Notwithstanding the bizarre experience of 2022, there are still plenty of little nuggets of information we can extract and digest as we push towards a more normalised market. In this piece we are going to analyse what happened in 2022 from both a macro and a micro view. 

On the macro side, we look at the overall development of the market as issuers tried to find innovative ways to get refinancing transactions done, and we consider what impact that has had on covenants. On the micro side, we look at the specifics of covenant capacity and consider some novel features that began to take off in 2021.

As a general disclaimer, please keep in mind the much smaller sample size of deals in 2022 when considering the data and trends described below. As 2023 progresses we will continue to monitor how these trends play out.

Deal Flow in 2022

From a covenant perspective, 2022 had two sides that couldn’t have been further apart. Bonds issued in January and February continued the trend of increasing covenant flexibility that we saw in 2020 and 2021 — everything else after that was part of a totally different market.

It’s no surprise, but LBOs (11 in 2022) maintained flexibility on par with LBOs in 2021, regardless of when they were issued during the year. Most of those transactions would have had committed financing in place prior to the primary market shutdown and subsequent repricing. As a result, price caps and the covenant terms / flex were already baked in to the commitment documents before the market shut down. Once the market partially reopened and repriced, which happened faster than most would have ever experienced, banks were still obliged to get deals done under the previously agreed price caps. To make this happen, we saw a spike in OID, resulting in the story of 2022 becoming partially one of how much the sell off cost the banks.

Setting aside the pricing, another interesting effect of the deal overhang was that sponsors were somewhat insulated from investor pushback on covenant terms. In a world where there is rapid market repricing, and deals can’t get done inside pre-agreed price caps regardless of how tight or loose covenants are, sponsors have little incentive to listen to investor feedback. While a bank might typically be able to rely on pre-agreed flex terms, or otherwise be able to convince a sponsor to tighten their documentation because of “pricing”, why would a sponsor give anything away if they wouldn’t see the benefit? It’s not quite this black and white, but this is certainly part of the story.

Rinse and Repeat: dominance of the refinancing

The second half of 2022 and Q1 2023 have been dominated by refinancing transactions by issuers looking to push out looming maturities. There were 24 non-LBO related bonds in 2022, 19 of which were for a refinancing (the others were for acquisitions or general corporate purposes). Due to the defensive nature of refinancing transactions in a bad market, these were broadly more conservative relative to 2021 deals.

Same stuff different day

In most of the refinancing transactions bonds were issued on nearly identical terms to the issuers’ previous bonds, which was likely to have been 2018/2019 vintage documentation. Some issuers such as Cirsa (Nov-22) and Emeria (Foncia) (Feb-23) issued their latest SSNs as pure “Additional Notes” under the existing notes indentures, meaning literally identical covenant terms. Others issued under new documentation but still generally mirrored their prior deals except for minor changes: Lottomatica (Sep-22), Verisure (Oct-22), Cirsa (Oct-22), and Kiloutou (Feb-23).

Similarly, towards the end of 2022 we saw a flurry of exchange offers with the likes of NewDay, Stada, iQera, and Italmatch Chemicals all trying their luck amid depressed market activity. Stada, iQera and NewDay all marketed their exchange offer notes in line with their existing notes covenant package with only minor changes such as increases in basket sizes matching EBITDA (again, to be expected). These transactions were interesting as they seem to be part of a new trend of exchanges coupled with tender offers that are structured to allow existing investors to easily roll in to the new deal. Issuers likely need to cater more to their existing investor base than they’ve ever had to in recent times.

But not for everyone

Italmatch Chemicals, on the other hand, had a mix of issuer-friendly and investor-friendly changes in its exchange offer. In particular, the company added portability, CNI adjustments for decreases in work volume (present in top-tier sponsor deals), a zero floor on the CNI Builder, and general basket size increases. But a J-Crew blocker was added and ratio-based permissions were generally tightened. Notably, Italmatch received an equity injection by the Saudi Arabian investment firm Dussur alongside the exchange offering, a strong defensive signal that perhaps gave Italmatch greater bargaining power over the covenants compared to other deals.

