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Private Credit 

Jainisha Amin

Christine Tognoli

In our latest 9fin Educational, we look at key areas of investor focus in European leveraged loan agreements, how terms may differ in the US market, and where we are seeing consistent pushback against some of the more borrower-friendly features. Our focus here is on loan agreements which include a high yield bond style incurrence covenant package, as the majority of the €250m+ TLB market. This is a high level review of covenants and features in leveraged loan agreements; we refer you to our other 9fin Educational pieces for a detailed explanation of individual covenants (e.g. debt, restricted payments and asset sales) and other features.

In Europe, a market standard margin ratchet provides two 25bps step-downs at each 0.5x of deleveraging. The margin ratchet holiday is typically six-months (or two financial quarters), though sometimes we see this extended to nine months (and anything shorter than six months is usually subject to pushback). On a few occasions, a margin ratchet with three step-downs and/or 0.25x of deleveraging between each step-down is proposed but both are commonly subject to pushback and the latter is still relatively unusual.

In the US, the margin ratchet is typically tighter than in Europe, with one step-down for TLB - though traditionally there was no step-down. Where loan agreements include both a $ and a € tranche, we see pushback where more than 1 step-down is proposed for the $ tranche.

In Europe, the interest rate floor is almost always zero with rare exceptions. In the US, the floor is usually greater than 0; it used to be 1%, however this has reduced in the last couple of years to 0.75% or, on occasion, 0.5%.

In Europe, a ticking fee of 0-45 days (0% margin); 46-60 or 90 days (50%); 61+ or 91+ days (100%) is market standard. Again, this is an area where we consistently see pushback, either where the ticking fee schedule differs from the timing above, or where it is initially omitted entirely notwithstanding a relatively long certain funds period. The discussion is a bit different in the US market where there is often less of a gap between signing of the facilities agreement and the closing date. However the ticking fee considerations are similar in the context of delayed draw term loan tranches that are available for a specified period after the closing date.

Nearly all European and US leveraged loan agreements are cov-lite in relation to TLB with a springing financial covenant for the RCF. Surprisingly, the financial covenant in Europe is often more borrower-friendly than in the US, notwithstanding these structures originated in the US.

In Europe, the financial covenant is typically only tested if 40% of revolving loans are drawn. This test trigger excludes various types of utilisations and is usually determined net of cash and cash equivalents. In the US, the test trigger for the financial covenant is often tighter at 35%, though a 40% trigger is seen in some of the more sponsor-friendly documentation. Exclusions from the test trigger are similarly common in top tier sponsor deals.

Equity cure rights are generally less sponsor-friendly in US loans. While EBITDA cure rights have traditionally been permitted in the US, they are now a staple of the European market as well. However, the European market has gone further by permitting EBITDA overcures and, more recently, RCF prepayment cures. The latter enables the borrower to avoid testing the financial covenant if the 40% test trigger is no longer met. Unsurprisingly, this European novelty is starting to appear in some US deals now too.

Both European and US loan agreements permit broad and numerous add backs.

Wording is often elastic and includes cost savings, synergies, revenue synergies/enhancement, restructuring costs in relation to acquisitions, disposals or broadly drafted group initiatives or even actions committed to be taken in relation to the foregoing.

There is not always a requirement that cost savings are realised or expected to be realised within a look forward period. At its broadest, actions simply have to be committed to be taken within such period, so synergies that may never be realised can still be included.

Independent verification of cost savings and synergies above a certain threshold (typically 10-15% EBITDA) used to be a requirement in European loans agreements. However, this feature has fallen by the wayside in the last couple of years.

In Europe, cost savings are typically capped at 20-25% EBITDA with a look forward period of 18-24 months.

Frequently, the initial syndication term sheet or draft senior facilities agreement will allow uncapped synergies, but this is usually pushed back on resulting in the insertion of a market standard cap (usually 25%, but sometimes 20%).

