What's Market: 2022 Mid-Year Trends in Large Cap and Middle Market Loans

Following a record-breaking year in 2021, and a strong start to 2022, leveraged lending levels pulled back as the market responded to geopolitical and macroeconomic concerns, such as the war in Ukraine, growing inflation, and rising interest rates. Lenders and borrowers continued to move forward with LIBOR transition and loans tied to a SOFR-based rate expanded significantly. Sustainability-linked loans (SLLs) remained popular, and direct lending, or private credit, continued to perform well, aligned to which was a surge in jumbo unitranche facilities. Loan agreement negotiations continued to include, among other things, discussions on incremental facilities, basket capacity and reallocation. 

Market Trends and Developments

Loan issuance surged to record levels in 2021 as the US economy continued to rebound from the initial shocks at the start of the COVID-19 pandemic. Despite challenges facing the market, such as inflation and the likelihood of further interest rate hikes, market participants were optimistic that 2022 would deliver another strong performance, with healthy M&A activity and a good supply of deals in the pipeline. The war in Ukraine abruptly shifted the landscape with soaring energy prices adding to already high levels of inflation (for more information on geopolitical concerns and the impact of the Ukraine crisis, see Expert Q&A on Market Implications of the Ukraine Crisis and Russia Sanctions). Combined with rising interest rates and greater overall market volatility, lending activity cooled in the first quarter; despite volume picking up in the second quarter, the first half of the year still finished at lower levels compared to the same period in 2021.

Total US syndicated lending reached $1.3 trillion in the first half of 2022. Leveraged loan issuance posted $479.3 billion through June 2022, down 31% from the same period last year. Although activity slowed in response to heightened inflation, geopolitical concerns, and other tensions in the market, leveraged loans typically provide better protection for investors in a rising interest rate environment compared to other financial products, partly due to their floating rate nature. The relative safety of the loan asset class may help this sector weather the high inflation numbers and choppy financial markets expected throughout 2022.

Investment grade loan issuance posted over $200 billion in the first quarter of 2022 and nearly $350 billion in the second quarter. US investment grade refinancing levels topped $135 billion in the first quarter and increased to $247 billion in the second quarter.

US collateralized loan obligation (CLO) activity pulled back from the highs observed in 2021 and decreased to $31.7 billion in the first quarter of 2022, a drop of 17% year over year. According to market observers, overall volatility in the market likely caused many managers to hold off on pricing new deals. Issuance picked up in the second quarter, rising 21% over first quarter levels. Although first-half volume is down 11% compared to the same period last year, CLO issuance still posted a healthy $71.7 billion through June 2022.

Covenant-lite loans are prevalent in the leveraged lending space, accounting for a record 91% of institutional loan issuance in October 2021, according to data from S&P Global. Additionally, according to the S&P/LSTA Leveraged Loan Index, of the $1.3 trillion of leveraged loans outstanding, approximately 86% are considered cov-lite. Cov-lite issuance has come from nowhere to dominate the leveraged loan market in a little more than 20 years (in 2000, only around 1% of deals were categorized as cov-lite) and is an attractive financing option for borrowers because of the fewer operational restrictions placed on them in the governing loan documents. Specifically, the lack of financial maintenance covenants may reduce the potential for default and provide less interference with business operations. However, according to an S&P report (citing a Leveraged Commentary & Data (LCD) analysis), cov-lite loans may recover less than their more traditional counterparts in a bankruptcy of the borrower. Market watchers also believe the saturation of cov-lite loans in the marketplace may have contributed to the rapid rise of direct lending, as most private loans still include maintenance financial covenants. Still, this landscape may also be shifting as the market has begun to see large cov-lite unitranche facilities, such as the $2.6 billion direct loan to Thoma Bravo in July 2021 to finance its buyout of Stamps.com.

New money loan volume topped $117 billion in the first half of 2022, down 32% from the same period in 2021. US M&A-related leveraged lending reached $70 billion in the first half, a decrease of 28% compared to this time last year, while non-leveraged buyout M&A transactions dropped 22% year over year to $59 billion. Sponsored leveraged loan activity in non-leveraged buyout transactions reached $130 billion in the first half of the year compared to $308 billion posted in the first half of 2021, a drop of almost 58%. Leveraged-buyout volume was down 21% year over year, totaling $59 billion through June 2022 compared to $75 billion reached through June 2021.

Investor appetite for refinancings stalled in the first half of 2022, with issuance totaling roughly $59 billion, a drop of 78% year over year. Dividend recap volume also dropped in the first quarter, reaching $4.7 billion, according to market data from Partners Group. Dividend recap activity was especially strong last year, posting roughly $20 billion in the first quarter of 2021.

Second lien loan activity posted $5.6 billion in the first quarter of 2022, down 55% compared to this time last year and down 66% from the fourth quarter of 2021. Levels dropped another 16% in the second quarter to $4.8 billion. Year-over-year activity is down 53%.

