As described in our previous trends report, each of the October deals in the table above (Modulaire Group, Multiversity and Arcaplanet) had a number of covenant terms changed between the preliminary and final Offering Memorandums, following pushback. Each of these deals were originally marketed with uncapped EBITDA synergies adjustments and no time limit. However, in all cases, a synergies cap and time limit were added prior to pricing. All three deals launched with 200% contribution debt and 200% Available RP Capacity Amount provisions. In Modulaire Group and Multiversity, these were both reduced to 100% (market standard), while in Arcaplanet, the 200% Available RP Capacity Amount was reduced to 150% and the 200% contribution debt provision remained the same. As a general note, substantive covenant changes were made in approximately a quarter of the sponsored HY deals in this period – watch this space for a deep dive report into the specifics of these changes.

In contrast, T-Mobile Netherlands, Ceramtec and Cerved sailed through without any covenant changes, despite their sizable baskets, uncapped synergies add-backs (among other expansive add-backs) and other significant documentary flexibility. As shown in the table above, Cerved’s portability and unlimited RP leverage tests were notably set very high relative to marketed opening net leverage (5.75x vs 4.6x).

Of course, the provisions we’ve highlighted in the table aren’t the only significant covenant features in these deals. See our Legal QTs on these deals for further colour on each of the individual docs (links included for each of the deal names in the previous paragraphs). A more fulsome comparison of key baskets in these deals is available using our Covenant Explorer side-by-side tool.

To see our Covenant Explorer tool for yourself, please sign up here for a trial.

Quick jaunt across the pond

Our table only lists European HY deals, but we have also prepared Legal QuickTakes on several recent US deals that have been at the very sharp end of sponsor aggressiveness - e.g., Medline (Blackstone / H&F / Carlyle), McAfee (Advent-led consortium) and athenahealth (Bain / H&F).

Each of those deals had 200% Contribution Debt and 200% Available RP Capacity debt baskets. Medline and athenahealth also had the relatively novel 20% voting cap and “no worse” flexibility for portability, RP and Permitted Investment (PI) ratio tests (including uncapped PIs subject to a 1.75x Fixed Charge Coverage Ratio (FCCR) / FCCR no worse), among other off-market provisions.

It’s important for European investors to keep abreast of developments in US deals, as it’s likely only a matter of time before such developments make their way into the European HY market (and vice versa). In fact, this year we have already seen a voting cap appear in a European leveraged loan deal. As a reminder, when this concept first appeared in the Ancestry.com bond offering in December 2020, The European Leveraged Finance Association (ELFA) published a note warning investors about the risk of such a provision taking hold in the European market.

“No worse”-ification

We have begun to notice “no worse” flexibility increasing in European HY deals. “No worse” ratio flexibility was historically limited to the incurrence of acquired / acquisition debt, allowing the issuer to incur acquisition financing and/or assume target debt subject either to: (1) meeting a certain leverage or FCCR test, or (2) the relevant ratio being no worse on a pro forma basis for the acquisition. This provision permits the company to make uncapped acquisitions that are either leverage- or FCCR-neutral or positive, regardless of what the pre-transaction leverage / FCCR is. The logic of that is relatively straight forward.

However, several deals have extended the “no worse” construct flexibility beyond the context of debt incurred for an acquisition (e.g., Modulaire Group - permitted for debt incurred to fund “any transaction”, permitted investment or capex, among other things; Arcaplanet - permitted for any debt).

We’ve also seen “no worse” flexibility expand beyond the debt covenants into other covenants. For instance, Modulaire Group, Ceramtec and Arcaplanet permit uncapped PIs subject to certain ratio tests being either met or “no worse” than immediately prior to the investment.

Such a formulation might not immediately appear to be something worth noting. However, “no worse” PI clauses can increase the potential for overall value leakage. For instance, investments of entities or assets that generate insignificant or negative EBITDA at the time of transfer would be leverage-neutral, even if those entities or assets represent significant future earnings potential (for example, imagine a drug manufacturer transferring a drug that is expected to be approved, but has not yet produced any revenue and is therefore generating negative EBITDA).

Investors should also keep in mind that common provisions in the RP covenant may permit shares of an unrestricted subsidiary, or value invested in unrestricted subsidiaries as PIs, to be distributed to shareholders. For this reason, it’s prudent to treat PI capacity as potential dividend capacity.

In Arcaplanet, the relevant clause allows for uncapped PIs if a 5.05x net leverage or 2x FCCR test is met, or if either ratio would not deteriorate pro forma. The 5.05x net leverage test was set at Arcaplanet’s opening net leverage, but marketing EBITDA / pro forma net cash interest expense was 4.4x. Assuming that this 4.4x accurately reflects opening FCCR under the covenant definitions, this means that Arcaplanet could ostensibly invest assets generating over half its EBITDA into an Unrestricted Subsidiary and still meet the 2x FCCR test (but note other covenants, e.g. the merger or change of control covenants, would need to be considered in such a scenario).

