Generally speaking, 'leveraged finance' refers to debt-related financings and similar financial arrangements (including in some cases preferred stock), for speculative (meaning non-investment grade) companies. These financings can include working capital facilities, whether through asset based lending arrangements (ABLs) revolving credit facilities or more permanent elements of a company's capital structure. In 2017, the overall US syndicated loan market (including investment-grade loans) was estimated at US$2.5 trillion,2 and the US high-yield market was estimated at US$1.233 trillion.3 A significant portion of these financial markets relates to acquisition finance, because leveraged acquisitions, leveraged buyouts and similar financings are an increasingly important aspect of this market, accounting for US$645 billion4 of the syndicated loans and US$97.2 billion5 in net new issuance volume in the high-yield bond market, as of 31 December 2017.
Often, a leveraged company's capital structure consists of a senior debt layer and a junior debt layer, in addition to the equity portion of the capital structure. The senior debt layer has traditionally been filled with bank loans (whether in the form of first lien term loans, revolving credit facilities or ABL revolving credit facilities), and the junior debt layer has traditionally been filled with bonds (whether in the form of subordinated notes, senior unsecured notes, mezzanine notes and, especially in Europe, holdco notes, which are 'structurally subordinated' to the senior debt layer). Over the past 30 years, these two layers have become increasingly differentiated, segregated and blurred, allowing issuers, financial sponsors and financial intermediaries the ability to access different aspects of the capital markets to optimise a capital structure given market demands, regulatory requirements and other considerations. Over the past 10 years, the markets have seen the senior debt layer of the capital structure often filled out with an ABL revolver (secured by a first lien on the company's working capital assets – inventory and accounts receivable) and term loans (secured by a first lien on the company's remaining assets), with 'butterfly' junior liens (where the term loans are secured by a second lien on the company's working capital assets and the ABL revolver is secured by a second lien on the company's assets other than the working capital assets). In addition, over the past five years, the United States syndicated loan markets have increasingly accommodated 'stretch' first lien loans, where the first lien loans have provided leverage levels sufficient to make junior debt layer unnecessary.
The junior debt layer of a leveraged company's capital structure has traditionally been provided by 'high yield' or 'junk bonds'. These instruments typically involve a fixed rate of interest and significant call protection, whereas loans have traditionally involved floating interest rates and have allowed for prepayments with only modest, if any, prepayment premiums. In the United States, these instruments are 'securities' and, therefore, are subject to the increased liability standards of the securities laws. Traditionally, many of these bonds were issued as 'subordinated' debt, meaning that the bonds were contractually subordinated in right of payment to the senior debt layer of the capital structure. Over the past 10 years, fewer and fewer bonds have provided for contractual payment subordination, requiring the senior lenders to be comfortable with their collateral as the only source of 'effective subordination' of the junior debt layer of the capital structure, or providing the senior lenders with priority claims with respect to collateral, where the bonds are secured by a lien with junior priority to the lien securing the senior debt layer of the capital structure. In 2017, the high yield market was estimated at US$1.233 trillion6 compared with US$727.4 billion7 in 2008. In addition to competition from 'stretch' first lien loans, the junior layer of the debt capital structure has increasingly been filled with syndicated second lien loans.
Recently, for regulatory reasons described below, as well as ratings agency considerations, and financial sponsors' financial return requirements, a portion of the third party financing in connection with acquisition finance has been provided in the form of preferred stock. Preferred stocks allows investors to achieve fixed income returns (whether in the form of fixed or floating dividend rates), with some debt-like covenant protections. If structured correctly, preferred stock can obtain equity treatment for regulatory and ratings purposes. As a result, preferred stock is being increasingly used in leveraged capital structures.
II OVERVIEW OF LEVERAGED DEBT PRODUCTS
What follows is additional detail regarding the financial products most commonly used in leveraged acquisitions today.
i Secured term loans
Secured term loans are generally thought to be the some of the less risky debt in a leveraged capital structure. These loans are usually secured by substantially all of the assets of the borrower and its subsidiaries. The covenant controls are typically the tightest of any debt in the capital structure. A borrower is usually required to provide to the lenders of the term loans more financial and other information than that received by other holders of debt. The interest rate is typically based on LIBOR or some other floating measure to mitigate the cost to lenders of changes in interest rates. Secured term loans are also, generally the 'cheapest' debt on the leveraged borrower's balance sheet. Since secured term loans are viewed as less risky, lenders require less compensation in the form of interest and fees for taking on the reduced risk.