Middle market lending totaled $29.8 billion in the first quarter of 2022 ($25.5 billion in large middle market deals and $4.3 billion in the traditional middle market), a small increase from the $28.8 billion recorded during the same period last year. Middle market issuance picked up in the second quarter, increasing 44% to $47.5 billion due to several large middle market transactions. First half middle market volume recorded approximately $80.5 billion.

Loan Terms

In addition to the usual commercial points of negotiation between borrowers and lenders, particular issues of note in the leveraged loan market during the first half of 2022 included:

Erroneous Payment Provisions

Erroneous payment provisions (EPPs) have become a relatively common feature in credit agreements in response to the decision of the US District Court for the Southern District of NY in the Revlon case (2021 WL 606167). In an EPP provision, if an agent mistakenly sends funds to a lender, the lender is contractually obligated to return the payment to the agent.

The Loan Syndications and Trading Association (LSTA) first published a Market Advisory and draft model form of EPP in March 2021 (revised in June 2021), which provides that a lender must return amounts mistakenly wired to it after it receives a request for the return of funds from the agent. In May 2022, the LSTA published their revised Model Credit Agreement Provisions (MCAPs), which include an updated form of EPP (LSTA EPP). In the LSTA EPP:

• The suggested claw back cut-off date, which appears in brackets, remains at five business days. It has been reported in the market that credit agreements often do not include any claw back cut-off date.
• The language no longer includes optional text regarding the determination by the administrative agent that a payment has been mistakenly made. The provision now only includes the agent’s sole discretion as the basis for the determination and is intended to reflect market practice. The LSTA EPP includes a footnote stating that in publicly-filed credit agreements, it seems that sole discretion has been selected, however the LSTA understands that reasonable discretion may often be found in private credit agreements.
• The language related to deemed assignment of loans has been deleted to reflect market practice.
• The language still provides for return of the funds with interest. This is despite objections from lenders that the agent should not be rewarded with interest as a consequence of its mistake.

For more information on the Revlon case and EPPs generally, see Practice Note, What’s Market: Erroneous Payment Provisions. For more information on the new version of the MCAPs, see Legal Update, LSTA Publishes New Model Credit Agreement Provisions and Box, An Expert’s View: Bridget Marsh.

Incremental Facilities and MFNs

Incremental facilities remain a key focus of credit agreement negotiations as borrowers and sponsors seek broad permission to allow the borrower to upsize its credit facility or incur additional financing outside of it. Traditionally capped at a fixed dollar amount (commonly referred to as a free and clear or freebie basket), incremental loans can sometimes include an EBITDA builder component that allows the basket to grow in step with increases in the borrower’s earnings. Credit agreements may also permit borrowers to incur an additional uncapped amount of incremental loans subject to the following terms:

• Compliance with a specified leverage ratio test (or tests in some deals where there are multiple classes of loans).
• A prepayment basket equal to the amount of any voluntary prepayments of the existing loans and the amount of any revolving credit commitment reductions.

For an example of a recent credit agreement with an incremental facility permission that includes a prepayment component and a leverage ratio-based component in addition to a freebie basket, see the summary for Cvent, Inc. credit agreement.

Some borrowers and lenders continue to include most favored nations (MFN) protections in their incremental facility provisions. An MFN provision provides that, in cases where the interest rate margin on an incremental term loan is higher than that on the initial term loan by more than a threshold amount, the interest rate margin on the initial term loan is increased so that it is not more than a specified number of basis points (bps) (usually 50, 75, or 100 bps) less than the rate on the incremental term loan. MFNs sometimes also contain “sunset” clauses after which the initial lenders are not entitled to receive an increased rate of interest on their loans no matter how much higher the interest rate may be on the borrower’s incremental loan. Sunset periods are commonly between six months and 12 months (although some recent deals have included longer time periods).

It is also common for MFN protection to exclude certain categories of incremental debt (such as debt relating to a permitted acquisition or investment or incremental debt with a final maturity date later than that of the initial term loans) so that the debt can be incurred without triggering MFN protection. According to practitioners, compared to syndicated loans, direct lending facilities are less likely to include MFN protections.

For examples of recent credit agreements with MFN protections, see summaries for Perrigo Investments, LLC credit agreement (50 bps with a 12 month sunset) and CPG International LLC first lien credit agreement (75 bps with a six month sunset and other limitations).

Reallocation and Reclassification

Reclassification and reallocation remain hot topics in loan market negotiations.

