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Business Law Today

October 2023

Equity-Like Sweeteners Go Mainstream

Elizabeth Rebecca Tabas, Ann Catherine Wallis, Angela T Richards, Daniel Philion, Dennis Michael Twomey, Anna Gumport, Maggie G Deutsch, and Victoria Grace-Hunt


  • Debt financing parties are becoming increasingly likely to utilize equity-like sweeteners for lenders. This enables borrowers to conserve near-term cash and incentivize debt investments while hardwiring lenders’ returns on their debt investments in anticipation of a near-term exit or other realization event.
  • Recent bankruptcy cases indicate that equity-like sweeteners may be subject to challenge in a downside case, including based on treatment as “unmatured interest” under section 502(b)(2) of the Bankruptcy Code. This presents risks for lenders.
  • Equity-like sweeteners may result in “phantom income” for an investor because debt instruments containing them may be treated as “contingent payment debt instruments.” This risk and the risk of gains being taxed as ordinary income may affect investor returns regardless of whether a downside case occurs.
  • Terms potentially impacting the ability to protect investor economics in a downside case and the ability to preserve tax efficiency include default and acceleration provisions, the timing of when the equity-like sweetener is paid, and language clarifying the parties’ intent and rationale. Downside case considerations and tax considerations may be in tension with one another in some instances, but both should be factored into structuring decisions.
Equity-Like Sweeteners Go Mainstream Chuchkova

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Make-whole provisions in most debt instruments traditionally are structured either as a make-whole based on simple interest or a straight percentage premium that ratchets down over time. In the current market, in which many private equity sponsors and other investors are leveraging debt as a means of avoiding repricing their investments, we are noticing a convergence of the characteristics of debt and equity return hurdles: debt financing parties are now more likely than ever to dip into the private equity toolkit by utilizing equity-like economic sweeteners for lenders. These provisions can appeal to both borrowers and lenders because they enable borrowers to conserve near-term cash and incentivize debt investments while hardwiring lenders’ returns on their debt investments in anticipation of a near-term exit or other realization event. While equity-like sweeteners can be useful tools under the right circumstances, they may pose heightened risks for lenders in a downside scenario. These risks, as well as the tax implications of such equity-like sweeteners, should be taken into account when negotiating debt financing transactions.

This article will examine some of these equity-like sweeteners, why they have become popular, and the risks and structuring considerations for investors considering including such provisions in their financing terms.

What Are the Most Common Equity-Like Sweeteners?

Multiple on invested capital (“MOIC”) and internal rate of return (“IRR”) are two of the most common metrics used to calculate return on investment in private equity, and they are also two of the most common equity-like sweeteners gaining popularity among lenders. An investor modeling for a near-term exit event will likely prefer to employ a MOIC, whereas an investor anticipating a longer exit timeline might prefer to include an IRR make-whole because it takes into account the time value of money invested.

Why Have Equity-Like Sweeteners Become Popular?

Equity-like sweeteners are a natural development in the evolution of the private equity and venture capital worlds’ business model of highly leveraged investing. Debt secured by future cash flows is now common. The idea is to use leverage to invest in a company’s balance sheet and infrastructure at a fixed coupon until the investment reaches a threshold value—and at that point, use funds received in a realization event (e.g., an exit) rather than from operations to refinance or repay the debt.

While these financings may be more expensive than traditional cash pay investments, they are often cheaper than another round of equity raising and, as a result, have become popular tools to allow companies to harness growth, avoid down rounds, and improve the returns for their management team and equity investors. An equity-like kicker allows the business to use tomorrow’s upside to finance current growth and pay a present-day cash coupon that it can support based on current revenue. While lenders may not receive regular cash flow income at a high interest rate during the life of the investment, locking in a fixed return is an attractive outcome, particularly for debt investors such as insurance companies and private credit funds, and allows the sourcing parties to be compensated for work, time, and cost involved with sourcing the investment.

Downside Case Considerations

It is presently unclear how equity-like sweeteners will fare in a downside case (which may be precipitated or exacerbated by the stress of the current market conditions, in which timelines for exits are being extended, real costs and cash burn are increasing, and valuation multiples are being compressed). Equity-like sweeteners have yet to be fully tested in bankruptcy. They share certain attributes with traditional make-wholes, and there is consequently a real concern that in light of the recent decisions on make-wholes in the Ultra Petroleum Corp. v. Ad Hoc Committee of OpCo Unsecured Creditors and Wells Fargo Bank, N.A. v. Hertz Corp. bankruptcy cases, they may be vulnerable to disallowance in a downside case, including based on treatment as “unmatured interest” under section 502(b)(2) of the Bankruptcy Code.

Section 502(b)(2) of the Bankruptcy Code generally disallows claims for “unmatured interest.” While this term is not formally defined in the Bankruptcy Code, it has been construed by courts to mean interest that is not yet earned or due and payable as of the date of a bankruptcy filing. Historically, a majority of courts allowed make-whole premiums to the extent validly triggered under the applicable debt documents (which issue was frequently subject to dispute), finding that such premiums constituted reasonable liquidated damages designed to compensate lenders for the cost of reinvesting in a less favorable market, rather than unmatured interest.