That said, the leveraged loan market has become more 'borrower-friendly' over time. The best example of this trend is the state of play today with respect to financial covenants. Secured term loans historically enjoyed the benefits of one or more financial covenants, which required a borrower to live within a maximum leverage ratio or maintain an interest coverage ratio. While there are still deals in which these sorts of financial covenants are present, a large percentage of leveraged loan transactions have adopted what has been come to be known as a 'covenant-lite' construct. In a covenant-lite deal, there are no financial covenants that exist contractually for the benefit of the term loan lenders. If there is a revolving credit facility in the capital structure, a single financial covenant (usually a maximum leverage ratio) is imposed for the benefit of the revolving lenders only. The revolver covenant usually includes a significant cushion to the borrowers' business plan and is only applicable when significant drawings are outstanding under the revolving facility. In addition to covenant-lite arrangements, large syndicated term loan facilities increasingly provide flexibility to incur additional debt, make investments and pay dividend so long as the borrower complies with various financial metrics. This trend has been referred to by some practitioners as the 'convergence' of term loan covenant controls with bond-style covenants described below.
Secured term loan facilities are usually provided by a group of lenders. One of the lenders in the group typically serves as an agent for the group, and one or more of the lenders will underwrite the term loan facility as an initial matter and subsequently syndicate all or a portion of the facility to other lenders (taking a fee for their efforts along the way). For large term loan facilities, there can be tens of lenders in the ultimate syndicate of lenders. For smaller deals, the entire amount of the facility may be provided and held by a smaller group of lenders. These arrangements are sometimes called a 'club deal'.
The regulations that came out of the financial crisis put limitations on the amount of leveraged debt that could be underwritten by regulated institutions for a given borrower. In response, a new category of lender, now commonly known as 'direct lenders', has emerged to offer greater degrees of leverage in connection with acquisitions and other transactions. These entities are institutional investors that are less regulated than banks, and have significant amounts of capital to invest. Unlike some other players in the market, these lenders, for the most part, do not look to underwrite and distribute loans, but rather to invest and hold the loans on their books. Because of the absence of an underwriter or arranger in the case of these investors, they deal more directly with the borrower, hence the title 'direct lenders'.
Today's leveraged loan market is huge, with total primary volume in the US leveraged loan market for 2017 of US$645 billion.8 2017 also marked the third-highest year ever for M&A lending at US$300 billion, with LBO M&A lending activity posting the second highest year ever at US$126 billion.9 Much of the growth in size can be attributed to the fact that, while in days of old leveraged term loans were relatively illiquid financial assets, today that is no longer true. There are now active trading desks around the world that can make a market in most sizeable term loans. The development of this liquidity has attracted new investors. Trade associations such as the LSTA in the US and the LMA in the UK have helped to organise the term loan market and provide useful information to participants thereon, making the market for loans more efficient.
ii High-yield bonds
High-yield bonds are non-investment grade debt instruments that typically have fixed interest rates and durations ranging from five to 10 years. They typically include call protection for a period of several years after issuance that requires payment of a premium if they are repaid during this period. Unlike secured term loans, they are treated as 'securities' for the purposes of the United States securities laws, which imposes heightened liability and typically results in enhanced disclosures in connection with their marketing, compared to the disclosures in connection with bank loans. They can be secured or unsecured and can constitute part of the junior debt layer of a company's capital structure through a junior lien, through payment subordination, or through structural subordination (issued from a 'holdco' without the benefit of subsidiary guarantees). Traditionally, in the United States, they were issued in private placements and registered under the United States Securities Act afterwards pursuant to 'registration rights' granted to the bondholders in the private placement. Increasingly, high-yield bonds are sold without these registration rights as the '144A for life' market has expanded, allowing issuers to limit access to their financial information to bond investors (rather than competitors that could have reviewed the financial information filed with the US Securities and Exchange Commission) and to avoid the additional expenses of compliance with SEC reporting. As of 31 December 2017, the high-yield market overall is estimated at US$1.233 trillion.10
iii Revolving facilities; ABL facilities, first out arrangements
Most companies with a leveraged capital structure require a line of credit to finance the working capital needs of their business. A classic leveraged acquisition capital structure would include a revolving credit facility (a 'Revolver') to meet this need. A Revolver is sized to fit the specifics of a company's working capital cycle and would usually include the option to make drawings under the Revolver in the form of loans or the issuance of letters of credit or bank guarantees. A Revolver is a line of credit that can be borrowed, repaid and reborrowing as a company's working capital needs require.
