October 22, 2024 - The evolution of credit documentation trends over the course of the past few months reflects the dominant macroeconomic and political themes of the year—geopolitical tensions, an unpredictable U.S. presidential election, uncertainty in the economy and the Federal Reserve’s rate-cutting policies—and idiosyncratic movements in credit markets, which were shaped by the keen pursuit of deal opportunities and hunt for yield, as well as healthy competition between the broadly syndicated and private corporate credit markets. Although elevated interest rates and inflationary pressures weighed on corporate borrowers in the beginning of the year and depressed M&A activity, the corporate loan market remained buoyant in early summer due to vigorous refinancing and repricing transactions. August proved to be quiet, as volatility chilled deal flow for a brief period.
While covenant packages proved borrower-friendly in the beginning of the quarter, market commentators observed higher clearing spreads and tighter deal terms when markets cooled for a few weeks. Post-Labor Day, markets reopened as economic growth, the Federal Reserve’s rate cut and lender appetite for new supply stimulated additional repricing, M&A and LBO activity. These factors have made for decidedly borrower-friendly credit agreement drafting and deal parties have described an erosion of lender protections, tighter spreads and looser covenants as the key trends of late Q3. Similarly, sponsors continued to push the envelope with liability management transaction (“LMT”)-style structures that enable debt priming, collateral- and covenant-stripping and basket capacity expansion. Given the recurrence of these structures in the market, the LSTA has produced a summary of drafting considerations in its “Private Corporate Credit – Representative Liability Management Transaction Protections for Credit Agreements,” as well as general drafting guidance in its “Liability Management Transaction: Drafting Fixes” Market Advisory. As the year closes out, we expect borrowers to maintain their superior negotiating position but for lenders’ keen awareness of credit agreement loopholes to continue. We continue this “Covenant Trends” series with an exploration of these topics below.
The appendix provides further details about each provision and it’s importance in the market.
| PROVISION | RECENT TRENDS |
|---|---|
| “HIGH WATER MARK” |
The high water mark mechanism originated in the European broadly syndicated loan market and is a relatively recent development in U.S. leveraged loan documentation. Market observers have noted the sudden increased frequency of the technique in the last quarter, especially considering its rarity in U.S. credit documents prior to 2023. Covenant Review, for instance, has documented that a substantial number of transactions launched to market with such provisions in early September alone. They note that, over the course of Q3, 7.8% of the loans reviewed cleared with a high water mark provision, whereas 3.8% of loans reviewed had this language in 2Q24 and 4.8% in 1Q24. A notable example includes Atotech’s 2021 credit agreement. Despite this recent pattern, as a general matter lenders have successfully resisted inclusion of high water mark language in their documents in the majority of instances. This is notable, as the market is currently trending towards more borrower-friendly covenant terms. In sum, though the use of high water mark language remains infrequent in the U.S. market, its recent emergence represents a notable trend of which lenders should be cognizant. View the Appendix. |
| “PAYMENT-IN-KIND” (“PIK”) OPTIONALITY |
PIK utilization has become more prevalent in deal terms over the course of Q3, during which borrowers faced with rising interest rates and elevated inflation continued to explore flexible loan structures. In a recent U.S. insights piece, for instance, LFI described the use of PIK interest as a bread-and-butter strategy, rather than a backstop for stressed borrowers. The provisions appear more frequently, and unsurprisingly, in private corporate credit, including performing credits, as borrowers can benefit from closer relationship dynamics with their lenders to negotiate more elasticity in their contract terms. PIK also makes sense as a component of private equity-backed acquisition financings where sponsors pursuing aggressive M&A strategies may opt to defer making interest payments during temporary periods when cash holdings are low. (Consistent with this, market observers have noted a concomitant increase in PIK income for Business Development Companies, a mainstay of private corporate credit, over the last few months.) Tellingly, Covenant Review has highlighted that a PIK toggle functions as a competitive advantage for direct lenders in the context of a strengthening, and cheaper syndicated loan market. Macroeconomic uncertainty and high interest rates imposed a heavy cash burden on borrowers during H1’24, rendering PIK interest a pragmatic option in Q3. It remains to be seen whether recent and projected rate cuts change this trend, as companies have more cash on hand to service their debt and resume making full cash interest payments. However, given the markedly borrower-friendly lending environment, we would expect PIK structures to remain a staple of private credit documentation as Q4 progresses. View the Appendix. |
| “PICK-YOUR-POISON” (“PYP”) BASKET |
