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Caitlin Carey

This is the second of a two-part series exploring the Debt covenant. This part looks at the Permitted Debt baskets, Debt re-classification provisions and certain other key considerations. Part 1, which focused on the purpose and structure of the Debt covenant and the Ratio Debt basket, is available here. Note that the Debt covenant also needs to be considered alongside the Liens covenant, which will be the topic of a separate report.

As touched on in Part 1, the Permitted Debt baskets are set out in the second paragraph of the Debt covenant. These “baskets” are clauses that can be used to incur debt even if the Ratio Debt tests are not met. They can be thought of as debt capacity in excess of the headroom (if any) under those ratios.

The list of baskets can be quite long — T-Mobile Netherlands’ bonds have 29 clauses for Permitted Debt baskets, running to about four pages in length; some US bonds have even longer lists (the Scientific Games Lottery deal has 38 clauses). Some of the Permitted Debt baskets provide for general-purpose debt capacity, while others can only be used to incur specific types of debt or debt for specific purposes. There are also various customary clauses for ordinary course and operational obligations, and certain deals might also include bespoke baskets depending on industry practice and the Issuer’s specific business needs.

Incurrence under some of the Permitted Debt baskets might be limited to specified members of the Restricted Group (e.g., the Issuer / Guarantors, as in the Ratio Debt and the Credit Facilities baskets in VoyageCare), or else there may be a cap on the amount of structurally senior debt that can be incurred by non-Guarantor Restricted Subsidiaries under certain baskets, as described in Part 1 (example in Schustermann & Borenstein (BestSecret)).

the Capitalized Lease / Purchase Money basket;

We’ll describe these baskets (along with a few others) in more detail below.

If multiple baskets are available, the Debt covenant generally gives the Issuer the discretion to choose how to classify the debt it incurs (except, in some cases, for the day one credit facilities, as described below).

Where possible, the Issuer will generally choose to “max out” its Ratio Debt capacity first before using the Permitted Debt baskets (subject to Liens capacity and limitations on non-Guarantor debt incurrence where relevant). This strategy maximises the amount of debt that the Issuer can incur under the Debt covenant. If the Issuer instead incurred debt under the Permitted Debt baskets first, that debt incurrence would generally increase the Issuer’s leverage and decrease its Fixed Charge Coverage Ratio, reducing the Issuer’s capacity under the Ratio Debt clause.

The Issuer can also divide debt instruments across multiple baskets in its discretion, including by incurring some portion of the debt under the Ratio Debt clause (e.g., to “max out” this capacity) and the rest under one or more Permitted Debt baskets. There is typically a provision in the relevant ratio definitions that facilitates this by excluding from the ratios any debt incurred on the same day under the Permitted Debt baskets.

The Debt covenant generally allows the Issuer to re-classify debt across the Ratio Debt and Permitted Debt clauses from time to time (except the day one Credit Facilities, as described below). Some deals provide for the automatic re-classification of certain Permitted Debt clauses into Ratio Debt when Ratio Debt capacity becomes available.

For example, assume the Issuer incurs debt under Permitted Debt baskets at a time when it lacks capacity under the Ratio Debt clause. If the relevant ratio(s) subsequently improve (perhaps as a result of an EBITDA increase or an equity injection leading to a higher cash balance) such that the Issuer meets the Ratio Debt test(s), then at that point it can re-classify the debt it incurred under the Permitted Debt baskets into the Ratio Debt clause. This will empty out the relevant Permitted Debt baskets, leaving these available for further debt incurrence in the future.

Below is a simplified illustration of how basket capacity and re-classification work. The illustration assumes that the Ratio Debt test is a simple 5x leverage test.

In the first column, the Issuer has maxed out its Ratio Debt and has used capacity under its Credit Facilities and General Debt baskets, bringing total leverage above 7x.

The second column shows the Issuer’s EBITDA increasing by 50%, which brings leverage back down below 5x and enables the Issuer to re-classify the debt originally incurred under the Credit Facilities and General Debt baskets as Ratio Debt. This re-classification “empties out” those baskets, allowing the Issuer to use them again to re-lever if it so chooses.

Many Permitted Debt baskets are formulated as the greater of a fixed amount and a percentage of EBITDA (sometimes total assets or another metric, depending on the industry of the Issuer). This is called a “grower” basket because it allows the Issuer to access more flexibility as the business grows (whether organically or via acquisitions). The fixed component of the basket acts as a “floor” for basket capacity.

Some deals (generally aggressive sponsor deals) have a “super-grower” concept (sometimes referred to as a “high watermark” feature) where the fixed amount of the basket automatically, and permanently, increases to match the highest level of the corresponding grower. This means that the “floor” is raised whenever EBITDA (or the applicable metric) reaches a new high, and basket capacity will never be reduced below that high watermark.