In the US, a cap of between 20-35% EBITDA is common. However, there is a much greater prevalence of allowing uncapped addbacks for cost savings, synergies, etc in the US market.

In Europe, a look forward period of 18 or 24 months is commonplace. In 2021 under 10% of deals omitted such a time period. This is another area of investor focus - look forward periods are typically added if initially omitted, or reduced in length (for example, we’ve seen proposals of 36 months frequently reduced to a market standard 18-24 months).

In the US, look forward periods of 18 or 24 months are also common, however 36 months is also seen with greater frequency than in Europe.

While certain cost savings and synergies may be capped and subject to a look forward period, other flexible (uncapped) features often remain. Uncapped add-backs are often permitted as per a base case model, quality of earnings and calculations of opening EBITDA - this can also be in respect of future acquisitions (and not just the current acquisition).

Incremental facilities are typically permitted under (i) a ratio-based debt basket permitting unlimited pari passu secured debt subject to an opening senior secured net leverage ratio; and (ii) a soft-capped freebie basket up to 100% EBITDA.

Occasionally, we see pushback on 100% EBITDA freebies baskets (to 50% or 75% EBITDA). There are still a notable minority of deals (around a fifth to a quarter in the last year) that had a freebie basket of less than 100% EBITDA.

In the US, 100% EBITDA freebie baskets are market standard and tighter baskets are less frequent than in Europe.

In Europe, 100bps MFN protection subject to a six-month sunset clause is the market standard. We rarely see pushback on 100bps unless driven by the presence of US TLB tranches in a European deal. Occasionally, we see sunsets extended to 12 months, but six-months remains in over 80% of European deals.

MFN protection is another area where the US market is generally tighter than Europe. 50bps MFN protection is the traditional position in the US, though this has been weakening over the last couple of years with an increase in 75bps protection and occasionally 100bps. In the US, six month sunset periods are also common, but there is a more even balance between six month and 12 month sunsets.

Inside maturity baskets permitting an amount of debt to mature prior to TLB first emerged in the US market. Until a couple of years ago, they were strongly resisted in the European market. Now, inside maturity baskets are now common in Europe and seen in nearly 60% of deals over the last year-and-a half. The size of the basket is usually 50%-100% EBITDA in both markets now, though such larger baskets are much more recent in the European market.

This is the ability to incur debt up to the amount of new equity contributed to the Restricted Group. In Europe, contribution debt is seen in most deals: typically the basket is set at 100%, meaning 1 euro of the debt can be incurred for every 1 euro of equity contributed. Usually, contribution debt can be pari secured without being subject to a leverage ratio. It can also usually be incurred by non-guarantors on a structurally senior basis (and usually without being subject to any sub-cap on non-guarantor debt), limited only by the amount of equity contributed.

In a little over 10% of deals last year, the contribution debt basket was 200% meaning 2 euros of debt could be incurred for every 1 euro of equity contributed. This is a common pushback item that remains relatively rare in the European market.

In the US, 200% contribution debt baskets are seen more often. However, in the US this permission was traditionally an unsecured permission (though this is evolving), unlike in Europe where it usually has a dedicated Permitted Collateral Lien.

This debt permission allows the company to sacrifice restricted payment capacity for debt capacity. It is now seen in many deals (just under a third of deals for the whole of 2021, but is gaining momentum). The basket is typically set at 100%. Usually, this debt permission can be pari secured without being subject to a leverage ratio (or it can be structurally senior and non-guarantor debt caps do not usually apply).

In past years, this concept was removed relatively consistently following pushback, but it is surviving increasingly. We saw it removed in only a few deals where it was proposed this year.

A 200% basket is seen but is unusual (even more so than 200% contribution debt). This allows 2x debt to be incurred for 1x restricted payment capacity sacrificed. This is often met with pushback, with the basket reduced to 100% (if not entirely removed).

In the US, an Available RP Capacity Amount at 200% is more commonly seen than in Europe. However, like contribution debt it is more often an unsecured permission unlike in Europe.

