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By: Patrick Yingling and Aleksandra Kopec King & Spalding
What is the “middle market” of the U.S. leveraged loan market? While there is no checklist for what constitutes the middle market, the two basic parameters are that the borrower has between $10 million and $100 million of annual earnings before interest, taxes, depreciation, and amortization (EBITDA) and the aggregate loan size is in the range of $30 million to $500 million. As a general matter, there are common characteristics of credit facilities in the middle market:secured by collateral, small lender groups and other club-type deals, and financial covenant and negative covenant packages that are more robust than those for large corporate borrowers.
THERE HAS BEEN A CONTINUED INCREASE IN ACTIVITY THIS year in the middle market. There has also been a loosening of terms and a move toward more borrower-friendly provisions in credit facilities similar to what have historically been present in bond facilities or large-cap loans. This move is most apparent in the provisions that govern mandatory prepayments, incremental facilities, and negative covenants. Additionally, limited condition acquisition provisions have become commonplace in the middle market, unitranche structures have been increasingly featured in middle market deals, and a new LIBOR issue has created uncertainty throughout the financial markets
There is a distinct move this year toward more borrowerfriendly provisions relating to mandatory prepayments resulting from excess cash flow (ECF), asset sales, and extraordinary receipts (i.e., any cash received by or paid to or for the account of any person not in the ordinary course of business).
With respect to ECF mandatory prepayments, thresholds are becoming more commonplace in an increasing number of middle market deals. If there is an ECF threshold in an agreement, a prepayment would be required only after the borrower accumulates a certain dollar amount of ECF in any given fiscal year. In addition, the calculation of ECF continues to be watered down by giving the borrower a dollar-fordollar reduction for prepayments of certain debt. Historically such dollar-for-dollar reductions were limited to optional prepayments of the term loans plus, more recently, voluntary prepayments of revolving loans (if the revolving commitment is also reduced). But that reduction has increasingly been expanded to include incremental loans, incremental equivalent debt, refinancing facilities, and second lien debt. In addition, the time period for when this debt has to have been prepaid in order to benefit from the ECF reduction is often expanded to include not only the prior fiscal year, but also the period from the end of the prior fiscal year to the ECF calculation date and, in some cases, the borrower can still get the benefit of the reduction even if it has not made the prepayment so long as it has committed to make the payment during the succeeding fiscal year.
Asset sale and insurance condemnation prepayments have also been watered down recently. Both are typically now subject to a certain dollar threshold (both for a single transaction and for all transactions in any given fiscal year). Furthermore, with respect to asset sales, the mandatory prepayment requirements are sometimes being tied to leverage ratios (with step downs) similar to ECF payments.
It is common in middle market loan agreements to give the borrower the option of reinvesting proceeds from asset sales in new assets instead of requiring those proceeds to be used to prepay the loans. Now, the same is becoming true for extraordinary receipts. And with respect to both asset sales and extraordinary receipts, such reinvestment right periods are becoming longer in duration. It is now not unusual for a borrower to have 12 or even 18 months to reinvest the net cash proceeds received from extraordinary receipts or asset sales in other assets useful for its business before the mandatory prepayment requirement is triggered, and that reinvestment period can be extended for an additional period of time (up to six months) if the borrower commits to reinvesting the proceeds during the reinvestment period.
The incremental facilities section has also evolved toward more borrower-friendly provisions as well. In the past, incremental facilities were available up to a fixed dollar amount. It is becoming increasingly prevalent in the middle market to set the amount available under incremental facilities equal to the sum of:
The free and clear basket typically does not have a leverage test associated with it. Many middle market deals permit the borrower to choose which basket they are utilizing at the time of the incremental loan, and some even permit the borrower conveniently to reallocate the amount of the incremental loan between the free and clear basket and the leverage based incurrence basket after the fact
Most deals set a cap on the amount by which the all-in yield with respect to an incremental term loan can exceed the allin yield with respect to the existing term loan (called a most favored nation provision). The cap is typically set at 50 basis points, though some very aggressive sponsors have begun asking for that cap to be increased to 75 basis points. Sponsors sometimes request a sunset, or a period of time after the closing date (usually 12 or 18 months, though it may be as long as 24 months or as short as six months in some cases), upon which the most favored nation provision terminates. The sunset provision is clearing the market more often, but it is still fairly uncommon in a true middle market transaction. The majority of deals that have a sunset provision also give the lead arranger the ability to remove the sunset provision if necessary to successfully syndicate the loan.
