Priority of Debt — Getting ‘Primed’

Jainisha Amin
+Oliva Mantock

16 November 2022•13 min read

In this 9fin Educational piece, we discuss the different types of senior and priming debt, including structurally senior, effectively senior and super-senior debt. While we focus on these debt categories in the context of large-cap European leveraged loan agreements (“SFAs”), each debt category is equally relevant when considering priority of debt in other debt instruments, including high yield bonds.

This is the first part of a two-part series on priority of debt. In part two, we will discuss junior and subordinated debt, including second lien, senior parent debt and subordinated shareholder debt.

Restricted Group

In both an SFA and high yield bond indenture, the covenants (including the debt covenant) apply to the Restricted Group. The Restricted Group includes the Company and its guarantor and non-guarantor restricted subsidiaries. Unrestricted Subsidiaries sit outside the Restricted Group and are therefore not bound by the covenants in the SFA or bond indenture. See our 9fin Educational pieces on the Restricted Group and Unrestricted Subsidiaries for further reading.

Structurally Senior Debt

Structurally senior debt ranks ahead of senior secured debt, including facilities such as TLB and the RCF, as it is incurred by a non-guarantor subsidiary.

A non-guarantor restricted subsidiary is part of the Restricted Group for covenant purposes but it does not guarantee the facilities. Even though a non-guarantor restricted subsidiary is subject to the debt covenant in the SFA which limits the amount of debt it can incur, any debt it does incur will be structurally senior because the non-guarantor does not provide credit support for the facilities. SFA lenders do not have a direct claim against the non-guarantor and its assets in an enforcement / insolvency scenario.

In the diagram below, we illustrate that creditors to the non-guarantor restricted subsidiaries are structurally senior to the lenders of the facilities. These creditors are paid first before any assets are available to be distributed to the equity holders (the shareholders of the non-guarantor) and its creditors, including the lenders of the facilities.

Effectively Senior Debt

Debt which is ‘effectively senior’ is secured on assets which do not secure the facilities (non-collateral).

The security package for the facilities is usually limited to shares in obligors (borrowers and guarantors), material intra-group receivables and material bank accounts. There remains a wide pool of assets which are not secured in favour of the lenders, for example, intellectual property, fixed assets, real estate, and contracts. Provided the liens covenant under the SFA permits these assets to be secured in favour of other creditors (for example, under the ratio debt permission, general permitted liens basket or the permission allowing non-guarantors to grant security over their assets), debt secured on this non-collateral will be effectively senior to the facilities. Creditors who have security over non-collateral assets have a first priority claim on the proceeds realised following enforcement of their security, and their debt is therefore effectively senior to the facilities up to the value of their priority claim on the non-collateral.

Drop-down financings

There have been a number of transactions in both the US and European loan market that have utilised drop-down financing structures. This structure is another way of enabling priming debt by transferring assets out of the Restricted Group (for example, to an Unrestricted Subsidiary) and using these assets as credit support for new debt financing. This debt is effectively senior as it is secured on assets which do not secure the facilities, and it also structurally senior because it is incurred by subsidiaries that do not guarantee the facilities. See our 9fin Educational: “J-Screwed” - a quick look at unexpected value leakage for further reading.

Unsecured Debt

Unsecured debt ranks pari passu (i.e. senior) in right of payment with first lien debt absent an express subordination agreement. In an enforcement and/or insolvency scenario, proceeds of unsecured assets are shared on a pari passu and pro rata basis between unsecured lenders and first lien lenders. However, lenders of first lien debt have a first priority claim on the proceeds realised following enforcement of their security (assuming there is no super senior debt outstanding). The first lien lenders only make a claim in relation to unsecured proceeds if there is a shortfall in the amount they are owed following security enforcement.

While the debt covenant in an SFA or bond indenture will regulate how much unsecured debt can be incurred, it does not usually restrict repayment of unsecured debt, unless it is subject to regulation under the intercreditor agreement. The intercreditor agreement ranks and regulates payment of the various categories of debt: first lien, second lien, and subordinated debt. While unsecured debt above a certain de minimis threshold used to be subject to the intercreditor agreement (including restrictions on ability to repay this debt ahead of the first lien debt), this requirement has loosened over the last few years and is now usually omitted.

Super Senior Debt

Super senior debt refers to debt which ranks pari passu in right of payment and security with TLB prior to an enforcement scenario. However, on enforcement, super senior debt has a priority claim in respect of security enforcement proceeds before any remaining proceeds are applied to senior secured debt and then to second lien debt.

High yield bonds

In a high yield bond, there is often a permission for revolving credit facility debt and hedging up to a capped amount to rank super senior. This means that the senior secured bonds and the revolving credit facility are pari passu in right of payment and security, but that the revolving credit facility lenders have a priority claim on the proceeds of security enforcement and receive these proceeds ahead of noteholders.

Unitranche and Super Senior RCF

While we focus on European SFAs for TLB and RCF below, it is worth first mentioning that a term loan with a super senior revolving credit facility structure is common in unitranche financings in Europe.

Leveraged Loans

In a typical European SFA, the borrower is only able to incur super senior debt once the ‘Designation Date’ has occurred. The Designation Date is defined in the intercreditor agreement as the date that TLB has been discharged or refinanced in full. Following the Designation Date, the SFA permits the original revolving credit facility and hedging to rank super senior. Sometimes, the debt permission for the original revolving facility will be soft-capped (up to the greater of a fixed amount [=original revolving facility] and a % EBITDA), and therefore permit a greater amount than the original revolving facility to be super senior.

