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By: Alexandra Margolis, Nixon Peabody LLP
LEXIS PRACTICE ADVISOR RESEARCH PATH: Banking & Finance > Commitment Papers and Syndicated Lending > The Commitment Letter > Articles > Trends in Acquisition Finance
Incremental loan facilities (also called an accordion) afford a borrower the ability to incur additional term loans or revolving loan commitments under an existing loan agreement if current and/or new lenders agree to provide them. These facilities enable the borrower to efficiently access additional funding because incremental debt incurrence requires the consent of only the lenders providing the financing and the administrative agent. Majority lender consent is not required. Rather, typically only a fairly simple amendment is needed—making incremental facilities an attractive option for borrowers, particularly for follow-on acquisition financing.
WHILE INCREMENTAL LOAN PROVISIONS TRADITIONALLY have been included in large cap loan agreements, they are now common in larger middle market deals and also appear in a limited number of smaller middle market deals (generally with tighter terms). In large cap deals, incremental facilities can be structured as either an increase to an existing class of term loans or revolving loan commitments or as one or more additional tranches of term loans or revolving loan commitments. Typically, the terms of incremental loans are substantially similar to those of the existing loans, except for pricing, fees, amortization, and maturity.
Incremental term loans customarily
Pricing, interest rate margins, discounts, premiums, rate floors, and fees for incremental term loans are determined by the borrower and the lenders providing such incremental term loans.
To protect the current term lenders from significantly higher pricing for the incremental loans, most favored nation (MFN) provisions customarily apply so that only a permitted increase in pricing (usually 50 basis points) for pari passu incremental term loans is permitted without requiring an interest rate increase on the existing term loans to the extent necessary to eliminate the greater pricing differential. The MFN protection applies to all-in yield, which includes interest rate margin and floors, original issue discount, and upfront or similar fees but excludes any arrangement fees, structuring fees, or other fees that are not shared with all lenders. MFN protection may “sunset” after a set time period (frequently 12 or 18 months) from incurrence of the existing term loans; however, the MFN sunset is an issue for negotiation and may be lengthened or eliminated during syndication if lenders resist. Although some borrowers have recently sought to limit MFN protection to only ratio-based incremental loans (excluding incremental loans incurred under the free and clear basket (described below)), that limitation has not become common.
Incremental revolving loan commitments are usually required to have substantially the same terms as the existing revolving loan commitments, other than pricing, fees, maturity, and other immaterial terms that are determined by the borrower and the lenders providing such incremental revolving loan commitments. Although additional tranches are sometimes permitted in large cap deals, incremental revolving loan commitments are commonly provided as increases to the existing revolving loan commitments and may be combined with an extension of maturity of the existing revolving facility. More often than not, existing revolving lenders do not have MFN protection with respect to incremental revolving loan commitments.
Traditionally, the borrower’s ability to incur incremental debt was limited to a fixed dollar amount and was conditioned on pro forma compliance with a maximum leverage ratio (typically the maintenance leverage ratio). With the highly liquid loan market in recent years, borrowers and sponsors have been able to successfully negotiate maximum flexibility in loan agreements to incur debt and implement changes in the borrower’s capital structure. This flexibility is reflected in several recent trends in incremental facility provisions—“free and clear” incremental debt baskets, reclassification of free and clear incremental debt as ratio-based debt, incremental equivalent debt, and limited conditionality for incremental debt to be used to finance an acquisition.
Recently, incremental debt capacity in the large cap market usually consists of the sum of (i) a “free and clear” dollar amount, (ii) the amount of prior voluntary term loan prepayments not funded with long term debt and permanent revolver commitment reductions, and (sometimes) prior cash payments made for loan buybacks and purchases, plus (iii) unlimited debt subject to pro forma compliance with a maximum net leverage ratio (frequently closing date leverage but sometimes tighter). To the extent proceeds of ratio-based incremental debt are being used to finance an acquisition, as an alternative to maximum leverage, the leverage test sometimes requires no increase after the incremental debt incurrence from the leverage ratio immediately prior to such incurrence. For purposes of calculating incremental ratio-based capacity, such incremental commitments are assumed to have been fully funded at closing, and the proceeds of such incremental loans being incurred are not included as unrestricted cash in calculating the net leverage ratio.
