that financial year, and/or an aggregate hard cap over the life of the facilities. Above a certain threshold, they are usually validated by an independent third party.
Grower baskets: a key feature of increased contractual flexibility
A "buy and build" strategy which holds the promise of substantial EBITDA increase will inevitably see growth in assets but also liabilities. The "grower basket" concept is based on the premise that, with increased EBITDA and/or assets, the borrower group can sustain increased liabilities and outgoings without increasing the lenders' credit risk.
US baskets tend to be purely EBITDA-based, i.e. the basket amount is simply indexed on the EBITDA of the group at the relevant time. European transactions have mostly maintained initial basket fixed amounts, which can grow over time, i.e. provided that a minimum threshold of percentage of EBITDA (or sometimes asset value) increase is triggered, some baskets increase in line with such percentage increase.
These baskets can include, for example, permitted financial indebtedness, permitted loans, permitted guarantees and security and permitted disposals. A distinction can be made between acquisitive EBITDA growth (i.e. increased EBITDA generated as a result of permitted acquisitions) and non-acquisitive EBITDA growth (i.e. EBITDA generated through organic growth of the business). Some lenders argue that nonacquisition growth should not give rise to basket increases, as this is accounted for in the initial business plan on which the baskets have been calibrated. When accepted, non-acquisitive basket growth tends to be capped by lenders at a maximum aggregate percentage increase over the life of the facilities, whereas acquisitive basket increase are more likely to be uncapped, although sometimes the lenders may insist on a maximum number of increases during the life of facilities and/or a general cap on increase. The correlation of increased baskets when EBITDA increases as a result of a permitted acquisition will be for the basket amounts to decrease where EBITDA decreases as a result of a disposal.
Other trends
These are some of the main trends that we have seen over the last couple of years, but there are a whole host of others. Other notable trends include structural change provisions with increased flexibility on extensions of maturities, the right to prepay earlier maturities, and the introduction of repricing clauses allowing lenders to reprice on an individual decision basis – and the list goes on …
And the trend for 2016?
2015 in particular was a boom time for sponsors, but with recent tremors in the market and pricing on the increase, it is possible that the pressure to find sufficient liquidity at attractive pricing might start to push the pendulum in the other direction in 2016. But it is just as possible that the sponsor-friendly trend will continue, and that this year will see the European market continue its alignment with the US market. Time will tell …
Keep up to date
Sign up to receive the latest legal developments, insights and news from Ashurst. By signing up, you agree to receive commercial messages from us. You may unsubscribe at any time.
Sign upThe information provided is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to.
Readers should take legal advice before applying it to specific issues or transactions.