Traditionally, negative covenants in loan agreements such as debt, liens, investments, and restricted payment provisions worked independently with separate exceptions and baskets for each covenant. However, over the last several years, borrowers have sought greater operational flexibility by being able to reclassify usage of one basket to another and to reallocate permissions from one covenant to another. For example, reclassification can permit the borrower to reclassify debt from its freebie basket to a ratio-based basket at a time when the borrower can satisfy the ratio requirement (thereby freeing up capacity under or “reloading” the freebie basket that can still be used in the future even if the borrower cannot satisfy the ratio requirement at that time). Reallocation involves combining multiple baskets from different covenants to increase aggregate capacity for particular transactions.

For an example of a credit agreement allowing reclassification, see the summary for Enhabit Inc. credit agreement. See also Box, An Expert’s View: Mark Ramsey.

Liability Management Transactions

Although loan terms are currently leaning borrower-friendly, lenders continue to look for ways to strengthen covenants and protect their collateral in light of several high-profile cases that have impacted the loan market in recent years.

One particular area of lender focus concerns preventing borrowers from removing material assets from the lenders’ collateral and transferring them to unrestricted subsidiaries outside of the credit group to be used to secure additional financing. Commonly known as a drop-down financing, this issue gained prominence in response to the litigation involving J. Crew. In the J. Crew case, the borrower transferred material intellectual property assets to an unrestricted subsidiary outside the credit group and then used those assets for its other financing needs. To prevent other borrowers from acting similarly, many loan agreements now include so-called J. Crew blockers to limit asset transfers to unrestricted subsidiaries. For an example of a credit agreement with a J. Crew blocker, see the summary for Crocs, Inc. credit agreement.

Lenders also continue to look for ways to reduce their subordination risk. A recent trend in the loan market has involved the use of uptiering transactions, as seen in the Serta Simmons Bedding litigation. An uptiering transaction involves a borrower amending its credit agreement so that the debt of any new lenders ranks ahead of the existing lenders and subordinates their liens to those of the new lenders. In order to protect their interests, some lenders have started incorporating anti-priming language in their loan agreements, which requires all lenders to consent to an amendment that subordinates their liens to the liens of new lenders.

EBITDA Addbacks

EBITDA adjustments, especially the pro forma addback for cost savings and synergies, continues to be a key area of discussion for borrowers and lenders. Although this was traditionally limited to a clearly identifiable transaction, such as an acquisition, many recent credit agreements have taken a broader approach and permit synergies for additional initiatives, such as restructurings, operational improvements, and revenue synergies.

The “run-rate” cost savings addback is intended to approximate a company’s cash earnings on a going-forward basis. Borrowers and sponsors continue to negotiate forward-looking periods (typically 12 to 24 months) into their credit agreements (for examples, see the summaries for AZZ Inc. credit agreement (with a 24 month look-forward period) and Lawson Products, Inc. amended and restated credit agreement (with an 18 month look-forward period)). Although a common approach has been to cap adjustments for pro forma cost savings and synergies based on a percentage of EBITDA (typically 10% to 25%), uncapped adjustments are also frequently observed in the market (for examples, see the summaries for BioTE Medical, LLC credit agreement (20%) and CPG International LLC first lien credit agreement (uncapped)).

Asset Sales

Borrowers continue to seek flexible terms in their mandatory prepayment provisions, with asset sales, in particular, a key point of discussion.

Loan agreements typically require 100% of net cash proceeds from the sale or disposition of assets to be used to prepay the loans which protects lenders and reduces the borrower’s debt. However, borrowers may negotiate to exclude certain types of asset sales that are permitted in the loan agreement from this prepayment requirement. This provides more flexibility for borrowers and allows them to use proceeds from an asset sale for purposes other than prepaying the loans. A key point of negotiation involves requesting step-downs on asset sales sweeps; levels may start at 100% and go down once the borrower has achieved a particular leverage ratio (for an example, see the summary for Latham Pool Products, Inc. credit and guaranty agreement). According to market participants, other considerations regarding asset sales where borrowers have been able to obtain more favorable terms include:

• Increasing restricted payment builder basket capacity.
• Excluding non-collateral dispositions from the definition of an asset sale.
• Decreasing the cash consideration requirement for an asset sale.

Interest Rates

The Fed has recently adopted a more hawkish stance towards inflation in its monetary policy, as recent interest rate rises show, while inflation stands at a 40-year high. At its March 2022 meeting, the Fed moved benchmark rates up by 25 bps to mark its first rate hike since it slashed rates to near zero at the start of the pandemic. The Fed pushed rates up by 50 bps at its May meeting to mark the largest single rate increase since May 2000. At its June meeting, the Fed went even further and raised target interest rates by 75 bps, ahead of market expectations and the largest single increase since 1994. At its July meeting, the Fed again raised rates by 75bps in the face of continued stubborn inflation.

The Fed’s current benchmark overnight interest rate is a target range of 2.25% to 2.50%. As the Fed battles continued inflationary pressure in the months ahead, further interest rate hikes look inevitable. According to Wall Street economists, additional increases are likely before the end of 2022, and the benchmark rate may reach as high as 3.25% to 3.50% by early 2023.