Going one step further, both Tendam (Oct-22) and LimaCorporate’s (Jan-23) refinancings provided covenant loosening across the board. Tendam’s most recent deal added in features that are more in line with the current market than terms in its previous issuance from 2017. The Spanish fashion retailer added features like net short disenfranchisement, reclassification language, a general RP basket for subordinated debt prepayments, asset sale leverage-based step-downs, unlimited carry-forward / backward calculation mechanics and removed the leverage test from the market cap limb in the post-IPO distributions basket (among others). 

LimaCorporate underwent a similar makeover with the addition of multiple baskets across the covenants including an RP starter amount and a leverage-based investments basket, as well as adding the Available RP Capacity concept (only seen in top-tier sponsor deals), significant adjustments to EBITDA, net short disenfranchisement, a super grower and ratio calculations exclude revolving facilities for working capital, among others. The company did, however, have minor pushback, and was forced to row-back portability so that it wasn’t available day one.

Verisure just continued its trend of progressively loosening its covenants — as shown below.

Pushback — every little bit counts 

Keeping with the theme that we’ve been discussing, the small sample size of deals in 2022 makes it hard to draw conclusions on investor pushback. Many deals that we anticipated seeing in 2022 never saw the light of day, and we saw a sharp rise in the use of “pre-marketing” to sound out a deal before a public launch. As a result, the deals that did launch publicly were already heavily baked. Nonetheless, not all of them made it through the market unscathed. 

Per 9fin’s Pushback Tracker, four deals experienced investor pushback in 2022 (888, Cerdia, True Potential, and Biofarma). Across all four deals with public pushback, caps and time limits relating to EBITDA synergy / cost saving adjustments were tightened. However, other pushback points were rather varied depending on the issuer.

By the numbers — positive trends for the buy-side

Moving on from the broader macro perspective and general transaction trends, let’s dive straight in to some data.

Value leakage is holding steady

At 9fin we treat most major investment baskets as potential Restricted Payment (RP) capacity. This is because most bonds contain a provision that permits the equity of Unrestricted Subsidiaries to be distributed out of the Restricted Group – bypassing the RP covenant. This provision is not viewed as controversial any more, but it does mean an issuer could transfer value to an unrestricted subsidiary using Permitted Investments capacity, and then transfer that entity to its shareholders (see the discussion on the implications of this basket). Therefore, for the purposes of value leakage, we combine RP and Permitted Investment (PI) capacity.

In light of the high interest rate environment, and general market instability, issuers were pushed to look at alternative forms of liability management. Therefore it will come as a welcome surprise for the buy-side that combined RP and PI capacity (our calculation includes numerical baskets, but excludes the CNI Builder and the Available Amount concept) has remained relatively stable between 2021 and 2022, although it is still noticeably up from 2020 levels. Note below that there is a big discrepancy between LBO transactions and bonds raised for other purposes.

Five of the top eight deals in 2022 for combined RP + PI capacity were LBOs. If you compare the deals in the chart below to 2020 and 2021, only Cerved and NewDay would break the top ten.

Link: Chart. Deals marked with an (*) are sponsor deals.

Hard-hit by Covid-19, travel agency eDreams ODIGEO appears so high on this list largely due to its meagre LTM EBITDA at issuance (due to covenant calculation mechanics, the company was able to annualise more recent and better quarters).

Beyond looking at totals, it’s worth looking at where this capacity comes from. A significant proportion of day one RP + PI capacity comes from ratio-based baskets, not fixed baskets. In FY 21, ~88% of deals featured an RP leverage-based basket decreasing slightly to ~86% in FY 22. Of those deals, ~18% and ~20% of deals in FY 21 and FY 22 respectively had headroom under the RP leverage-based basket on day one. Interestingly, in FY 22 the average amount of headroom increased to 1.2x EBITDA compared to 0.98x EBITDA in FY 21.

