Using leverage

GLOSSARY OF TERMS

Amortising tranche A: Leveraged buyout facilities are commonly structured with three term facilities – A, B and C – which all rank pari passu, with only the A facility amortising over time. Facilities B and C are repaid in bullet repayments on their respective final maturity dates.

Certain funds: Originally a concept derived from public-to-private acquisitions, the concept has made its way in to private acquisitions. The ‘certainty’ is that the lenders agree to fewer grounds on which they can stop acquisition loans being drawn.

Covenant lite: Usually a reference to an incurrence covenants-approach rather than more traditional maintenance covenants.

Equity cure: A provision allowing a shareholder to ‘cure’ a breach of a financial covenant by injecting additional capital into the borrower.

Mulligan: Originally a golf term, a Mulligan is a clause allowing deemed cure for certain limited breaches of financial covenant.

Reverse flex: Contrasting to market flex (which allows the arranging bank to increase the margin and to rearrange the structuring of the debt), the reverse flex incentivises the arranging bank to achieve a reduction in the margin in circumstances where the facilities are oversubscribed in syndication.

Second lien: A second lien tranche, or D facility, ranks pari passu with the other senior facilities, other than in respect of security. This allows lenders that are not permitted to provide subordinated debt to provide debt that is quasi-subordinated in that it ranks senior and is deemed a senior loan, but ranks after the other senior loans but before the mezzanine loan in case of enforcement of security.

In September 2007, Norton Rose carried out a survey to gauge how bankers, equity sponsors and corporates thought the credit crunch would affect the leveraged buyout (LBO) market. Among other things, the respondents believed we would see a revival of the amortising tranche A and the disappearance of second lien and covenant-lite loans.

They also predicted that usage of equity cure and certain funds provisions would become rare and that Mulligan clauses and reverse flex clauses would no longer be seen. Now, six months later, has the market changed as anticipated?Autumn 2007 showed a clear upward trend on margins and fees, as well as resistance to previously high ‘earnings before interest, taxation, depreciation and amortisation’ (Ebitda) multiples. This has caused problems for vendors, who are less able to achieve the exit values they want, effectively bringing fewer deals to the market – or at least fewer completed deals.

With leveraged loans trading at substantial discounts to par in the secondary market, syndication of new loans is becoming increasingly difficult. Lenders’ willingness to agree borrower-friendly terms depends on the effect this would have on their ability to sell on loans. This has resulted in lenders developing a growing aversion to terms perceived in the market to be too borrower-friendly.

As expected, covenant-lite and Mulligans clearly fall into this category and are no longer “market” (for now). While financial covenants are getting tighter, the equity cure remains in the market, albeit in less generous versions, with mostly only cashflow-related cure rights and more limited rights of repetition. For example, where a borrower could have expected to be able to ‘cure’ breaches of revenue-related financial covenants five or six times during the life of a loan facility, it seems that lenders today are only prepared to allow two or three such cures.

In terms of structuring the loan facilities, the survey respondents were proven right:

• Second lien has disappeared from the market and more debt is being put into the amortising A tranche. There are a large number of LBO facilities predating Q3/2007, where there is no amortising tranche at all. As a result, such loan facilities are less vulnerable to the borrower’s cashflow drying up. With an A tranche revival, together with stricter financial covenants and less cure rights, borrowers will have to watch their cashflow and interest cover covenants more closely.

• Although some respondents believed that fewer term facilities would be made available on certain funds terms in private acquisitions, it remains a very common feature, with lenders appearing to be quite relaxed about the concept, which, in the end, can be seen as a means to facilitate the underlying acquisition.

It will be interesting to see if the stresses in the syndication market force a rapid tightening of document terms in a more marked way than has been seen during the past six months.

The liquidity crisis has not gone away as swiftly as some had hoped (most respondents had predicted a relatively full recovery by spring 2008) and this may result in more traditional lender provisions returning to the fore.

Tomas Gärdfors is a partner at Norton Rose

has the leveraged buyout market changed in line with predictions? By Tomas Gärdfors