Below we walk through the key baskets that will typically be found in the Debt covenant. This list is not exhaustive, and often transactions will include additional baskets that are tailored for the specific Issuer or its industry.

The Credit Facilities basket allows for the incurrence of a certain amount of debt under “any Credit Facility”, with the term “Credit Facility” defined broadly to include not only bank loans but a broad range of other debt, including bonds. This basket is almost always clause (1) among the Permitted Debt baskets.

The main purpose of this basket is to ensure that the Issuer can draw on its credit facilities (including the revolving credit facility), even if the Ratio Debt tests aren’t met. In keeping with this purpose, the Credit Facilities basket is usually sized in line with the commitments under the main credit facility(ies), plus additional capacity for any “accordion” or “incremental facilities” capacity available under the facilities agreement. This typically makes it quite a large basket!

In some cases, the basket amount may not match the day one credit facilities and may in fact offer significant headroom above the amount of the committed facilities, so it’s important to look closely at the fixed basket amounts and their corresponding growers. For example, several recent LBO deals (Ceramtec, Aggreko, Modulaire Group) have included 100% EBITDA growers on the Credit Facilities basket limbs where the fixed amount was sized to the day one RCF commitments, even though this fixed amount was less than 100% of day one EBITDA.

The Liens covenant generally permits debt incurred under the Credit Facilities basket to have the same security ranking as the day one facilities (may be different across the respective basket limbs), so any headroom could potentially be used for incremental senior secured debt (where the facilities are senior secured) or for super senior debt (where the RCF is super senior).

Capacity under the Credit Facilities basket doesn’t typically reduce if the relevant facility commitments get reduced or repaid. Older / more conservative deals sometimes include an “asset sale ratchet” (e.g., in Sappi’s bonds) that reduces the amount of the basket to the extent that any Credit Facilities debt is repaid from asset sale proceeds, but this concept has all but disappeared in recent years.

The Credit Facilities basket and classification / re-classification

As a matter of principle, any debt outstanding on the issue date under the main facilities agreement should be required to be classified under the Credit Facilities basket (and, if there are multiple limbs, under the specific limbs sized to the relevant facilities) and should not be permitted to be re-classified. This is an exception to the general re-classification permission described above.

The reason for this is that the credit facilities typically represent a large amount of the debt in the capital structure, sometimes even constituting the bulk of the Issuer’s leverage. If the Issuer were permitted to classify (or re-classify) its outstanding credit facilities debt as Ratio Debt rather than under the Credit Facilities basket, then the capacity under the Credit Facilities basket could be used to raise further incremental debt in excess of the Ratio Debt thresholds, significantly increasing debt capacity.

For example, let’s say the secured Ratio Debt test was set at opening SSNL of 4x, and the day one credit facilities debt represents 2 turns of EBITDA, equal to the size of the Credit Facilities basket. If the Issuer classifies the credit facilities debt under the Credit Facilities basket, then both baskets are “maxed out”. However, by classifying (or re-classifying) the credit facilities debt as Ratio Debt rather than under the Credit Facilities basket, the Issuer would “empty” the Credit Facilities basket, freeing this up for future debt incurrence up to 2x EBITDA.

This would be contrary to most investors’ expectations and, indeed, is not permitted in the majority of deals. Some conservative deals go further and do not permit re-classification of any debt under the Credit Facilities basket, rather than only limiting classification / re-classification of credit facilities debt outstanding on the issue date.

Either as a drafting error, or deliberately, the provision restricting classification / re-classification of day one Credit Facilities debt is sometimes omitted altogether (e.g., in Upfield’s bonds). In considering the practical risks of such an omission, note also that:

any re-classification would have to comply with the Liens covenant, so the risk is mitigated if there is not an available Liens clause that can be used to re-classify the day one credit facilities debt (e.g., if the Credit Facilities basket is the only basket permitted to have super senior status);

any new debt incurrence would have to comply with the covenants under all the debt documents, including the facilities agreement, so emptying the Credit Facilities basket would have limited value unless the corresponding capacity exists under the other agreements (or consent can be obtained); and

Issuers may be reluctant to upset their investor base by relying upon debt capacity created by reclassifying the day one Credit Facilities.

Capitalized Lease / Purchase Money basket

This basket allows for the incurrence of a certain amount of debt consisting of Capitalized Lease Obligations (generally, finance leases/leases capitalized on the balance sheet), mortgage financings, Purchase Money Obligations (generally, debt incurred to finance asset acquisitions, leases and improvements, including through the purchase of capital stock in entities that own assets) and other similar debt items.

This basket is usually a simple capped basket with a grower component and sometimes requires the debt to be incurred within a specified time limit of the relevant acquisition, lease or improvement.