However, in Ultra and Hertz, the courts rejected the distinction between liquidated damages and unmatured interest and adopted an expansive view under section 502(b)(2) of the Bankruptcy Code. In Ultra, the U.S. Court of Appeals for the Fifth Circuit found that the make-whole at issue was the “economic equivalent” of unmatured interest. In Hertz, the U.S. Bankruptcy Court for the District of Delaware reached the same conclusion after examining the “economic substance” of the applicable make-whole. Both courts acknowledged that make-wholes may be allowable in some instances but found that the premiums at issue, which were calculated using interest-based formulas, represented claims for unmatured interest rather than noninterest damages such as reinvestment costs. While the full impact of the Ultra and Hertz decisions—the latter of which is subject to ongoing appeal—remains to be determined, the decisions increase the risk that a debt investor who agreed to price a deal up front based on a fixed-return hurdle may now find its borrowers considering bankruptcy as a way to avoid paying a significant piece of the investor’s expected compensation for its debt investment. Investors may become more circumspect about the likelihood of achieving that return in a downside case as a result.

Given the expansive view of unmatured interest taken by the Ultra and Hertz courts, it is possible that if the same courts were presented with an equity-like sweetener, claims for amounts owed under such provisions (or for other amounts not expressly calculated by reference to future interest, such as exit fees and other fixed fees) may also be viewed as the economic equivalent of unmatured interest. Alternatively, a court might distinguish such equity-like sweeteners as less directly tethered to future unearned interest than the make-wholes in Ultra and Hertz, but investors should be mindful that the existing case law leaves room for debate.

In addition, equity-like sweeteners may be challenged as unenforceable penalties/unreasonable fees even where they do not constitute unmatured interest, especially if the borrower is under financial distress or facing imminent financial distress when such consideration is negotiated. Debtors and/or creditors’ committees often challenge make-wholes as unenforceable penalties subject to disallowance. Equity-like sweeteners that are perceived as overly aggressive may risk disallowance under section 502(b)(1) of the Bankruptcy Code (and/or, if the claim for the premium is fully secured such that section 506(b) of the Bankruptcy Code applies, as an unreasonable fee).

Tax Efficiency Considerations

Equity-like sweeteners based on a MOIC or IRR hurdle may result in “phantom income” for an investor because debt instruments with these terms provide for a payment at an unknown future date for an unknown amount. As a result, such debt instruments may be treated as “contingent payment debt instruments” (“CPDIs”) under the Internal Revenue Code unless an exception applies. Additionally, any gain resulting from the MOIC or IRR hurdle is generally taxed as ordinary income instead of capital gains.

A debt instrument is treated as a CPDI if it provides for one or more payments that are not fixed as to time or amount and that are not “remote” or “incidental.” A contingency is treated as “remote” if the likelihood that it will occur (or not occur) is remote. A contingency is treated as “incidental” if the amount of the contingent payment under all reasonably expected market conditions is insignificant relative to the total expected payments on the debt instrument.

To avoid having a debt instrument with a MOIC or IRR or similar equity-like sweetener treated as a CPDI, the borrower would need to be able to represent to the satisfaction of the investor and its tax return preparers that the likelihood of a triggering event is remote and that the CPDI rules should not apply. Context matters, and debt instruments containing equity-like sweeteners ideally should be structured in a way that utilizes one of the exceptions. For example, in the circumstance where a borrower is an investment grade company, a default that triggers traditional make-whole, MOIC, or IRR payments will likely be treated as a remote contingency that will not cause a debt instrument to be treated as a CPDI at the time of issuance.

However, if no exception applies, a borrower would construct a hypothetical payment schedule for the CPDI based on a “comparable yield,” which generally is the rate at which the applicable issuer could issue a fixed-rate debt instrument with terms and conditions similar to the applicable debt. The investor holding such debt instrument would agree upon such schedule with the borrower and accrue interest income from the initial issuance date based on the projected payment schedule, with adjustments if the actual contingent payments differ from the projected payments.

While such phantom income is not unusual in a CPDI, in light of the Ultra and Hertz decisions, investors should be aware that if the equity-like sweetener contained in their debt instrument is disallowed in bankruptcy, the investor not only would be exposed to the lost investment upside but also would possibly have current tax liabilities to pay (and may have potentially passed such tax liabilities on to its own investors) without ever realizing any cash return on the investment. Additionally, income would be taxed at ordinary income rates, while any losses realized on the debt instrument would be capital losses.

Balancing Downside Case and Tax Considerations in Protecting Investor Economics

Even if an equity-like sweetener is potentially unenforceable in bankruptcy, it may still serve as a valuable means of preserving upside for lenders not only in out-of-court exit scenarios such as a sale, refinancing, or prepayment but also by giving companies runway to grow. To avoid the outcome described immediately above, debt investors need to balance the desire to preserve upside recoveries against the desire to manage tax liabilities and maximize the chances of the equity-like sweetener being enforceable in a downside scenario.