The Revolver for a leveraged acquisition usually has a shorter maturity than the term loans in the capital structure, and is commonly provided by a subset of the financing sources providing the secured term loan financing. The Revolver is otherwise pari passu with the secured term loans, meaning it has the same credit risk as the term loans in the case of an insolvency.
A somewhat new feature being added to Revolvers is what is commonly referred to as 'first out' or 'super senior' status. Under these structures, the Revolver is not pari passu with the secured term loan. Rather, it is entitled to receive first proceeds of recovery on collateral or payments in a distress scenario to ensure repayment of the Revolver ahead of term loan lenders. These arrangements are more commonly used in credits where lenders willing to provide a Revolver are scarce. Differences exist between the specifics of the structures used to document these facilities in the US and Europe, but structures on both sides of the Atlantic have the same purpose: to ensure that, in a distressed scenario, the Revolver is repaid in full before the term loan.
An asset based facility (ABL) is much like a Revolver but with enhanced credit support. An ABL is not pari passu with the secured term loans but, instead, has a first priority claim on selected assets (usually inventory and receivables) ahead of the claims of the secured term loan and other debt.
Under the terms of an ABL, a borrower is only permitted to make borrowings up to a percentage of the borrower's inventory and receivables deemed financeable. Hence, an ABL is considered less risky in that it has its own separate pool of readily monetisable collateral designed to support borrowing under the ABL. Because an ABL is less risky, it is also less expensive and is often used as a substitute for a classic Revolver where a borrower's inventory and receivables provide suitable support. Some of the savings on interest is offset by the fact that a typical ABL requires a borrower to report additional information to the ABL lenders along with third-party assessment of collateral values to ensure that the borrower is adhering to the specific requirements of the ABL structure.
iv Preferred stock
Preferred stock is equity, issued by a company in accordance with the applicable corporate law, and is entitled to preferential payment ahead of common stock in certain situations such as insolvency or liquidity. It allows a company to provide investors with contract-like protections, in the form of covenants, mandatory repurchase requirements and fixed returns, so that it can be structured to be 'debt-like.' But because it is issued in the form of equity, under the company's charter or other governing document, it does not have creditor-like remedies, and in the case of an insolvency will not receive any recovery until all debt of the issuer is repaid.
Historically, in the context of non-investment grade companies, the limitations on these remedies have prevented preferred stock from playing a large role in the context of third party capital for acquisition financings, with investors often referring to preferred stock as providing 'debt-like returns' in exchange for 'equity-like risks'. Instead, preferred stock was historically used mainly by financial sponsors to turn a portion of their capital contribution into preferred stock, senior to the common equity held by management or other investors, or in the form of 'seller financing' where the seller of a business maintained some interest in the business after the sale, but its rights and returns were limited to the negotiated rights of the preferred stock terms.
In response to the Leveraged Lending Guidelines, some financial sponsors have found third parties willing to provide preferred stock as part of the capital for a leveraged acquisition, on terms that meet the sponsor's return requirements (the cost of the preferred financing was 'debt-like' enough, compared to the financial sponsors' expected returns on its common equity contribution) while also meeting the debt financing source's requirements of being 'equity-like' enough that it was not considered as debt for purposes of the Leveraged Lending Guidelines (which typically limits leverage to 6:1) and for rating agency purposes. This balance of competing interests can be achieved by having the preferred issued at a level that is structurally junior to the debt financing, assigning a perpetual maturity to the preferred stock (rather than having a stated maturity), permitting dividends on the preferred to be paid in kind, and limiting remedies in the event of breaches of protected provisions contained in the preferred stock documentation. Preferred stock investments of this type are becoming increasingly common in leveraged acquisition financing structures.