Traditionally, this basket’s purpose is to allow the Issuer to raise debt to finance purchases of fixed assets. However, the broad drafting seen in most recent deals could potentially permit this basket to be used for general M&A purposes.

Some deals may also have a separate debt basket for Sale and Leaseback transactions. However, it has become increasingly common for debt “arising out of Sale and Leaseback Transactions” to be permitted without a cap. Pre-IFRS 16 operating leases are frequently permitted without any cap (if not carved out of “Indebtedness” entirely). Some aggressive sponsor deals may have no cap on Capitalized Lease / Purchase Money debt incurred “in the ordinary course of business” and, even more aggressively, we have seen a few deals permit an unlimited amount of Capitalized Lease / Purchase Money debt (e.g., in T-Mobile Netherlands).

This basket is exactly what it says on the tin — a capped basket with a grower that can be used for any purpose / type of debt.

This basket permits “Acquired Debt”, generally existing debt of a target entity, and “Acquisition Debt”, generally debt to finance an acquisition, so long as either: (1) the Ratio Debt test is met (i.e., the FCCR test and/or relevant leverage based Ratio Debt test described in Part 1 of this series), or (2) the relevant ratio would not deteriorate on a pro forma basis for the transaction (the “no worse” test). Some (typically sponsor-backed) deals also have an additional capped basket with a grower component.

The purpose of this basket is to provide flexibility for value-enhancing acquisitions, including in circumstances where the Ratio Debt test is not met, but the acquisition improves the relevant ratio (or is ratio-neutral). Under a typical high-yield covenant package, any acquisitions that become part of the Restricted Group are generally permitted under the covenants, so debt incurrence capacity is the main limiting factor on the Issuer’s ability to undertake acquisitions.

In certain sponsor-backed deals, the Acquisition Debt limb of the basket can be used for a much broader range of purposes than just acquisitions. For example, in Modulaire Group, this clause can be used for debt “Incurred or issued to finance any transaction, acquisition (including an acquisition of any assets, business or person), permitted investment, merger, amalgamation, consolidation or any capital expenditure or (in each case) other similar transaction”. This means that the Issuer can use the generous “no worse” flexibility and capped Acquisition Debt basket to raise debt for any transaction at all, even if the transaction does not involve an acquisition.

The Contribution Debt basket permits debt up to 100%, or in some sponsor deals 200%, of any cash contributions to the Issuer’s equity (or via equity-like subordinated shareholder debt) received after the issue date.

The rationale goes that, if new equity is raised, this increases the equity cushion and is creditor-positive. Bondholders should therefore feel more secure about their recoveries and allow the Issuer to take on an equivalent (or double) amount of new debt.

The basket typically builds only from cash injections, without giving credit for non-cash contributions. This basket is not typically subject to any leverage test or other conditions, except that equity contributions cannot be double-counted for purposes of the Restricted Payments Builder Basket or other Restricted Payments capacity.

One drafting point is that the Contribution Debt basket should not build from equity contributions that are already planned at the time of the bond offering — for example the initial sponsor equity injection in an LBO context — because such contributions would already be baked into investors’ understanding of the post-transaction capital structure. In LBOs or other similar transactions, the Contribution Debt basket should only build from the relevant completion date or should specifically carve out the contemplated equity contribution.

The “Available RP Capacity Amount” debt basket permits the Issuer to raise debt up to 100%, or in some sponsor deals 150% or 200%, of certain Restricted Payments baskets, in lieu of using those baskets for Restricted Payments. This basket is sometimes referred to as the “Pick Your Poison” basket or the “Available Shareholder Amount” debt basket. We’ve published a separate and more detailed 9fin Educational report on this basket specifically, which is available here.

Below we briefly touch on a few of the other Permitted Debt baskets that may be present in the Debt covenant.

Note that for specific-purpose baskets (e.g., the Cap Lease / Purchase Money basket described above and the local / working capital facilities, non-Guarantor debt and guarantees of JV debt baskets below), these are not the only options for incurring that specific category of debt! As described above, the Issuer can divide and classify debt at its discretion. For instance, non-Guarantors don’t have to incur debt under the non-Guarantor debt basket; they may also be able to use the Ratio Debt provision or other Permitted Debt baskets, depending on how those baskets are drafted and whether a non-Guarantor cap applies.

Local / working capital facilities basket: A capped basket with a grower that can be used for any debt under local lines of credit, overdraft facilities, bilateral facilities and/or working capital facilities. Usually a fairly small basket but worth bearing in mind, particularly if this basket can be secured on transaction collateral (pari passu with the bonds) and/or non-collateral assets (effectively senior).