In a stressed / distressed situation where the FCCR is below 2x, sponsors and issuers could use this type of “no worse” provision in creative ways, for instance in a “J. Crew”-esque transfer of assets to an Unrestricted Subsidiary in connection with a distressed debt exchange. All that would be required is for the transaction to be FCCR or net leverage neutral. There is also a risk that the issuer could try to use this clause alongside other fixed baskets in a transaction that is decidedly not leverage- or FCCR-neutral overall (i.e., carefully orchestrate the order and timing in which baskets are utilized).

RP + PI basket capacity at an all-time high in Q4 2021

In Q4 2021, average RP and PI basket capacity jumped to a record 1.88x EBITDA (shown below on a combined basis as turns of EBITDA - utilizing at issue metrics, while excluding CNI build-up and Available Amount capacity). This increase is mainly driven by a small number of outliers — UGI International (5.25x) and Pinewood Studios (4.22x). Without those issuers, the Q4 average would drop to 1.66x, more in line with the previous three quarters.

Of all the sponsor-backed deals that priced in Q4 2021, Pinewood Studios (Aermont), T-Mobile Netherlands (Apax and Warburg Pincus) and Multiversity (CVC) had the highest RP and PI capacity, at 4.22x, 3.13x and 2.79x EBITDA, respectively. This is noticeably higher than the top transactions in Q3 2021, namely Pasubio (PAI) and Nobian (Carlyle and GIC) at 2.56x and 2.43x EBITDA, respectively.

Another Look at the Available Amount

In our Q2 2021 and Q3 2021 trend reports, we discussed the development of the “Available Amount” RP and PI baskets appearing in European HY deals. Prior to this report, the Available Amount concept only cleared the market in three European bond deals — Ahlstrom-Munksjö, Arxada (Lonza Specialty Ingredients) and Birkenstock. Now the concept has appeared in several further bond issues, including Modulaire Group, Arcaplanet, T-Mobile Netherlands (via “Permitted Funding”) and Ceramtec.

To recap, the Available Amount basket permits the issuer to make uncapped RPs / PIs at leverage levels higher than those that would otherwise apply (or in some cases, without even testing any leverage or other ratio test), so long as those payments are funded from the Available Amount. The Available Amount typically includes a broad range of components such as, among other things, retained cash, IPO proceeds, closing overfunding, and, most notably, permitted debt (i.e., convert debt capacity into restricted payments capacity).

The breadth of the Available Amount definition, including the method / components used to calculate the available capacity, as well as the relative looseness of the conditions, are key concerns. For example, the current market standard drafting leaves scope for three potential interpretations as to how the the Available Amount actually operates with respect to the “permitted debt” component. Each interpretation could result in a significantly different outcome. For example, depending on whether you read the clause to allow an issuer to, one could read the clause to permit an issuer to only count debt that has been issued for the purpose of making the related RP when calculating the Available Amount, but equally, it could be read that any debt issued under an applicable basket “builds” the Available Amount (which then could be used at any time in the future), or finally, one could read that you could convert debt to RP capacity with incurring any debt whatsoever. We discuss these three interpretations, and feedback we’ve heard from several partners at leading law firms in our recent podcast.

In the chart below, we show the FY 2021 deals with the highest combined RP + PI Capacity (excluding the CNI builder), including the additional capacity generated using the Available Amount. The deals with an Available Amount concept are bunched at the top; in each case the Available Amount concept could potentially more than double (in some cases, more than triple) the capacity otherwise available under their respective RP and PI baskets.

In many cases, there are very few or no conditions for making RPs and PIs from the Available Amount. Each of the above-mentioned deals permits uncapped PIs funded from the Available Amount, without any leverage or other ratio test. Birkenstock, Modulaire Group and Ceramtec further permit uncapped RPs funded 100% from the Available Amount without a maximum leverage / other ratio test.

We spoke about the key considerations when assessing the Available Amount in further detail in our webinar with ELFA this February (recording here), and very recently in our podcast (here)- in which we specifically breakdown the three main interpretations of the Available Amount clause.

Toggling Capacity via the Available RP Capacity Amount

Another innovation on the rise in 2021 was the Available RP Capacity Amount or, ‘Pick Your Poison’. This concept is similar to the Available Amount discussed above, but works the opposite way. It permits the issuer to convert certain RP basket capacity into debt capacity. This clause is more clearly drafted than its counterpart, and typically explicitly reduces the corresponding RP basket that was converted to debt (to avoid double counting).

Approximately 35% of marketed deals in Q4 2021 featured the Available RP Capacity Amount.

Of the top 20 deals in 2021, in terms of debt capacity, ten featured the Available RP Capacity Amount. Arcaplanet’s debt capacity is almost doubled by the presence of this concept - they can incur additional debt up to 1.5x RP capacity.

The Available RP Capacity Amount was not universally accepted, however, as it was removed following marketing in three deals, Birkenstock, Arxada (Lonza Specialty Ingredients), and Multi-color, and was tightened in a further three deals, Modulaire Group and Multiversity (200% to 100%) and Arcaplanet (200% to 150%).

Note: We have based our data on final documentation / terms where these have been made available to us. For deals where we have not received final documentation / terms, our data is based on preliminary terms.