Loan Defaults

Total default volume rose to $4.3 billion in the first quarter of 2022, an uptick of 17% quarter over quarter. Default volume inched higher in the second quarter, and according to Fitch Ratings, topped $10.6 billion through late June, more than double the $4.6 billion posted during the same period in 2021. Three companies (Diamond Sports LLC, Revlon Consumer Products Corporation, and Envision Healthcare Corporation) have accounted for 74% of the default volume seen so far this year.

Fitch forecasts current loan default rates to remain steady at 1.50% in 2022 and hover between 1.50% and 2.00% in 2023 (up 25 bps from their first quarter forecast due to mounting recessionary concerns). According to Fitch, the 2024 default rate could go even higher (reaching 2%) if economic challenges persist.

According to market participants, rising inflation and interest rates, coupled with supply chain disruptions and price volatility, are all factors pointing to higher loan default rates as greater numbers of borrowers begin to face financial distress. The volume of distressed loans priced below 80 cents on the dollar has also increased, doubling since the beginning of the year, with the volume of loans in the retail sector priced below 90 seeing especially steep increases, according to data from LCD. The cryptocurrency market has not been shielded from these difficulties, with several lenders recently filing for bankruptcy protection (see Legal Update, Cryptocurrency Lenders File for Chapter 11 Bankruptcy Protection).

LIBOR Transition

June 2023 will mark the end of LIBOR, with the final publication of the remaining and most commonly-used US dollar (USD) settings of LIBOR. With this timing in mind, market participants have continued their transition away from LIBOR to replacement rates.

In its 2021 Year-End LIBOR Transition Progress Report, the Alternative Reference Rates Committee (ARRC) identified several key issues where further work will be required in 2022 to move LIBOR transition ahead, including:

• Accelerating the transition of LIBOR-based futures activity “given the large role that non-banks play in these markets.”
• Developing market conventions for Secured Overnight Financing Rate (SOFR) loans, including more information about pricing of SOFR loans.
• Ensuring market participants are operationally ready for cessation in 2023.
• Building on the legislative progress that has already been made to ensure that legacy contracts are protected.

SOFR

Although there are several LIBOR-alternative reference rates that have been seen in the market, including the credit sensitive rates Ameribor and BSBY, the most popular replacement rate for LIBOR, and the one preferred by the ARRC, is SOFR. Origination of credit agreements with an initial interest rate tied to SOFR has accelerated since the start of 2022 (see Article, Current Trends in LIBOR Transition Provisions). There are several variations of SOFR, including:

• Term SOFR: A forward-looking term rate based on SOFR that is fixed for any selected interest period. This is currently the preferred rate in the loan market. For an example of a credit agreement with the initial interest rate tied to Term SOFR, see the summary for Hawkins, Inc. second amended and restated credit agreement summary.
• Daily Simple SOFR: A simple (not compounded) rate that is calculated each day during the interest period and is based on SOFR. For an example of a credit agreement with the initial interest rate tied to Daily Simple SOFR, see the summary for Robinhood Securities, LLC amended and restated credit agreement summary.

Market participants have also observed inclusion of fallback language in many SOFR-based loans in case the initial benchmark interest rate chosen becomes unavailable or non-representative. The LSTA published a Term SOFR Concept Document for Term SOFR-based loans (originally published in August 2021 and updated in December 2021) (LSTA Concept Document) that outlines two fallback approaches for loan parties to consider: an amendment and hardwired fallback, which are similar in scope to the ARRC’s LIBOR fallback language.

The SOFR hardwired fallback language in the LSTA Concept Document provides that if a trigger event related to Term SOFR occurs, the benchmark replacement rate for Term SOFR follows a two-step descending waterfall:

• Daily Simple SOFR (with an adjustment if an adjustment was used for Term SOFR).
• An alternate benchmark rate selected by the agent and the borrower as the replacement rate through the amendment approach.

Benchmark replacement provisions applicable to Term SOFR generally provide that if there is a hardwired fallback to a specified rate, such as Daily Simple SOFR, no amendment or required lender consent is necessary under the loan agreement to implement that change. However, if an alternate rate is to be selected by the agent and the borrower, an amendment to the loan agreement may be necessary to effect the change, and the required lenders often have negative consent rights which would allow them to block it.

According to the amendment approach (in the LSTA Concept Document), the administrative agent and the borrower would select the benchmark replacement giving due consideration to either:

• Any selection or recommendation of a replacement benchmark rate or the mechanism for determining such rate by the Relevant Governmental Body (as defined).
• Any evolving or then-prevailing market convention for determining a benchmark rate as a replacement to the then-current benchmark for dollar-denominated syndicated credit facilities at such time.