Investors should carefully consider the default and acceleration provisions in proposed debt documents to ensure that any equity-like sweetener will be validly triggered if the debt is accelerated before the anticipated exit event—but should also bear in mind that the ability to accelerate an equity-like sweetener will not necessarily ensure its collectibility in bankruptcy. Bankruptcy-triggered acceleration is generally disregarded for purposes of determining whether a claim for interest has matured under section 502(b)(2) of the Bankruptcy Code, and courts have reached differing conclusions as to whether prepetition acceleration suffices to protect against disallowance under section 502(b)(2) where the claim is for the economic equivalent of unmatured postpetition interest.

Having the equity-like sweetener earned up front and paid later rather than earned at the time of a realization event may help to mitigate the risk of disallowance under section 502(b)(2) of the Bankruptcy Code. However, the efficacy of this largely untested tactic is uncertain given that (1) a court may not accept the contractual characterization of the equity-like sweetener as “earned” to the extent the court finds that such amount is intended to compensate for future interest; and (2) even if fully earned, the equity-like sweetener may still be deemed “unmatured” to the extent that it is not due and payable as of the bankruptcy filing. In addition, there is a cost to this approach: upon recognition of this revenue (at the time so earned), the investor (and its own investors) would need to treat the whole amount as fee income for tax purposes without having commensurate cash flows to offset the liability, and the investor (and its own investors) would carry the risk that the amount is never actually paid.

Another potential way to reduce challenge risk in bankruptcy is to include language in the debt documents clarifying the intent of the parties and the specific rationale for the equity-like sweetener—i.e., that the equity-like sweetener is designed to compensate for damages other than future interest streams and is reasonable under the circumstances. While there is no guarantee that such language will be persuasive to a court (both the Ultra and Hertz courts emphasized that the economic reality rather than the labels given by the parties in their agreement dictated whether a given claim was for unmatured interest), it may at least create additional room for argument by providing evidence of the parties’ understanding at the time of the transaction. The persuasive force of such argument may depend, in part, on the ability to credibly articulate the specific noninterest damages for which the equity-like sweetener is designed to compensate the investor (as well as on the underlying economic terms and financial condition of the borrower at the time such financing is entered into). It remains to be seen whether equity-like sweeteners will face other bankruptcy risks (e.g., recharacterization) in addition to implicating the risks faced by traditional make-whole claims.

In addition to addressing bankruptcy challenge risk in the up-front structuring for equity-like sweeteners, lenders may also mitigate such risk at the time of the bankruptcy filing by negotiating debtor-in-possession financing that refinances the equity-like sweetener at the outset of the bankruptcy case and/or by making favorable treatment of the equity-like sweetener part of a comprehensive restructuring support agreement—assuming the debtor is willing to agree to such terms. These later-stage mitigation strategies can be subject to challenge by creditors’ committees and other interested parties but may enhance lenders’ chances of recovering potentially controversial claims.

What Should I Do If I Have an Equity-Like Sweetener in My Debt Documents?

General Considerations for
All Debt Financing Parties
Lender-Specific Considerations

For existing deals, engage counsel to (1) review the debt documents and consider whether an amendment to clarify the nature of your premiums is advisable and (2) assess your strategic options if a bankruptcy filing by the borrower appears imminent.

For new deals:

• Consult with counsel to ensure that the debt documents contain the latest market language for addressing premiums as well as the latest bankruptcy and tax technology (tailored to the interests of the relevant debt financing party).

• Establish ample documentation of the parties’ understanding regarding the basis for any equity-like sweeteners.

• Engage in discussion with tax advisers early on.

In general, consider notice and reporting obligations and best practices for investors regarding changes in the nature of the obligations and changes in risk profile. (If nothing else, equity-like sweeteners implicate potential underwriting and disclosure risks given the lack of precedent regarding their treatment in bankruptcy.) Also, set alerts for updates on the appeal in Hertz, and keep abreast of new cases involving make-wholes and their close cousins, equity-like sweeteners.

For existing deals, if a bankruptcy filing by the borrower appears imminent, consult with counsel to determine whether any risk-mitigation options may be available in connection with such bankruptcy filing (e.g., in connection with the negotiation of any debtor-in-possession financing and/or restructuring support agreement).

For new deals:

• Ensure that deal documentation reflects the noninterest basis for, and reasonableness of, any equity-like sweeteners.

• Consider requiring the authorization of such items to be provided via board meeting and involve—appropriately documented in the meeting minutes—a detailed and separate discussion of the premium and, if applicable, any CPDI schedule (potentially including written materials prepared by and discussed with advisers), with an opportunity to ask questions.

• Consider requiring MOIC/IRR cash payments in connection with a realization or mandatory prepayment event to de-risk a potential bankruptcy situation (tax advisers may be able to assist with durational structuring of MOIC/IRR kickers to minimize tax liability while accounting for deal downside risk).