Most European deals now have a 50% consolidated net income-based builder basket (around 80% of 2021 deals), and the vast majority of these deals have an additional starter amount which is soft-capped by reference to a % of EBITDA.

We don’t see pushback against the presence of this basket, but we do occasionally see pushback to reduce the size of the starter amount. We also see pushback around the ratio test applicable to use of the builder basket, either adding a test if omitted or tightening the test required.

In the US, the builder basket used to be based on retained excess cashflow. However, a 50% consolidated net income basket is now common too. There is therefore more of a mix of consolidated net income and excess cashflow-based baskets in the US.

In the US, some builder baskets are formulated as the ‘greater of’ 50% consolidated net income or cumulative retained excess cashflow (or even 100% EBITDA minus a percentage of cumulative interest expense - commonly 140% or 150%).

A separate (and additional) Available Amount basket has become much more common over the last couple of years in Europe. There is not much pushback here except occasionally around the leverage test required for use of the basket. The Available Amount comprises retained excess cashflow, retained proceeds, cash overfunding, cash/cash equivalents, investment returns from investment made with the Available Amount and sometimes permitted debt.

This is a large area of investor focus both in Europe and the US.

In Europe, we don’t tend to see the ‘trapdoor’ provisions made infamous by J.Crew (i.e. a specific basket allowing non-Guarantors to make investments outside the group with amounts that were permitted to be invested in those non-Guarantors by Guarantors).

However, there are still risks of leakage out to Unrestricted Subsidiaries (or otherwise) through increasingly generous permitted investment capacity, including ratio-based investment permissions set at a higher leverage than required for ratio-based restricted payments (or by reference to the looser FCCR test).

When we do see pushback, it is generally around the ratio-based investments (tightening the ratios, removing the FCCR alternative or ‘no worse than’ flexibility which would permit an investment of an EBITDA negative business).

The specific J.Crew type trapdoor provision is more of a US loan feature, but still present only in a minority of US deals. The more problematic extension of this is the ‘blackhole’, which couples the trapdoor, with a high yield style construct of unlimited leakage within the restricted group. So, there is no limit on investments by guarantors in non-guarantors, and those non-guarantors can make investments in unrestricted subsidiaries with the proceeds of any investment made in them.

This blackhole has survived in a small number of US deals, though we have yet to see it as such in a European deal. We can recall a euro bond where it was in the preliminary offering memorandum but removed in the final offering memorandum.

In both the US and European market, prior written consent of the company (not to be unreasonably withheld and deemed given if no response within a specified period, typically 10 Business Days) is usually required for assignments, transfers and voting sub-participations.

Sometimes there is pushback on the length (or omission) of the deemed consent period or omission of a reasonableness standard.

Prior notice requirements (even where transfer doesn’t require company consent) have been gaining some momentum in Europe, having previously been resisted. They were seen in almost a quarter of deals this year.

Typical exceptions to the consent requirement include during a non-payment or insolvency event of default or, in Europe, to a whitelist entity. In the US, there is no whitelist concept. Instead, there is a Disqualified Lender list: effectively a blacklist of competitors and other ineligible institutions. The ineligible institutions on the list are generally fixed as at the credit agreement date and should not be capable of being added to (though there are sometimes exceptions to this).

In Europe, the whitelist can usually be unilaterally amended by the company by removing a few names per financial year (but not day one lenders or affiliates). It is rare to see a Disqualified Lender list in Europe, but there are certain sponsors who consistently include one in their precedent documents. At times, the concept goes beyond the traditional US approach, allowing the list to be updated at any time after the senior facility agreement date, amounting to a veto right.

For a more in-depth look at individual covenants and specific documentary features, we have a number of 9fin Educationals available. For additional reading, please use the search function on 9fin.com/dashboard for “9fin Educational”.

If there are covenant features not yet covered that our readers would like to see, we invite you to get in touch with us at legals@9fin.com.

Investor Hot Topics in Leveraged Loans Europe vs US (9fin Educational)

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