III REGULATORY DEVELOPMENTS
Leveraged lending is subject to various regulations in jurisdictions around the world. The most significant regulatory development in recent years, however, has been the issuance of guidance by regulatory authorities in the US and Europe with respect to acceptable standards for leveraged lending transactions.
In the US, in 2013 three federal bank regulatory agencies, namely the Board of Governors of the Federal Reserve (the Federal Reserve), the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC), jointly issued guidance regarding leveraged lending (the US Guidelines). The US Guidelines replaced prior, pre-crisis guidance issued in 2001, and apply globally to US chartered banks, and to loans made by the US-licensed branches and agencies of foreign banks.
The US Guidelines are a comprehensive set of quantitative and qualification requirements for regulated banks engaging in leveraged lending activities. Among other requirements, banks subject to the US Guidelines must (1) establish a sound risk-management framework that includes risk rating for leveraged loans; (2) have strong underwriting standards, including valuation standards; (3) manage their deal pipelines; and (4) undertake stress testing, reporting and analytics.
The US Guidelines also suggested quantitative, numerical limits on banks' ability to make certain highly leveraged loans. The US Guidelines specifically exclude certain other types of debt (e.g., ABL facilities and high-yield bonds). In particular, noting that the basis on which any leveraged loan is extended must be the borrower's ability to repay, the US Guidelines note that a level of leverage in excess of six times measured cash flow would raise supervisory concerns under most circumstances. The colloquial effect of the implementation of the US Guidelines has been to discourage certain previously used, highly leveraged structures, and to move business from the bank lenders to the non-bank lenders. In 2018, there have been discussions among the regulators as to whether the US Guidelines should be re-evaluated based on the evidence and experience of the past five years.
In 2017, the European Central Bank (ECB), issued its own guidance relating to leveraged lending. Like the US guidelines, the ECB's pronouncements are not legally binding, but are expected to be largely followed by major credit institutions in the EU Member States. While there are differences between the US and ECB guidelines, the similarities are strong. Like the US guidelines one of the strongest features is the discouragement of providing financing when total debt exceeds six times EBITDA.
In the US, on 11 September 2018, five federal agencies, including the Federal Reserve, the OCC and the FDIC issued the Interagency Statement Clarifying the Role of Supervisory Guidance (the Guidance). The Guidance noted that supervisory guidance, such as the US Guidelines, does not have the force and effect of law, and is not the basis for enforcement actions.
While both the US and European guidelines are not 'law' to date they have been taken very seriously on both sides of the Atlantic. Whether over time this relevance will diminish remains to be seen.
The legal considerations involved in leveraged finance are considerable and complex. The overview above only scratches the surface at the highest levels, but hopefully provides an overview of the landscape involved that will enable the reader to more readily absorb the jurisdictional detail that follow in this volume.
1 Marc Hanrahan is a partner at Milbank, Tweed, Hadley & McCloy LLP.
2 2017 U.S. Primary Loan Market Review, LSTA Loan Market Chronicle 2018, p. 20.
3 Fitch High Yield Default Index, Bloomberg, https://www.fitchratings.com/site/leveragedfinance/data.
4 2017 Leveraged Loan Market Review, LSTA Loan Market Chronicle 2018, p. 26.
5 Market Trends 2017/8:High Yield Debt Offerings, LexisNexis Practice Advisor Practice Note by Simpson Thacher & Bartlett LLP, p. 8.
6 Fitch High Yield Default Index, Bloomberg, https://www.fitchratings.com/site/leveragedfinance/data.
7 Fitch High Yield Default Index, Bloomberg, https://www.fitchratings.com/site/leveragedfinance/data.
8 2017 Leveraged Loan Market Review, LSTA Loan Market Chronicle 2018, p. 26.
9 2017 U.S. Primary Loan Market Review, LSTA Loan Market Chronicle 2018, p. 20.
10 Fitch High Yield Default Index, Bloomberg, https://www.fitchratings.com/site/leveragedfinance/data.