For more information on fallback language, see Loan Agreement LIBOR Fallback Language Toolkit.

Credit Spread Adjustments

A key concern around LIBOR transition is that SOFR is a risk free rate because it is based on the cost of borrowing cash overnight, collateralized by Treasury securities, while LIBOR embeds a measure of bank credit risk as it is intended to reflect the average current rate at which certain panel banks can obtain unsecured funding in the London Interbank Market. This means that SOFR is generally lower than LIBOR and, in periods of market disruption, LIBOR is likely to widen, while SOFR is likely to remain flat or decline. Even though the market is generally embracing Term SOFR, questions remain about how to originate new SOFR loans that are intended to be economically equivalent to LIBOR loans.

In response to these concerns, credit agreements for SOFR-based loans often include credit spread adjustments as a way to reimburse lenders for the difference between the LIBOR rate and the SOFR rate used. Credit spread adjustments are highly negotiated and the market does not currently appear to favor one over the other. Some credit agreements include a flat adjustment for all tenors of Term SOFR (for example, a flat credit spread adjustment of 0.10%) while others have incorporated a spread adjustment curve where the adjustment varies over different tenors (for example, 0.10%, 0.15%, and 0.25% across one-month, three-month, and six-month Term SOFR tenors respectively). Some agreements do not include a spread adjustment at all, either because there is no adjustment or the parties have instead incorporated the economics of the spread adjustment into the margin.

For additional information on LIBOR transition and credit spread adjustments, see:

• Article, In Search of “Fair” Spread Adjustments for New SOFR Loans.
• Article, Expert Q&A on LIBOR Transition: Issues for Borrowers to Consider.
• Article, Current Trends in LIBOR Transition Provisions.
• LIBOR Replacement Toolkit.
• Loan Agreement LIBOR Fallback Language Toolkit.
• Practice Note, What’s Market: LIBOR Interest Rate Provisions.
• Practice Note, What’s Market: SOFR Spread Adjustments and Fallback Language.

For examples of credit agreements with credit spread adjustments, see summaries for Crocs, Inc. credit agreement (Term SOFR credit spread adjustment of 0.10% for one-month tenor, 0.15% for three-month tenor, and 0.25% for six month-tenor) and Sprouts Farmers Markets Holdings, LLC credit agreement (Term SOFR and Daily Simple SOFR credit spread adjustment of 0.10%). See also the summary for Graham Holdings Company second amended and restated credit agreement, which references a flat 0.10% credit spread adjustment initially, with the ability to reduce to 0.00% credit spread adjustment if certain conditions are satisfied.

LIBOR Remediation

According to the LSTA, in June 2022, more than $4 trillion of syndicated loans are still linked to USD LIBOR and may need to be remediated by June 2023. Direct lenders, who are typically not subject to bank regulation, have also continued to use LIBOR in 2022. As a result, LIBOR remediation will be a key focus for market participants in 2022 and 2023.

According to the LSTA, there are four ways for borrowers and lenders to remediate in preparation for LIBOR’s cessation. Specifically, they may:

• Refinance or amend their credit agreement directly into a new SOFR loan before the June 30, 2023 end date.
• Fall back from LIBOR to SOFR using existing credit agreement fallback language before the June 30, 2023 end date.
• Fall back from LIBOR to SOFR using existing credit agreement fallback language on the June 30, 2023 end date.
• Switch to a base rate formulation after the June 30, 2023 end date.

There are several important considerations for lenders regarding LIBOR remediation. Lenders should review their existing credit agreements to determine current fallback language, if any, in loan agreements maturing after June 2023. This information should be assembled in a useful format to enable remediation, as necessary. For many, an amendment to their credit agreement will be necessary.

For a Checklist of points of best practice for lenders and borrowers to help their transition from LIBOR to a replacement benchmark interest rate, see Loan Agreement LIBOR Fallback Checklist. For a discussion of issues facing borrowers in connection with LIBOR transition and remediation, see Article, Expert Q&A on LIBOR Transition: Issues for Borrowers to Consider.

Breakage

Traditionally, if any LIBOR loans were prepaid before the end of an interest period, the borrower was required to pay breakage costs if the prevailing rate of LIBOR was less than the borrower’s contract rate of LIBOR at the time of prepayment. According to practitioners, the market is less settled on how to apply breakage (or redeployment costs) in SOFR-linked loans and this may be a negotiated issue for loan participants. Some market participants have observed a limit to breakage costs in recent SOFR-linked deals. Although breakage costs may apply to both Term SOFR and Daily Simple SOFR, some deals with a daily rate limit breakage to costs and expenses, while others have applied breakage solely to term rate loans.