Though the “dividend-to-debt” toggle/PYP basket originated in the European markets, it has made inroads into the U.S. space given recent market dynamics. Covenant Review reports that, by August, the frequency of the provision remained at a record high in L3M of 43% for all loans reviewed and, tellingly, 53% for PE-backed loans (as compared with 43% and 52%, respectively, in Q2). The former figure increased to 46% of all loans while the latter stayed flat at 52% of PE-backed transactions by October, and the recurrence of the language marks a noteworthy development. Interestingly, market analyses reveal that the 2x PYP Basket has also featured in many top-tier sponsor bond and loan instruments. Though the PYP provision remains controversial among market participants, its inclusion in a non-negligible number of financings indicates that borrowers are attracted to this construct, both because it facilitates additional debt raises and as an avenue to general increased flexibility within the four corners of their deal documents. We will continue to observe the evolution of this trend as the final quarter of the year unfolds. View the Appendix. |
| PREFERRED EQUITY/”PLURALSIGHT” |
The Pluralsight LMT was unprecedented in that its structure employed preferred equity financing at a restricted subsidiary, commonly viewed as nonthreatening to senior lenders, as an avenue to raise priming debt and, secondly, because it occurred in the private credit markets, where loan parties expect covenant packages and enhanced protection for lenders. Despite this novelty, the use of preferred instruments in larger LMT-type transactions may evolve into a nascent loan trend. Indeed, in a recent analysis of 20 private credit loan agreements, credit analysts at KBRA found that the documents reviewed permitted preferred equity issuances at any member of the credit group. Given this existing flexibility and a market environment in which, as KBRA has remarked, there is “more money chasing after limited deal supply”, increased use of preferred equity financing is certainly a possibility. Given the precedent-setting nature of past LMT structures, and with market technicals where they are, we would expect borrowers and sponsors to increasingly exploit the absence of guardrails around preferred equity issuances to pursue collateral-stripping and priming maneuvers similar to Pluralsight. Indeed, the pairing of preferred equity financings and LMT mechanics may well remain par for the course as Q4 progresses. For further information, please review the LSTA’s “Private Corporate Credit – Representative Liability Management Transaction Protections for Credit Agreements”, which refers to this mechanic in the “General Considerations” section. Please also reference the LSTA’s “Liability Management Transaction: Drafting Fixes” Market Advisory. View the Appendix. |
APPENDIX
“HIGH WATER MARK”
| WHAT IS IT? | WHY DOES IT MATTER? |
|---|---|
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The “high water mark” construct changes the typical formulation of baskets in a credit agreement. Baskets appear as exceptions to the negative covenants and are customarily expressed as the greater of a fixed dollar amount or a multiple of an agreed financial metric, namely EBITDA or total assets, or, alternatively, are based on a leverage ratio. In such a way, the carveouts to the loan covenants grow or diminish based on the borrower’s general cash flow and the basket sizing is matched to a company’s size and performance. A high water mark feature diverges from customary covenant drafting by permitting the borrower to use the largest EBITDA achieved on a historical basis, in lieu of its current earnings, for the purpose of setting basket sizes. This is regardless of whether its current earnings dip below this amount. The practical effect of this drafting is that basket capacity will expand on a permanent basis with historical EBITDA rather than being pegged on the greater of a dollar cap or percentage of actual earnings. As the language typically appears in the interpretive provisions of a loan agreement, rather than in the covenants themselves, it may also be difficult to identify. |
The high water mark provision employs a noncurrent EBITDA amount (which may be artificially high) to dictate basket capacity and thus represents a significant deviation from current market practice. The logic behind traditional capped baskets is to link basket capacity to EBITDA, which is understood to reflect a company’s profitability and overall creditworthiness. Using a historical snapshot of corporate cash flow may not reflect a borrower’s current performance and thus may pose a significant risk to lenders for several reasons. Firstly, such provisions provide the borrower with an opportunity to manipulate restrictions around basket capacity and thus the negative covenants, which creditors use to put guardrails around a borrower’s activities, including debt and lien incurrence, restricted payments and investments activity. This may exacerbate practices prevalent in today’s markets that may already distort valuations, such as the use of uncapped addbacks or other adjustments to EBITDA, as well as certain LMT maneuvers. Furthermore, and as some market commentators have noted, cherry-picking an EBITDA figure based on historical financials may “reward a borrower even for bad performance” and reflects a troublesome trend toward “borrower overreach”. From a practical perspective, the language changes the calculus for creditors, who will struggle to diligence when a borrower reached this “high water” mark. As we have noted previously, EBITDA is a critical factor lenders use to assess a borrower’s overall financial health and therefore its ability to repay its debts. By clouding the picture on a borrower’s current repayment capacity, a high water mark clause can put lenders at a significant disadvantage. |