In FY 21, ~25% of deals featured a PI leverage-based basket, increasing to ~34% in FY22. PI leverage-based baskets were set above opening leverage in ~25% of deals in FY 22, down from ~30% in FY 21. Furthermore, the average headroom in FY 22 was 0.6x EBITDA, significantly lower than FY 21 which stood at 1.12x EBITDA. This may (or may not) imply that others are beginning to see PIs the way 9fin does (i.e., indistinguishable from RPs) — why not call a spade a spade? We’ll continue to monitor this.

Overall debt capacity is down, but not for the count

Combined RP and PI capacity may have remained stable, but a slightly different narrative exists for total debt capacity. The average total debt capacity available immediately after issuance for issuers has decreased across the board. In non-LBO transactions (where there has been very little deal flow), this has contracted by 0.1x EBITDA from FY 21 to FY 22. This isn’t a meaningful move, nor is the deal flow sufficient to extract any trend from this. However, the average total incremental debt capacity for LBO transactions dropped by 0.5x EBITDA from FY 21 to FY 22. So far in 2023 all high yield issuances were non-LBO, with incremental debt capacity rising to 2.76x EBITDA in Q1 FY 23, ~0.2x above the average total debt capacity for non-LBO transactions in FY 22 — this is a trend we will watch closely.

Link: Chart

9fin calculates total debt baskets as the sum of all debt baskets (including the Available RP Capacity Amount), minus debt basket capacity deemed utilised day one, e.g., outstanding term debt. This calculation excludes any ratio-based debt capacity.

EBITDA adjustments — the tide is turning

Last, but not least, we always need to look at EBITDA cost savings / synergies adjustments. These continue to be a contentious subject and a main focus for the buy-side. A quick glance at 9fin’s Pushback Tracker shows that this is one area with consistent pushback every year.

We often discuss internally whether there is significant value in a cap or a time horizon, but nonetheless, EBITDA forms a critical aspect of covenant calculations (e.g., ratios, grower baskets). As a result EBITDA has wide ranging impacts across the covenants, including capacity to make Restricted Payments (including investments) or to incur debt. Therefore, if a company is looking for flexibility to do a transaction, it will of course paint the rosiest version of EBITDA possible.

In 2022 uncapped add-backs to EBITDA were featured in around 50% of deals, having decreased year-on-year by 10%. On the other hand, ~34% of deals featured a 25% cap, a significant increase from prior years.

Link: Chart

A similar trend can be seen on the time horizon limits for these adjustments — the 24-month time limit has increased by ~27% since 2020 but stayed roughly the same between 2021 and 2022.

Link: Chart

Despite the rise in the “market standard” 24-month time horizon, it is not always water-tight. Ideally, the time limit should relate to when such cost savings / synergies are actually expected to be realised, but often these are drafted much more broadly. 

For example, in some cases the issuer only has to expect to take the actions expected to result in the cost savings / synergies (i.e., no requirement to see even €1 of the benefit yet!) — or “substantial steps” with respect to such actions — within the time limit. 

Novel Features — what’s available?

Two features have been steadily creeping in to documentation over the last few years. They blur the distinction between debt and dividend capacity. As a result, in any deal in which they are included, the level of complexity goes up. We are always careful to comment on these in our Legal QuickTakes, and to help you understand exactly how much capacity can be flipped between the RP and debt covenants. 

Steady rise of the Available RP Capacity Amount

First up is the Available RP Capacity Amount (see 9fin Educational), which allows the issuer to convert certain Restricted Payment capacity into debt capacity. This concept is not new to top-tier sponsor deals, but it is making its way into the broader market. The inclusion of this provision has largely increased since 2020, and was present in ~30% of deals in 2022 (~95% and 100% of deals with this feature in 2021 and 2022, respectively, were sponsored).