Consolidated Appropriations Act

On March 15, 2022, President Biden signed into law the Consolidated Appropriations Act, 2022, which, among other things, discusses legacy financial contracts with no workable fallback language that mature after LIBOR’s cessation (see Legal Update, Legacy LIBOR Transition Measure Signed into Law by President Biden as Part of Omnibus Spending Bill). The Act provides that the Board of Governors of the Federal Reserve System will decide on the replacement rate for those contracts based on SOFR, but it is not expected to have significant impact on the loan market as credit agreements typically include fallback language.

Sustainable Financing

Market appetite for SLLs and other sustainable financing products continues to grow as an increasing number of borrowers look to incorporate environmental, social, and governance (ESG) metrics and targets into their loan documents. Although issuance pulled back slightly in the latter half of the first quarter as overall lending levels dropped, sustainable lending still reached approximately $325.3 billion in the first half of 2022, an 11% drop from last year, according to a Refinitiv report.

SLLs are one of the sustainable financing products available in the market (green loans and social loans are other examples), but they are among the most popular because of their suitability to all types of companies and the diversity in the terms they offer. Unlike green or social loans, SLLs do not require loan proceeds to be used for a green or social project or purpose. Instead, they are performance-based loans with terms (typically, interest rate margins) that adjust up or down depending on the borrower’s ability to meet pre-determined sustainability performance targets (SPTs) as measured by pre-defined key performance indicators (KPIs). The SPTs that must be met are varied and range from environmental or energy-related targets to more social-related ones. Borrowers are also increasingly focused on SPTs related to governance and social issues as diversity and inclusion initiatives continue to gain prominence at the corporate level, a trend that is likely to continue beyond 2022. For examples of recent credit agreements that have incorporated governance and social SPTs, see summaries for:

• Kinetik Holdings LP credit agreement: metric related to female representation in corporate officer positions.
• Sprouts Farmers Markets Holdings, LLC credit agreement: metrics related to diversity at the board level, and sales of socially and environmentally sustainable products.
• Trimble Inc. credit agreement: metric with respect to a specified percentage of gender diverse employees.
• Select Energy Services, LLC amended and restated credit agreement: metric related to employee health and safety, specifically the total recordable incident rate.
• Teva Pharmaceuticals USA, Inc. credit agreement: metric related to the number of new regulatory submissions in low and middle-income countries.

As the sustainable lending market matures, the way ESG is being incorporated in loan documents is also changing. Instead of entering into an SLL which includes SPTs from the outset, an increasing number of borrowers are including a provision in their credit facilities that allows for sustainability terms to be added to the loans at a future date (ESG Amendments). These amendments provide that certain SPTs and related provisions will apply to the loans (such as the amount of the fee or margin adjustment and any monitoring requirements) through a streamlined approach by which the borrower and the administrative agent can amend the loan document and incorporate the SPTs, subject to certain conditions (such as a negative consent right for the required lenders). ESG Amendments allow borrowers that may not be ready to comply with the requirements of an SLL to incorporate these terms when it makes financial and market sense to do so without having to undergo a complicated and expensive amendment process. For examples of credit facilities that include ESG Amendments, see summaries for Kennametal Inc. sixth amended and restated credit agreement and Kemper Corporation third amended and restated credit agreement.

ESG Amendments do not qualify as SLLs under the Sustainability-Linked Loan Principles and will not do so until the effectiveness of the ESG Amendment. Most credit agreements do not specifically delineate this point, although an example has been found in the market (see Blackstone Private Credit Fund amended and restated credit agreement):

(”Prior to the effectiveness of the ESG Amendment, none of the Borrower, the Administrative Agent, the Lenders or any Sustainability Agent will, in writing and with the intent to advertise the same, quote or refer to any Sustainability Agent in their capacity as such under this Agreement or communicate, in writing and with the intent to advertise the same, that the credit facilities described herein are ‘Sustainability-Linked Loans’”…).

Practical Law recently spotted an example in the market where the borrower exercised its rights under its credit agreement and triggered the ESG Amendment. In the original credit agreement, the ESG provision stated that, before a specified date, borrower would set KPIs in connection with certain ESG targets and amend the credit agreement to incorporate these metrics. On June 30, 2022, the borrower entered into the ESG Amendment to include a “Mine Safety and Health Administration Injury-Incident Rate Target.” See The North American Coal Corporation ESG Amendment for more information on the amended pricing provisions and metrics. Practical Law will continue to monitor the market to see whether any other borrowers trigger the ESG Amendments in their credit agreements. But as companies grapple with inflation and a potential recession, the rising costs of key energy-related inputs, supply-chain bottlenecks, labor shortages, and other issues, market watchers expect that borrowers may be hesitant to trigger the ESG Amendments in the near term.