The SFA and intercreditor agreement should work together to prohibit super senior debt to be incurred while TLB is outstanding (as discussed further in ‘Amendments and Waivers’ below).

Uptier Exchanges and Debt Buybacks

There have been a number of transactions in the US market that have involved the introduction of priming debt into the capital structure, though many remain subject to ongoing litigation. In 2020, Serta, TriMark and Boardriders received lender attention as certain amendment and debt buyback provisions were used to conduct “super priority uptier exchanges’. A majority of lenders (rather than all affected lenders) approved amendments to the relevant loan agreements to introduce new super senior term loans into the capital structure. In the case of Serta, the majority lenders exchanged their existing first lien term loans for new super senior term loans, and minority lenders were effectively left with subordinated debt. Boardriders and TriMark went a step further — the uptier exchanges were carried out in conjunction with covenant stripping under the existing facilities, so minority lenders under those facilities lost the benefit of the covenants.

An amendment which subordinates the lenders’ liens to a priority lien requires majority lender consent (>50%). This is because it is not a “sacred right” which requires all lender or all affected lender consent to be amended. Sacred rights usually include changes to the pro rata sharing provisions, however these can be circumvented by carrying out debt buybacks on a non pro rata basis, as was the case in Serta, Boardriders and TriMark.

US credit agreements usually include debt buyback provisions which allow the borrower to repurchase loans through a bilateral process and/or open market repurchases; the latter can be negotiated with individual lenders without needing to give all lenders the opportunity to participate pro rata. In the Serta transaction, the borrower used open market repurchases to offer some (but not all) lenders the ability to exchange their existing first lien debt for super senior debt. As non-participating (minority) lenders were not offered the opportunity to exchange their debt for super senior debt, their existing debt effectively became subordinated to the new super senior debt.

As a result of these transactions, lenders pushed for ‘Anti-Serta’ provisions to be included in credit agreements. These provisions were aimed at preventing majority lenders from amending the credit agreement to permit priming debt while subordinating the lien of minority lenders. While Anti-Serta provisions were prevalent in loan agreements in 2020, they have not been seen as frequently since 2021.

What about Europe?

Could a Serta-like transaction be completed under a European leveraged loan agreement?

Debt Purchase Transactions

European leveraged loan agreements usually require debt repurchases to be made through a solicitation (each lender has the opportunity to sell an amount of its participation to the borrower) or open order process (all lenders are notified of the borrower’s intention to purchase an amount of participations at a certain price). All lenders of the relevant facility are provided with an equal opportunity to participate. If the borrower chooses to accept offers through a solicitation process, it must be in inverse order of price.

Some loan agreements also permit bilateral repurchases which allows the borrower to choose which lenders to purchase participations from directly. However, usually these repurchases can only be made after a solicitation process has been carried out, and the bilateral purchase rate cannot exceed the lowest purchase rate tendered by the lenders during the solicitation process. There may also be a time limit on bilateral purchases, for example that they are carried out within 60-90 days of a solicitation process ending.

Covenant Stripping

Covenant stripping and other coercive tactics are less common in respect of European SFAs than in high yield bonds or the US loan market. Covenant stripping under a European SFA generally only requires majority lender consent (usually >50%), and a release of all or substantially all guarantees/security usually requires super majority lender consent (80% or sometimes 66.67%).

As all lender consent is not required to remove these key protections, successful amendment and extension processes which include a release of guarantees/security and/or covenant stripping can result in existing senior secured debt being split into two layers of debt: unsecured (though temporally senior) debt held by dissenting lenders and senior secured debt held by consenting lenders. While not strictly an uptiering exchange, the effect of such amendment and extensions can be that consenting lenders (unlike the unsecured dissenting lenders) end up with a priority claim on the proceeds of any security enforcement.

However, unlike the US, all lenders are involved in these amendment and extension processes and can therefore choose to either roll over their debt into new senior secured debt or remain in the existing structure and lose key existing protections. There are also matters of English case law that need to be considered when borrowers conduct any process that may be considered coercive. See our 9fin Educational on amendment and extension processes.

Amendments and Waivers

A European SFA should prohibit (i) the introduction of a loan ranking senior to the facilities, without all lender consent, and (ii) changes in the order of priority ranking in the intercreditor agreement. The intercreditor agreement ranks various categories of debt in order of payment and security priority and also includes the definition of Designation Date which, as noted above, is the date following which the borrower can incur super senior debt.

Unfortunately, many large-cap SFAs now frequently omit the requirement for all lender consent to introduce a loan ranking senior to the facilities. If the SFA also requires only super majority lender consent for changes to the manner in which security enforcement proceeds are distributed, this could arguably allow priority changes as between SFA lenders without all lender consent, regardless of the position under the intercreditor agreement. The entire amendments and waivers clause needs to be carefully reviewed to ensure that lenders are adequately protected from the introduction of a super (priority) tranche without all lender consent.

Another clause to pay attention to is the incremental facility clause. While a change in the order of priority ranking in the intercreditor agreement is an all lender consent matter, this does not apply in respect of incremental facilities. This is because incremental debt is already permitted under the SFA and is itself subject to certain conditions, including that it cannot rank senior to the facilities. However, under the incremental facility clause the conditions relating to incremental facilities (amortisation, maturity, ranking etc) can usually be amended with majority lender consent. The ranking condition (requirement that incremental facilities rank pari passu or junior to the facilities) should be an all lender (not majority lender) matter. While this may be unintentional and a drafting over-sight, it should be corrected where seen.

The key point remains that the SFA and intercreditor agreement provisions should work together to prevent the borrower from incurring super senior debt while TLB is outstanding.