“PAYMENT-IN-KIND” (“PIK”) OPTIONALITY
| WHAT IS IT? | WHY DOES IT MATTER? |
|---|---|
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This feature in a loan document permits a borrower to make a portion or the entirety of its interest payments in-kind (“PIK”), rather than in cash, by capitalizing that amount and adding it to the principal amount outstanding under the relevant facility. Interest therefore accrues to principal on each interest payment date and is settled as part of the increased principal balance on the maturity date of the loan. Market participants also commonly refer to this feature as the “rolling-up”, “compounding” or “capitalizing” of interest. Typically, there is an interest-rate step-up on any portion of interest that is “PIK’d” in order to compensate the lender for the additional credit risk inherent in deferring cash interest payments. PIK provisions may appear in various formulations. For instance, some loan documents contain a “PIK Toggle” mechanism, which provides the borrower with the option to switch, or “toggle”, from cash interest payments to in-kind interest payments as it may elect over the life of the loan (subject to any limitations on timing). In other cases, parties will agree at closing of the facility to a “partial PIK/partial cash” structure pursuant to which a borrower must pay agreed-upon portions of interest as PIK and as cash, respectively. Another nuance is that certain credit agreements, notably in the European market, may apply the PIK feature to the full interest rate (i.e., the base rate and margin) and others solely to the margin, with the latter being the most common construction. Furthermore, PIK provisions are often paired with additional limitations and structural safeguards for lenders, such as caps on the amount of interest that can be compounded, fixed time periods (frequently two years) for exercise of a PIK option and Event of Default blockers, in addition to the interest premium described above.
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PIK provisions are yet another avenue for borrowers to attain more latitude within the terms of their loan documents, as entities may utilize this flexibility for a number of reasons. For a borrower facing financial distress, a PIK toggle may be helpful in managing cash outflows and maintaining covenant compliance. At the same time, companies looking to prioritize various business and financial projects to improve working capital, develop new products and pursue expansion plans may also benefit from the construct. PIK provisions may add considerable nuance to the drafting process. One such example is call protection, as deal parties need to question whether the relevant language covers prepayments of principal comprising previously capitalized PIK interest, as opposed to just the original principal amount. Similarly, in the case of MFN protection, parties will need to consider whether PIK interest will be included when calculating “All-In Yield” in order to avoid triggering this language. From a lender perspective, there is a twofold risk of agreeing to PIK provisions. Firstly, capitalization of interest translates to a deferred cash revenue stream and lenders are, quite literally, “out-of-the money” during the “PIK period”, if not the life of the loan. At the same time, it is integral for lenders to ensure that a borrower is not capitalizing on the option to avoid a payment default during a period of material financial distress. PIK utilization may also cause trading issues for BSL market participants, as “PIK” and cash interest have different treatments in the context of secondary loan trades. Whereas PIK “travels for free” to the buyer of a loan, cash interest is allocated to one of the trading parties. Therefore, where the borrower has the option to elect “PIK” or pay cash at the end of an interest period, trading counterparties face uncertainty in how to allocate interest upon settlement. Market participants should be aware of these issues and seek to address them when negotiating PIK provisions in their credit documents. Finally, a borrower must also consider that while a PIK toggle may afford considerable flexibility, electing to PIK interest over the life of a loan instrument will increase its overall debt burden. Companies should thus view the toggle as a proactive tool to employ cash for business growth, rather than as a “last resort” option. |
“PICK-YOUR-POISON” (“PYP”) BASKET
| WHAT IS IT? | WHY DOES IT MATTER? |
|---|---|