Non-Guarantor debt (Europe) / foreign subsidiary debt (US) basket: A capped basket with a grower specifically for structurally senior debt incurrence by non-Guarantors. This basket may be described as a foreign subsidiary basket in US deals, which tends to have the same result, as foreign subsidiaries are typically excluded from giving guarantees in US deals.

Guarantees of JV debt basket: A capped basket with a grower specifically for guarantees provided by members of the Restricted Group in respect of debt of joint ventures (sometimes broadened to also include debt “incurred on behalf of” JVs, as in Cedacri). These joint ventures may be outside the Restricted Group, and even if they are within the Restricted Group, it’s very unlikely that they would provide credit support for the bonds. This basket is sometimes combined with the non-Guarantor debt basket.

Grandfathering of existing debt: A clause permitting any debt already outstanding (including, in an LBO/acquisition financing, target debt outstanding on the completion date) that will remain in place pro forma for the transactions. This may also extend to debt incurred under facilities committed and as in effect as of the issue / completion date, but typically excludes the day one senior facilities, for the same reasons described above under “Credit Facilities basket”.

Notes themselves: A clause permitting the Notes being issued on the issue date (note this excludes additional notes (i.e., tap notes), which require separate capacity, except that in PIK deals, notes issued as PIK Interest will not be treated as a debt incurrence).

Refinancing debt: A clause permitting the refinancing of Ratio Debt and debt incurred under certain Permitted Debt clauses (typically existing debt and Acquired / Acquisition Debt - as a matter of principle, this clause should not enable capped baskets to be “emptied” out), subject to certain conditions.
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Qualified Receivables Financings / Securitizations / Factoring: Typically, uncapped on a non-recourse basis (i.e., where the creditor can only enforce against the specific assets and not against the rest of the Restricted Group, subject to certain customary exceptions), often with a capped basket with a grower for recourse financings.

Intra-group debt: A clause permitting any debt owed to another member of the Restricted Group. In other words, intercompany loans between Restricted Group entities are generally uncapped. This clause typically places certain conditions on debt owed by the Issuer or a Guarantor to non-Guarantors (i.e., that such debt must be unsecured and subordinated, perhaps subject to a de minimis threshold or certain other exceptions) in order to limit structural subordination risk.

Certain ordinary course/operational obligations: Including letters of credit, bankers’ acceptances, performance and surety bonds, tax guarantees, workers’ compensation, cash management /cash pooling, financing of insurance premiums and take-or-pay obligations, among other things. Typically, such obligations are permitted without any cap if they are in the ordinary course of business. Certain recent sponsor deals have added separate capped baskets for these types of obligations outside of the ordinary course of business. We’re not clear on the specific rationale behind these additions, other than just to increase flexibility.

Disqualified Stock: As mentioned in Part 1 of this series, disqualified stock (generally, capital stock that is or may become redeemable prior to the Notes' maturity) is treated as debt for Debt covenant purposes. There may be a specific capped basket with a grower for this.

The baskets described above are by no means exhaustive, and a particular bond may have other commercially significant baskets. In 2020, some issuers drafted in Permitted Debt baskets for “Regulatory Debt Facilities”, to specifically capture debt arrangements pursuant to COVID government relief measures. Masmovil, Lutech and T-Mobile Netherlands each have a basket for debt “arising in connection with a Permitted Investment”, which does not have a corresponding Permitted Collateral Liens clause but we read it as allowing the Issuer to debt-fund any Permitted Investment (which would include uncapped acquisitions that become part of the Restricted Group, as well as investments outside the Restricted Group subject to Permitted Investments capacity).

What should you look out for when reviewing the Permitted Debt baskets in a particular transaction? The following is intended to be a short list to help you focus your review on the key points.

Consider the overall quantum of debt permitted to be incurred under the numerical Permitted Debt baskets. You could use 9fin’s Legals QuickTakes or Covenant Capacity tool to quickly check these figures.
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Are non-Guarantors restricted from incurring structurally senior debt under any Permitted Debt baskets? If there is a non-Guarantor cap, consider which baskets the cap applies to and if any key baskets are outside its scope.

Is there headroom under the Credit Facilities basket above the day one commitments under the main facilities?
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Is there an Available RP Capacity Amount debt basket?

Is the Contribution Debt basket and/or Available RP Capacity Amount basket set higher than 100% of cash equity contributions / RP capacity, respectively?

If certain types of obligations are uncapped (e.g., Sale Leasebacks, Capitalized Lease / Purchase Money debt, debt arising in connection with Permitted Investments), consider whether these should be capped or otherwise limited.

If there are any significant bespoke or unusual Permitted Debt baskets, consider whether these are commercially justified and appropriately tailored.

The Debt Covenant — Part 2 — The Art of Basket Weaving

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