There has also been an increase in middle market transactions that include the concept of incremental equivalent debt, or sidecar facilities. This is a large cap concept that has worked its way into middle market deals for aggressive sponsors. If a deal has an incremental equivalent debt concept, the borrower can use incremental debt capacity to raise additional pari passu or subordinated secured or unsecured loans outside of the credit agreement. The conditions applicable to incremental loans would also apply to incremental equivalent debt.
A similar large-cap feature—refinancing facilities—has also become more prevalent in large middle market deals. These facilities allow the borrower to refinance all or a portion of its existing loans with new debt issued under the existing credit agreement or with additional debt issued outside of the credit agreement. This concept is attractive to borrowers because it allows them to seek out lower priced debt that would be permitted to share pari passu in the collateral and guarantees of the senior credit facility.
The trend toward borrower-friendly provisions in the negative covenants section is most notable in context of the restricted payments and investments covenants (including permitted acquisition flexibility). In the restricted payments and investments covenant, it has become common to have an available amount or builder basket for the borrower. When the concept of an available amount first made its way into middle market transactions, it was usually defined as the amount of ECF that was not required to prepay the loans (i.e., retained ECF). But the available amount definition has slowly picked up additional components, including some or all of the following: (1) a hard dollar starter amount (typically based on a percentage (usually less than 25%) of the borrower’s EBITDA), (2) qualified equity contributions made to the borrower (excluding amounts received in connection with equity cures), and (3) amounts received from gains on investments utilizing the available amount.
The available amount basket can be used by the borrower for acquisitions and other investments and, in some deals, for restricted payments as well. Some aggressive middle market deals contain:
Also, for the benefit of the borrower, it is becoming commonplace in the restricted payments and investments covenants to have an additional basket that is unlimited but subject to a leverage ratio test. Such basket is in addition to the available amount basket (but usually with a de-levering requirement prior to availability).
The relaxation of the restricted payments and investments provisions, which allow cash to be siphoned out of the credit party group, should be viewed in conjunction with the other potential value leaks in the credit facility. This year, J. Crew famously used a trap-door provision in its credit facility to transfer millions of dollars in intellectual property to an unrestricted subsidiary, effectively moving a substantial portion of the collateral that secured such facility away from J. Crew’s lenders. This “J. Crew Trap Door,” as the provision has been dubbed, may be viewed as a cautionary tale toward the borrower-friendly shift in credit agreement provisions.
Furthermore, in the negative covenant provisions, the ability to consummate permitted acquisitions, consistently based on various conditions the borrower must satisfy before consummating any such acquisition, has seen a loosening in the middle market as well. There has been a move away from a general cap on acquisition consideration in larger middle market deals, with the typical approach now being to cap only the consideration with respect to the acquisition of noncredit party subsidiaries (typically comprised of foreign subsidiaries) or, in some deals, doing away with caps altogether and instead relying on a leverage ratio condition.
Also, many of the limitations that previously existed with respect to permitted acquisitions have almost entirely fallen away (including caps on earnouts and a requirement that the target have positive EBITDA). There has also been a continuation of the development of the limited condition acquisition concept.
The limited condition acquisition (LCA) concept has become commonplace in the middle market. The LCA is a permitted acquisition or investment not conditioned on obtaining thirdparty financing. The concept is tied to incremental loans and whether a permitted acquisition can be consummated. This provision allows the borrower, to the extent it has committed to an acquisition without a financing condition, to elect the date of the acquisition agreement as the relevant date (i.e., the test date) for testing whether the incurrence of debt (including pursuant to the incremental facility) and liens and the taking of certain other actions (such as investments, restricted payments, asset sales, or fundamental changes) are permitted.
If the borrower makes an LCA election, the measurement of ratios and baskets relating to debt or lien incurrence or the taking of other actions (including consummation of the acquisition), as well as the existence of any default or event of default, until consummation of the acquisition or termination of the acquisition agreement, is determined as of the test date. This concept is akin to the funds certain concept contained in underwritten commitment letters for acquisition financings, and it provides the borrower with certainty when committing to an acquisition that an EBITDA decrease, default, or other adverse event occurring between the date of the acquisition agreement and consummation of the deal will not impair its ability to raise debt under the incremental facility or take other actions if conditions are met on the date of the acquisition agreement. With this concept, the borrower can bid successfully in competitive sale processes with other potential buyers who may be coming to a deal with traditional standalone “SunGard” style commitment papers or other offers not subject to a financing condition.
