While financing sources are competing for deals again, lenders and lead arrangers continue to focus on the fundamentals.
As credit markets continued to improve in 2010, private equity sponsors and borrowers have been able to obtain and implement increasingly favorable financing terms and deal structures. Original issue discounts are tightening, sponsors have been able to effect dividend recapitalizations, and borrowers have been able to negotiate loan provisions allowing discounted buy-backs or the purchase of loans by the private equity sponsor. The credit crisis, however, continues to exert an influence on the debt markets: asset-based loans have become increasingly popular, arrangers remain conservative about committed financings, and certain economic terms such as "soft-call" premiums and LIBOR floors have become standard.
The Popularity of Asset-Based Lending
Continuing a trend that started in 2009, asset-based loans (also known as ABLs) are an increasingly popular source of financing. According to the Commercial Finance Association, new credit commitments of asset-based lenders increased by 49 percent in the second quarter of 2010 compared to the first quarter of 2010.
Asset-based loans are revolving loans secured by specified borrower assets such as accounts receivable, inventory, or equipment. The amount that can be borrowed under the facility depends on a percentage (typically between 65 percent and 80 percent depending on the asset class) of the value of the collateral. This percentage is known as the "advance rate."
ABLs are attractive to borrowers and sponsors because they typically feature more favorable pricing than cash flow loans. Further, with the primary collateral being limited to specified assets, the borrower can often preserve significant flexibility to incur other secured indebtedness. In addition, because asset-based lenders are more focused on collateral provided by the borrower than on cash flow, ABLs usually contain less stringent negative covenants than traditional cash-flow revolving loans. Most notably, ABLs typically do not provide for any financial maintenance covenants other than a fixed-charge coverage ratio, which is usually only applicable if "excess availability" (i.e., the amount by which the lesser of the borrowing base or the commitment of the lenders exceeds amounts outstanding under the facility) falls below a specified threshold. Finally, negative covenants in ABLs are generally inapplicable if there is sufficient excess availability and, if applicable, typically provide for larger baskets than in cash-flow loans.
Because lenders under ABL loans focus on the collateral against which the loans are made, asset-based loans contain more rigorous information and inspection covenants than in cash-flow loans. In particular, ABLs require:
- delivery of monthly or more frequent (weekly or even daily) borrowing base certificates providing a calculation of the borrowing base,
- regular appraisals of the borrower's inventory, and
- field examinations of collateral.
Field examinations and appraisals, which are conducted by third parties, typically take place two or three times per year. Accordingly, an ABL borrower must have requisite reporting and financial systems in place prior to entering into an ABL facility in order to comply with such requirements. In addition, if excess availability or other triggers occur, the collateral agent has the right to take control of the borrower's cash. This so-called "cash dominion" is triggered at a much earlier point in ABL loans than in cash-flow loans where lenders do not usually have the right to exercise control over bank accounts until an event of default has occurred.
Asset-based loans are not only used to provide working capital but also to finance acquisitions. The assets of the acquired company can be used as part of the borrowing base to obtain leverage on the closing date. However, the use of asset-based loans to finance acquisitions presents certain risks. Because the amount that may be borrowed under an asset-based loan facility varies with the borrowing base, using an ABL for an acquisition may present the risk of not having sufficient funds available at closing. As a result, drawings under an ABL facility typically are used to finance only a small part of the acquisition (e.g., backstopping letters of credit and funding additional closing fees due if the lenders exercise their rights to "flex" in syndication) and are coupled with borrowings under a term loan facility, bridge loans, or the issuance of high yield notes.
In the current sinking interest rate environment, lenders are seeking to protect their yields by imposing "soft-call" provisions on borrowers in the case of a refinancing or repricing of loans under a term loan facility. On the other hand, borrowers and sponsors are resisting the inclusion of such "soft-call" provisions to limit the cost of a refinancing in connection with a change of control. These "soft-call" provisions are ultimately part of the pricing terms and have in some situations necessary to achieve a successful syndication of certain loan facilities.
The refinancing or repricing may be implemented by the incurrence of incremental terms loans under the existing facility at a lower interest rate, by the incurrence of new term loans under a new facility or by amending the existing facility to reduce the applicable interest rate. Such "soft-call" provisions typically impose a 1 percent prepayment premium within the first year of the loan only if the refinancing or repricing has the effect of reducing the effective interest rate or weighted average yield (which includes any upfront or closing fees or original issue discount) on the debt of the borrower.
The Disappearing Swingline Facility
Several banks acting as administrative agent under credit agreements have stopped offering swingline facilities to borrowers. Swingline facilities are part of a revolving facility and are provided by one swingline lender. Swingline facility loans are available upon same-day notice by the borrower.
Some administrative agents are shying away from this type of facility because, acting as swingline lender, the administrative agent advances the full amount of the swingline loan and is concerned about other lenders defaulting on their obligations to fund their portion of the swingline facility.
As an alternative for borrowers seeking to be able to access their revolving facility on a same-day basis, base rate loans that were traditionally only available to be borrowed upon one-day notice are now more frequently accessible upon same-day notice.
Continued Focus on Conditionality
Arrangers and lenders continue to focus on their ability to syndicate deals to a comfortable hold level (i.e., the proportion of the loan retained by the lead arranger). In light of this trend, "club deals" (in which with several banks team-up to each provide part of the commitment to the borrower) remain a regular fixture of the syndicated loan market. Further, while "flex" terms which allow lenders to modify the terms of a loan to achieve a successful syndication remain limited to a list of certain provisions, they continue to permit lenders fairly expansive discretion. In particular, pricing flex is much broader than experienced prior to the financial crisis and there lenders are focused on being able to add more stringent terms (such as the soft-call provisions described below) or modify and curtail borrower-friendly provisions such as equity cures, the percentage of excess cash flow eligible to be swept to prepay debt, reinvestment periods for proceeds of asset sales, or the size of the incremental facility.
Finally, lenders continue to focus on conditionality. In particular, lenders will review and comment on the material adverse change provisions in the acquisition agreement before agreeing that the related condition in the financing documents will mirror that in the acquisition agreement. Financing sources also are reviewing acquisition agreements in more detail (and earlier in the transaction) than in the past and may require the principals to make certain modifications before delivering a commitment letter (such as requiring that lenders have third-party beneficiary rights to the assistance with financing covenant or the choice of law provisions).
Where are the Credit Markets Headed?
Current trends are encouraging and suggest a return to normality making financing more accessible and cheaper for corporate borrowers and private equity sponsors. Financing sources are competing for deals again, which has resulted, and should continue to result, in more advantageous terms for borrowers. That being said, lenders and lead arrangers continue to focus on the fundamentals, and at least for now it appears unlikely that credit markets are headed for the next bubble.