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A “Pick-Your-Poison” (“PYP”) feature in a credit agreement is a construct permitting a borrower to reallocate capacity available under the facility’s restricted payments (“RP”) basket to the debt basket, and in some facilities, to use such capacity for investments in unrestricted subsidiaries. In practical terms, this means that a borrower can elect to incur, on a dollar-for-dollar basis, additional debt up to the amount of the original RP basket (this would be described as a “1x PYP Basket.”) Any amount remaining under the RP basket is reduced by that shifted capacity, so that it is then unavailable for distributions under the RP covenant. This type of permission grew out of the use of another capacity-shifting construct—the “contribution debt” or “equity credit” basket, which is a type of permission allowing a company to incur debt equal to the amount of any equity contributions from its sponsor. The rationale behind a PYP basket is that if a borrower can distribute value to its shareholders as an RP, the same amount could theoretically be contributed back to that borrower in the form of equity, thereby building debt incurrence capacity. In other words, a PYP mechanism short-circuits this drafting approach and supplants it with a direct conversion of RP capacity to the debt covenant. The basket may also simplify the drafting process by negating the need to include explicit reallocation, rebuilding or reclassification language under other specified baskets, as a borrower may wish to simply negotiate a PYP feature so that the conversion of RP capacity under such baskets is automatically converted into debt incurrence capacity. In current market standard facilities, this feature appears in various manifestations. Some facilities include a related exception to the liens covenant, which permits such PYP debt to be incurred on a secured basis. In more aggressive formulations, this appears as a 200% PYP basket and enables a borrower to raise debt in an amount equal to two times the dollar allotment under the RP basket. Market participants may also refer to this mechanic as a “dividend-to-debt toggle” or, less artfully, the “Available RP Capacity Amount” basket. |
A PYP basket effectively empowers a borrower to leverage “leakage” capacity for the purpose of expanding the exception under its debt covenant. It is highly beneficial for a company seeking opportunities to raise financing for other corporate purposes, to plan for future liquidity needs or simply looking for optionality when deploying cash. This may be a concern for lenders, as granting a borrower any increased flexibility to build debt capacity increases the risk of a company incurring “priming debt” or, in the same vein, exploiting the basket as a loophole for liability management exercises. The pertinent question then becomes whether a creditor would prefer the borrower to use available cash for purposes of making a dividend to its Holdco or sponsor, or to raise debt that may dilute or prime the credit agreement debt. Ultimately, the sharing of general baskets across various non-debt negative covenants, including restricted payments, entails a considerable degree of risk which lenders will need to consider when conducting a credit analysis for any relevant borrower. |
PREFERRED EQUITY/”PLURALSIGHT”
| WHAT IS IT? | WHY DOES IT MATTER? |
|---|---|
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Preferred Equity (frequently defined as “Qualified Stock” under a credit agreement) refers to equity that lies in between debt and common stock in the capital structure of a company. Preferred equity instruments typically do not have a stated maturity or cash entitlements, are unsecured and, critically, rank junior to the outstanding debt of that company. For this reason, lenders do not view them as presenting a heightened risk of dilution or asset leakage, and standard credit agreements do not impose limitations on their issuance (they are also not counted for purposes of leverage calculations). In contrast, “Disqualified Stock” under a credit agreement constitutes equity with “debt-like” characteristics: Such instruments may redeem prior to the maturity date of a loan facility, require regular cash payments or may be convertible to debt. Given these characteristics, “Disqualified Stock” is subject to limitations under market standard debt covenants, to prevent cash leakage and in order that the existing lender group will not be primed. Preferred equity notably featured in a June 2024 transaction involving blue-chip sponsor Vista Equity Partners and its portfolio company, Pluralsight. Using investment capacity under its existing credit agreement, the company transferred valuable intellectual property assets (“IP”) to a non-guarantor restricted subsidiary, that subsequently issued preferred equity to Vista . The proceeds from the financing were then used to pay a dividend to Pluralsight, a structure which allowed the company to meet an upcoming interest payment on its existing debt. The transfer of the IP effectuated a release of the liens held by Pluralsight’s existing lenders, which enabled Vista, as holder of the preferred equity, to obtain a structurally senior claim against the IP collateral backing the preferred equity issuance. Vista, as sponsor, was thereby able to “prime” the company’s existing lender group. |
Because typical debt covenants (including the terms of Pluralsight’s loan agreement) do not typically place tight restrictions on preferred equity, a borrower can exploit this structural nuance to raise preferred equity financing at the subsidiary level as the functional equivalent of structurally senior debt. In addition, the use of a preferred equity instrument by a restricted subsidiary within a variation of the well-known “drop-down”/“J. Crew” structure, presents a novel way in which a company can capitalize on the “nonthreatening” nature of equity instruments to undermine the key protections in a credit agreement, and circumvent existing debt and liens covenants or other capped baskets. |