Unitranche facilities have become more common in the middle market and are typically offered by less traditional lenders such as specialty finance companies. The unitranche concept combines first lien and second lien debt (or senior/ subordinated debt) into one credit facility that has a blended rate of interest for the borrower. The lien (and payment) priorities between the first lien/second lien or senior/subordinated debt are addressed in an agreement among lenders, which the borrower usually acknowledges in writing (but in certain situations may not know exists).
This structure simplifies the financing process by reducing the number of loan documents and therefore may reduce transaction costs for the borrower. However, due to some bankruptcy concerns (e.g., the structure is largely untested in bankruptcy and the first out portion of the unitranche financing may not be entitled to receive post-petition interest if the financing is treated as one class and it is undersecured) and familiarity with the traditional structure, the unitranche concept has some hurdles to clear before it becomes more prevalent in the middle market for traditional bank lenders.
The UK Financial Conduct Authority announced that it will phase out LIBOR by the end of 2021. LIBOR is featured in almost every credit facility in the middle market. Unfortunately, there is no indication that a replacement rate will be agreed to in the near future.
This uncertainty has caused much debate in the middle market (and other loan markets) on how credit facilities should protect against the possibility that LIBOR cannot be ascertained in the future. The Loan Syndications & Trading Association (LSTA) has suggested an approach in which the agent bank and the borrower would negotiate a new rate, and after determining the new rate, the required (majority) lenders would have a five-business day period in which they could object to the new rate selection.
One alternative to the LSTA approach would be to have the agent bank, the borrower, and the required lenders approve an alternate rate, and during the negotiation period, either all loans convert to base rate or the agent bank could implement a rate that they determine accurately reflects the lenders’ costs of funds. The market has not yet adopted a preferred approach, and it will be interesting to see how lenders adapt to the LIBOR rate uncertainty.
Lending activity in the middle market is likely to remain strong into 2018. Nontraditional direct lenders are expected to continue gaining market share in the middle market because they are not subject to the same regulatory regime as bank lenders. The flexibility afforded to direct lenders will likely continue the trend of loosening terms, resulting in an even more borrower favorable environment.
Patrick Yingling is a partner in the Charlotte office of King & Spalding, where he is a member of the firm’s Finance Practice Group. Mr. Yingling’s practice focuses primarily on the representation of lead arrangers and agent banks in connection with the structuring and documentation of syndicated credit facilities, including merger and acquisition-related financings, first and second lien credit facilities, investment grade financings, cross-border facilities, financial sponsor leveraged acquisitions, and asset-based lending. Mr. Yingling has experience with a broad range of industry types including business services, healthcare, media/communications, sports and entertainment, defense, real estate investment trusts, and manufacturing. Aleksandra Kopec is a senior associate in King & Spalding’s Global Finance practice group resident in the Charlotte office. Ms. Kopec is active in King & Spalding’s leveraged finance practice.
To find this article in Lexis Practice Advisor, follow this research path:
RESEARCH PATH: Finance > Market Trends & Insights > Market Trends > Practice Notes
For additional information on all segments of the loan market, see
> SEGMENTS OF THE LOAN MARKET: INVESTMENT GRADE, LARGE CAP, MIDDLE MARKET AND LEVERAGED FINANCE
RESEARCH PATH: Finance > Fundamentals of Financing Transactions > Credit Facility Basics > Practice Notes
For more on asset-based lending and leveraged finance, see
> COMPARING AND CONTRASTING ASSET-BASED LENDING AND LEVERAGED FINANCE
RESEARCH PATH: Finance > Asset-Based Lending > Introduction to Asset-Based Lending > Practice Notes
For additional details on covenant obligations, see
> RECENT TRENDS IN COVENANT OBLIGATIONS
RESEARCH PATH: Finance > The Credit Agreement > Representations, Warranties and Covenants > Practice Notes
For more about financial covenants generally, see
> FINANCIAL COVENANTS (CREDIT AGREEMENT)