The world of leveraged finance is full of terminology that, to the uninitiated, may seem overwhelming. The terminology is helpful shorthand for features of the market, documentation and risk allocation dynamics that have developed over time and lend themselves to shortened descriptions.2 Some of the terminology is explained in this Introduction and the chapters that follow. To start with the most basic term, 'leveraged finance' to most market participants refers to finance (debt or another form of similar capital) that is provided to speculative grade credits (ie, not investment grade). The forms of this credit, the credit providers and the arrangements under which it is offered can vary widely and have morphed over time. What follows is an overview of some of the most common leveraged finance products, together with a bit of background around who are the players and what are some of the issues involved in recent days.
Leveraged financings can include working capital facilities, whether through asset based lending (ABL) arrangements revolving credit facilities or more permanent elements of a company's capital structure (including bridge financings, usually with a high-yield bond take-out financing, or, in European financing, interim financing agreements.
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). At certain times in the markets and more generally in certain industries, the 'senior' layer of the capital structure has been provided by relatively small ABL revolving credit facilities and the 'junior' layer of the capital structure has been provided in the form of secured high-yield bonds, because of dislocation in the syndicated loan market; these capital markets are dynamic and the participants adapt accordingly. 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 was traditionally 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. In years past, 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 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.
Over the past 15 years, the senior and junior layers of a leveraged capital structure have often been a bifurcation between first lien and second lien debt. With robust syndicated loan markets over this period, we have increasingly seen a first lien term loan and revolver and a second lien term loan provide the entire debt financing for an acquisition. In some industries, especially the oil and gas exploration and production industry, the lien between the 'senior' and 'junior' layer of the capital structure has become further blurred, with '1 and ½ lien' and even '1 and ¼ lien' and '1 and ⅛ lien' structures, where senior secured debt, either in the form of term loans or high-yield bonds, where the priority of the liens securing the debt is allocated pursuant to contractual intercreditor agreements or trust arrangements.
Recently, for regulatory reasons described below as well as ratings agency considerations, and financial sponsor's financial return requirements, a portion of the third party financing in connection with acquisition finance has sometimes 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 debt purchase. 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'.
Regulations that came out of the financial crisis known as the Leveraged Lending Guidelines 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'. Recent regulatory developments have called into question some aspects of the Leveraged Lending Guidelines. However, direct lenders appear to have ensured a continuing place for themselves because of their ability to commit significant amounts of capital quickly, without the market 'flex' provisions discussed below that allow arranging banks that intend to syndicate the loans with flexibility to adjust the terms of the loans based on market reaction.
Much of the growth in size of the leveraged loan market 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 usually 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 legally required 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.
Recently, the high yield market, like the syndicated loan market, has been perceived as more robust than the IPO market for the types of leveraged companies that are typical portfolio companies of private equity sponsors. As a result, over the last few years, we have seen high-yield bonds serve as an interim step before an IPO or sale of the portfolio company. These bonds are typically issued by a holding company, to they are structurally subordinated to the original acquisition financing debt capital structure. The proceeds of the bonds are used to pay a dividend to the financial sponsor. The bonds have smaller redemption premiums, allowing the issuer to redeem the bonds if they are taken public or sold, with less 'breakage' costs from the redemption premiums. More recently, some sponsors have used these subsequent holding company financings as a way to effectively reduce the size of their initial 'equity check', by using these holding company high yield issuances as soon as months after the closing of a leveraged acquisition, with the proceeds being used to pay a dividend to the financial sponsor.
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 structure, 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 ABL facility 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 Leveraged finance documentation and process
Generally speaking, leveraged finance transactions can be differentiated between 'committed financings' and 'best efforts financings'. In committed financings, one or more parties contractually commit to provide the relevant financing at a later point in time to the financial sponsor or borrower. After the commitment stage but prior to funding, 'long form' or 'definitive' documentation is prepared to set out the final terms of the financing. In best efforts financings, one or more parties under taken to arrange the relevant financing for the borrower or financial sponsor, but there is no obligation to provide that financing. In the case of best efforts financings, the borrower or financial sponsor only obtains the financing if the marketing process is successful and on the terms dictated by the market.
In committed financings, the documentation entered into at the commitment stage typically includes:
- a 'commitment letter', which sets out the financing sources' commitments to provide the financing described in a series of attached term sheets and contains the conditions to the financing sources' obligations;
- a 'fee letter', which contains certain of the economic terms of the financing sources' commitments, as well as containing any 'flex' rights (described below) that the financings sources have to alter the terms of the financing based on marketing conditions; and
- an 'engagement letter', if the financing contemplates a high yield bond offering that will hopefully will be used in lieu of any bridge financing commitment.