While the sustainable lending market is growing, it is facing several challenges including concerns around green washing, social washing and, in the case of SLLs, SPTs that are not sufficiently ambitious or rigorous. To address these concerns, the LSTA, together with the Loan Market Association and the Asia Pacific Loan Market Association:

• In May 2021, revised the SLLP to tighten the requirements for an SLL and to emphasize the importance of setting proper targets and establishing clear methods of verifying that these targets are met (Legal Update, LSTA Publishes Revised Versions of the Sustainability-Linked Loan Principles and Accompanying Guidance).
  
• In March 2022, published two new guidance documents on SLLs, green loans, and social loans. The Guidance for Green, Social and Sustainability-Linked Loans External Reviews describes best practices on the external review process for market participants while the Guidance on Social Loan Principles provides clarity and promotes consistency in the development and integrity of social loans (see Legal Update, LSTA Publishes New Guidance on Green, Social, and Sustainability-Linked Loans).

Direct Lending and Unitranche Financing

With untapped liquidity available in the private credit markets, practitioners expect direct lenders to remain competitive and aggressive players in 2022, especially as banks in the syndicated market remain cautious in light of economic and geopolitical factors.

Initially a middle market financing solution, direct lending deals of an order of magnitude traditionally only seen in the syndicated lending space have been seen in the market, typically involving top-tier sponsors and large-cap borrowers. Deal sizes for unitranche transactions (loans that combine separate senior and subordinated debt financings into a single debt instrument) have also expanded. According to a report from Churchill Asset Management, while only 28% of unitranche deals were worth more than $250 million in 2017, now this share has grown to approximately 77%. Unitranche facilities in the billion-dollar range are now a familiar sight and, according to practitioners, these jumbo deals are expected to go even higher. Market participants may be gravitating towards these larger unitranche loans because of the privacy, speed, and certainty of execution that these loans provide. While the syndicated loan or high yield bond markets often involve road shows and rating agencies, unitranche financings do not require these steps, which saves time and costs and decreases the risk of the financing not closing.

As direct lending continues to evolve, practitioners reported a convergence of terms between the syndicated and direct lending markets. While direct lending transactions have traditionally been viewed as having stricter covenants and higher pricing, market participants report that direct lenders appear more open to negotiating looser covenant packages and pricing in their facilities, especially for the strongest credits. In fact, according to market observers, an increasing number of direct lending loans are covenant-lite, a feature not usually associated with this type of deal.

Direct lenders are also more willing to fund debt structures that are harder to push through the syndicated market, such as delayed draw term loans. In order to remain competitive, banks have also appeared more flexible and willing to work with borrowers on certain terms and processes. Although banks have traditionally mandated pre-closing syndication of facilities, lately they have been more willing to underwrite and close the deal without this requirement. Some banks have also initiated their own private credit funds in a move that may circumvent some of the regulations currently facing syndicated lenders.

Banks are also looking to compete with alternative lenders by using structures similar to the typical unitranche loan structure. However, unlike the traditional unitranche structure, these so-called “public” unitranche financings are rated and can be less expensive than unitranche loans provided by direct lenders. For example, in early 2022, a broadly syndicated leveraged loan for Veracode Inc., was rated above the lowest rank of speculative-grade debt, which allows CLOs to buy the deal and overwhelming demand allowed the sponsor to switch from a first lien/second lien deal to a unitranche deal saving interest expense. Although the market has not yet fully embraced the public version of unitranche deals, according to market participants, there appears to be momentum in that direction.

For more information on unitranche financing and direct lending, as well as recent developments, see Article, Developments in Unitranche Financing (2022).

Preferred Equity

Practitioners have recently observed an increase in the use of preferred equity as part of a broader acquisition financing package, a trend they expect to continue through 2022.

Preferred equity provides a flexible financing structure where the preferred equity component ranks senior to an issuer’s common equity interests, which means the preferred equity issuer is first in line in terms of the right to receive dividends and payments on an issuer’s liquidation or bankruptcy (known as liquidation preference). Covenants are often tighter and restrict the amount of distributions a common equity holder can receive.

In an acquisition financing, the preferred equity is usually structured with cumulative dividends that are payable “in kind”, which raises the liquidation preference. Preferred equity holders receive certain benefits, such as an increased dividend rate after a certain period of time. Additionally, ratings agencies typically view preferred equity more favorably than common equity components, which can be a benefit for a company when the agency is assigning a rating.

Preferred equity terms are negotiated, and may focus on redemption premiums, sale and initial public offering demand rights, covenants, and anti-layering provisions. According to market participants, some deals with preferred equity in the borrower’s capital structure include caps on the amount of operating company debt, limit or prohibit the incurrence of certain issuer debt, or place restrictions on additional issuer preferred equity or restricted payments.

Recurring Revenue Loans

Market participants have shown a strong appetite for M&A financings, especially in the software and technology space, which has benefitted from shifts towards remote working brought about by the pandemic. To help finance these acquisitions, a growing number of sponsors have turned to recurring revenue loans.