Link: Chart

Use of the Available RP Capacity Amount in deals added an average of 0.74x EBITDA in FY 21 to total debt capacity, which increased to 0.98x EBITDA in 2022. Notably, no deals in 2022 featured the Available RP Capacity Amount concept that converted RP capacity to debt capacity on a 2:1 basis.

How available is the “Available Amount”?

Next we go the other way and convert debt capacity (among other things) to Restricted Payments capacity. We have previously documented the development of the “Available Amount” (see 9fin Educational), but broadly it permits the issuer to make RPs / PIs from an amount equal to the “Available Amount”, which is built from a wide range of components including retained cash, IPO proceeds, closing overfunding, and, most notably, ”permitted debt”. This concept will feel familiar to loan lawyers, but it’s novel in bonds.

In 2021 the “Available Amount” concept appeared in six deals, which represented less than 10% of the sponsor deals issued that year. In 2022, it appeared in four sponsor deals out of 26 (888, House of HR, Ceramtec and Fedrigoni). It also popped up in Inetum’s pulled bond in Sep-22. Inetum’s proposed covenant package was a ~67% match, according to 9fin’s Similarity Scorer, to Arxada and Arcaplanet, which both featured the Available Amount concept in 2021.

The key to the Available Amount is understanding which components build it. For purposes of this article, we have focused on what we view as the most important component, namely the inclusion of “permitted debt”.

The presence of the concept forces investors to see permitted debt capacity as akin to RP and PI capacity (meaning additional potential value leakage), particularly when its use is not subject to a maximum leverage test. House of HR and Ceramtec are able to convert permitted debt baskets totalling 4.1x and 5.7x, respectively, into RP and PI capacity. This shuffling around of capacity may not always be completely clear and could give surprising issuers flexibility when their backs are against a wall.

This chart shows how much RP and PI capacity was added in Ceramtec and House of HR as a result of the Available Amount. The addition pushed both deals to the top of the chart for FY22.

Link: Chart

Notably each of House of HR and Ceramtec may use the Available Amount to fund RPs for subordinated debt prepayments and investments, and their use is not subject to a maximum leverage test. 888 on the other hand has a more conservative formulation where the foregoing uses are subject to a maximum leverage test and permitted debt is not a component of the Available Amount. Similarly, the Available Amount in Fedrigoni does not include permitted debt as a component and it does not have a separate basket to make investments from the Available Amount.

Portability — porting more than just the company 

In the current environment, where we have a sharp decline in M&A activity and overall less deal flow, portability is probably not top of the mind. However, taking a longer term view, sponsor-owned businesses will eventually still be looking for exits. The inclusion of portability in deals will once again come in to focus.

The inclusion of portability — both ratings-based portability or a leverage-based portability — has seen a relatively steady rise over the past few years. In Q1 FY 22 almost all sponsor deals included portability, but this levelled out to 50% of the sponsor deals in FY 22 as a whole. As we close out Q1 23, we are actually seeing a decline, but again due to small sample size and lack of LBOs (which tend to have the more aggressive terms), we won’t read much into this just yet.

Link: Chart

Beyond the simple inclusion of portability, it’s important to keep an eye on when portability is available. With respect to a leverage-based threshold, this is usually set at or around opening leverage. However, there remains a small percentage of deals that have portability set well above opening leverage. Both Cerved and United Group stood out, with the companies setting their portability leverage ratio 1.15x and 1.3x EBITDA above opening leverage, making it available even if they lever-up.

Conclusion

Overall, 2022 was less record-breaking and more broken-record. The volume of A&Es, exchanges and refinancings slowed down the pace of covenant innovation and resulted in covenant capacity holding steady. 

We’ve tried to prise out a few bits of interesting information from a much smaller sample size and to let you know what we are seeing in the market. Please let us know your thoughts, and what you’re expecting to see in the rest of 2023.