Generally speaking, acquisition finance uses committed financings so that the buyer and seller have confidence that the capital will be available to fund the transaction. About 15 years ago, the conditionality of the financing commitments in connection with United States public company acquisitions was significantly limited in what became known as 'SunGard' conditions (the name of the target company in the first transaction in which these provisions appeared). Broadly speaking SunGard conditions limit representation and warranties with respect to the target that are required to be made as a condition to funding to those negotiated in the acquisitions agreement. Over time, the limited conditionality of SunGard provisions expanded into acquisition financing involving private companies as well and is standard in most acquisition financing commitments in the United States.
In the UK, acquisition financing commitments involving public companies have been subject to the 'Certain Funds' of the UK Takeover Code. Broadly speaking, this regulation severely limits the amount of conditionality around funding committed finance so as to give public shareholders certainty of closure once a deal is announced. This limited conditionality has spread to the financing for many private transactions and other transactions that are not subject to the Takeover Code as financial sponsors and other buyers' have sought to burnish their bids with aggressive financing proposals.
While commitment letters describe many of the terms the financing to be provided, they only include term sheets that detail some, but not all, of the specifics of the financing documents. Final details of the financing were historically negotiated in the long form or definitive documentation, based on reference to market conditions, comparable transactions arranged by the financing sources, as well as comparable transactions involving the financial sponsor and the industry in which the company operates. When the capital markets were turbulent, especially during the extreme turmoil in the 2008–2010 time period, the negotiations around the definitive documentation often became contentious, as financing sources modified terms that were not specifically spelled out in the commitment letters to reflect the current state of the financial markets. Ever since the financial markets rebounded, financial sponsors and other borrowers have been limiting the amount of terms left open for negotiation in the definitive documentation stage. The length of the term sheets has also expanded, so that more and more terms are covered explicitly and the remaining terms are now commonly defined by reference to a specific precedent agreement so that less and less is left to be negotiated later. Initially the referenced precedent transactions were transactions that the financial sponsor and financing source had been involved in in the past or precedents that pertain to an industry in which the borrower operated. However, with the accommodative debt capital markets of the last few years, referenced precedent transactions have become as likely to be transactions that the financial sponsor or borrower (or their law firm) were not involved in, but felt were generally attractive due to their terms. All this has meant that fewer and fewer items are left to be negotiated with the market and that especially attractive terms quickly spread from one transaction to another transaction.
One aspect of documentation for committed financings that are expected to be syndicated is the inclusion of what are known as 'flex provisions'. These provisions, usually included in the fee letter so as to be less readily subject to broad disclosures, outline certain specific provisions of the financing referenced in the commitment letter or attached term sheets which the financing source has the option to charge or 'flex' if, in the process of marketing the debt, potential investors do not accept the committed terms. The flex provisions are usually quite specific and detailed (as opposed to broad terms or categories) and are subject to significant negotiation between borrower and financing sources at the commitment stage. It should be noted that direct lenders often have an advantage over other commitment parties with respect to flex provisions. Since direct lenders do not typically syndicate the debt they commit to provide, their terms are usually set at the commitment stage and their documentation does not usually include flex provisions. Hence, from the borrower's perspective, the terms of financing provided by a direct lender at the commitment stage may be preferable to the terms of a commitment to be sold to the market that could be flexed based on market reaction.
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 were 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, bur are expected to be largely followed by major credit institutions in the EU Member Scares. 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 EBJTOA.
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.
In 2019, the US Congress and regulators have begun examining whether growth in the leveraged loan market has created a systemic risk to the US financial system. As one example, on 19 April 2019, Senator Sherrold Brown of Ohio sent a letter to Treasury Secretary Mnuchin requesting that the Financial Stability Oversight Council (FSOC), which Secretary Mnuchin chairs), further investigate risks from the leveraged lending markets.3 In response, in its meeting of 30 May 2019, FSOC reviewed the corporate debt and leveraged lending markets. Minutes from the meeting stated that 'banks' exposures to leveraged lending. . . were relatively limited and there did not appear to be significant concentrations'.4 FSOC agreed to continue to assess these risks and issues with other agencies. In Europe, on 26 August 2019, in a report on Risks and Vulnerabilities in the EU Financial System, the Joint Committee of the European Supervisory Authorities (ESAs) stated that '[r]isks related to the leveraged loan market . . . in the financial sector should be further explored and identified . . . [s]upervisors have raised concerns about a possible underpricing of risks'.5
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 LLP.
2 In the US, the Loan Sales and Trading Association (LSTA) publishes a helpful glossary of terms relating to leveraged finance.