Startups in the tech sector tend to have high development costs and other expenses associated with building their businesses, making them unsuitable candidates for traditional borrowing base or cash flow-based loans. Recurring revenue loans provide another option, in which covenants are based on the borrower’s recurring revenues (which may include subscription, maintenance, and support revenues) instead of its EBITDA. For a certain length of time, recurring revenue loans may allow the borrower to use its cash flows to re-invest in its business, instead of allocating them to pay down debt.

Borrowers are expected to achieve a positive EBITDA within a designated timeframe (typically one to three years after closing). Financing terms then shift from recurring revenue based to more traditional EBITDA-based leverage covenants. According to market watchers, lenders may incentivize businesses to flip to earnings-based covenants ahead of schedule, either with pricing step-downs or greater investment and dividend capacity. Many recurring revenue loans also include a minimum liquidity requirement.

Are Loans Securities?

Finance attorneys are keeping a close eye on a Second Circuit court case, which has the potential to upend the long-held understanding by market participants that commercial loans are not securities for purposes of the securities laws.

The lower court held in Kirschner v. JPMorgan Chase Bank, 2020 WL 2614765 (S.D.N.Y. 2020) that syndicated loans are not securities applying the “family resemblance” test from the Supreme Court decision in Reves v. Ernst & Young, 494 U.S. 56 (1990). The Kirschner decision in the District Court endorsed the established view among many loan market practitioners and participants that syndicated loans are not securities (for more information, see Legal Update, Kirschner v. JPMorgan Chase Bank: Syndicated Loans Are Not Securities). In October 2021, the plaintiff filed an appeal to the Second Circuit which is now keenly awaited.

The LSTA recently filed an amicus curiae brief in the Kirschner case arguing that syndicated loans are not securities, and therefore should not be subject to state and federal securities laws. According to the LSTA, if the Second Circuit Court held that syndicated loans were securities, loan parties would be forced to comply with onerous compliance requirements, thereby raising the costs of borrowing. Secondary market trading activity would need to involve a registered broker-dealer and parties receiving compensation from a loan transaction would need to determine whether they too needed to register as broker-dealers, all resulting in additional complexity and transaction costs. Additionally, traditional borrower/lender relationships would likely be disrupted.

According to practitioners, the decision could have even more far-reaching consequences. CLOs, in particular, could be severely impacted. Most CLOs only permit a limited quantity of securities as part of their asset portfolios. Banks may also be more hesitant to fund loans to borrowers, thereby making it more difficult for businesses to negotiate flexible terms. According to market participants, the Second Circuit decision could also affect the rapidly expanding cryptocurrency market.

Oral argument will likely commence sometime in the fall, with the Second Circuit issuing an opinion soon after. Practical Law will continue to monitor this development.

Digital Assets and Cybersecurity

Cyber Risk

As cyber risk continues to evolve and data privacy breaches and ransomware attacks become more common, the focus on cybersecurity risk in finance is likely to become even more crucial. Lenders should conduct due diligence to assess a borrower’s cyber risk and should arrive at appropriate terms that reflect that assessment and the allocation of attendant risk.

In the M&A context, in addition to undergoing a robust due diligence process, many transactions now incorporate strong cyber provisions as an extra level of protection. Although current loan documents do not often contain these M&A-type cyber-specific terms, practitioners believe the tide may be turning. As lenders look for additional ways to minimize cybersecurity risk, market participants anticipate that it will become more common for credit agreements to include cyber representations and warranties.

For more information, see Expert Q&A on Cyber Risk in Finance.

UCC Amendments

Commercial transactions using emerging technologies, such as artificial intelligence, virtual currency, and blockchain have become more prevalent in recent years. This raises important questions, including whether virtual currencies constitute money and how to perfect security interests in digital assets.

Proposed amendments to the Uniform Commercial Code (UCC) relating to emerging technology and digital assets are currently under review and discussion. These involve revisions to most Articles of the UCC, including the official comments, and include a new Article 12. Proposed Article 12 governs the transfer of property rights in certain digital assets, referred to as controllable electronic records, which have been created by technology that exists now or may be developed in the future. Once these amendments are approved, they will be ready for introduction by the states for adoption later this year.

For more information, see Article, Proposed UCC Amendments Relating to Emerging Technology.

Looking Forward

As the US economy continues to grapple with heightened inflation, rising interest rates, and mounting fears of a recession, overall debt issuance may continue to decline, although demand for leveraged loans may increase as market participants gravitate towards floating rate instruments.

Direct lenders look set to remain key competitors in the market, and appetite for large unitranche financings is likely to remain strong. SLLs are also likely to remain popular as businesses look for ways to demonstrate their commitment to environmental and social issues. LIBOR transition and remediation will also continue to move full speed ahead, as market participants prepare for the June 2023 deadline.