The “free and clear” fixed amount is available to the borrower without regard to leverage and sometimes contains a “grower” component so that the basket is the greater of a fixed dollar amount and LTM EBITDA (or a specified percentage of LTM EBITDA) at the time of incurrence. The ratio-based capacity may be deemed to be used before, or together with, the free and clear basket, in which case any amount concurrently incurred in reliance on the free and clear basket does not count in the leverage calculation. In many large cap deals, the borrower can initially utilize the free and clear basket to incur incremental debt that does not at the time satisfy the leverage test and subsequently reclassify that debt (or sometimes the debt is automatically deemed reclassified) as ratio-based debt when the leverage test is met, having the effect of refreshing the free and clear basket.
The ability to incur incremental equivalent debt (or “sidecar” facilities) is now common in large cap deals. Sidecars use the incremental debt capacity (including the free and clear basket), but are incurred as a separate facility outside the loan agreement, subject to customary conditions, including an acceptable intercreditor agreement. Sidecars may include first lien secured notes, junior lien or unsecured loans and notes, and (to a lesser extent) first lien loans. An issue for negotiation will be the application of MFN protection to any permitted sidecar first lien loans; however, MFN protection invariably does not apply to other sidecar debt.
Customarily, conditions to incremental debt incurrence have included material accuracy of representations and warranties, absence of default or event of default, and pro forma compliance with the existing financial covenant (if any), each tested at the time of incurrence of the incremental debt. In recent years, borrowers and sponsors have succeeded in limiting conditionality for incremental debt incurred primarily to finance an acquisition, thereby diminishing financing risk for follow-on acquisitions. As it has become common for acquisition agreements to not contain a financing condition, this development enables buyers to assure sellers of the certainty of funding.
Limited conditionality for incremental acquisition financing in large cap deals now frequently incorporates so-called Sungard (or “certain funds”) conditionality, under which incremental debt incurred primarily to finance an acquisition is conditioned on a bringdown of only (i) those representations and warranties in the acquisition agreement relating to the target that are required to be true at closing and (ii) certain agreed “specified representations,” limited to fundamental corporate status and authority, compliance, and regulatory issues (i.e., margin regulations, Investment Company Act of 1940, antiterrorism, and money laundering laws), enforceability of the loan documents, no conflicts with law, solvency, and status of liens (subject to limitations). Also, the absence of defaults condition is limited to the absence of payment or bankruptcy default. As an alternative, some incremental facility provisions provide for testing of the absence of all defaults condition, and (sometimes) the bringdown of all representations, at the time of signing of the acquisition agreement rather than at closing. This limited conditionality may be set forth expressly in the loan agreement or may be subject to the agreement of the lenders providing the incremental facility.
In addition, many large cap loan agreements now permit a borrower that has committed to an acquisition without a financing commitment to elect the date of the acquisition agreement (instead of the closing date) as the date of determination for purposes of calculating leverage ratios in order to test ratio-based incremental debt capacity. Testing of the leverage ratio at signing eliminates the risk of a decline in EBITDA of the borrower and the target between signing and closing, when the ratio would otherwise be tested. This risk is of special concern in deals involving a lengthy delay between signing and closing due to regulatory approvals.
While many large cap and upper middle market deals reflect this flexibility for incremental debt and limited conditionality for incremental acquisition financing, incremental loan provisions in smaller middle market deals remain more traditionally restrictive. Many lower middle market agreements do not permit incremental debt at all and lenders frequently resist lower middle market borrowers’ requests to include incremental facilities. When permitted, lower middle market deals invariably permit incremental loans only up to a fixed dollar amount and frequently impose a limit on the number of times that incremental debt can be incurred over the term of the loan agreement (usually three to five times). Limited conditionality does not apply in lower middle market deals and pro forma compliance with the financial covenants (and sometimes with a tighter leverage ratio) in the agreement is typically required.
Frequently, lower middle market incremental debt consists only of increases in the amount of revolving loan commitments or pari passu new tranches of term loans with identical terms (other than fees), including maturity, to the existing loans. Pricing may sometimes be permitted to differ; however, any increase in interest rate may have to be matched for the existing loans. Other restrictions may apply, such as a maximum time period during which incremental loans can be incurred or a maximum amount for each incremental loan incurrence. In some lower middle market loan agreements, incremental financing may be limited to increases in commitments in an existing tranche of revolving loans, and incremental term loans are not permitted.
Alexandra Margolis is a partner in Nixon Peabody’s Banking & Finance practice in New York City.
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