The Latest in US Leveraged Finance

This article provides a high-level overview of the general macroeconomic conditions and related events that helped to shape the financing markets and, in turn, leveraged and other financing activity, structures and terms in the US over the last 15 months, largely with a focus on the private equity sponsor perspective.

Macroeconomic conditions in 2023

In 2023, debt markets were influenced by a host of intertwined global factors, including major geopolitical conflicts, lingering and renewed supply chain disruptions, rising inflation, regulatory and monetary tightening – including the Federal Reserve’s four consecutive 25-basis-point interest rate increases to 5.50% by July 2023 – as well as resulting recessionary fears and a banking sector crisis. Related investor wariness, lack of consumer confidence and remnants of unsold commitments on major banks’ balance sheets from a number of large (and, perhaps, infamous) end of 2021/early 2022 leveraged buyouts (LBOs) further contributed to the complexity of, and challenges to, the financing markets in much of 2023.

Market conditions and terms in 2023

In early 2023, increasing interest rates, anaemic institutional loan and high-yield bond markets, differing views on the likelihood and depth of an impending recession and other economic factors contributed to significant valuation gaps in the M&A market, affecting, among other things, buyers’ and sellers’ investment and exit strategies, and resulting in tepid M&A deal volume. Executed financings in the syndicated market typically reflected all senior capital structures, higher equity contributions and overall lower leverage than what was the norm in previous years. Institutional second lien facilities and unsecured high-yield bonds effectively disappeared from the market. The vast majority of syndicated debt market activity consisted of amend-and-extend transactions and refinancings, in addition to occasional recapitalisations. Inevitably, these market conditions accelerated the already strong expansion of private credit at the expense of institutional debt markets. In addition to turning to private credit lenders, private equity sponsors that remained active during this period looked for creative deal structures, such as acquisitions of targets with portable capital structures, investments around change of control provisions in the targets’ existing debt instruments and/or utilisation of fund-level credit facilities.

In the second half of 2023, market conditions improved considerably. Large investment banks were able to access markets to sell down significant “hung” positions and de-risk their balance sheets – including syndicated debt for Cloud Software Group (formerly Citrix and Tibco Software) in April 2023 and Tenneco in August 2023 – which allowed these banks to be more active in providing commitments for new transactions. In addition, the Federal Reserve signalled a willingness to halt further interest rate increases, thus providing more certainty in this respect to both borrowers and lenders going forward. However, despite the positive developments, the gap between buyers’ and sellers’ pricing expectations persisted and, as a result, M&A activity remained tepid and borrowers continued to principally pursue opportunistic amend-and-extend transactions and refinancings, as well as occasional recapitalisations. Despite the reopening of the institutional debt markets, the high cost of capital contributed to the continuation of the trend of predominantly all senior capital structures, sparking concerns over the general thinning of the traditional loss-absorbing junior debt portion of a traditional high-yield capital structure. However, this phenomenon has been accompanied by, and could be outweighed by, lower overall leverage and higher equity contributions.

Notwithstanding these conditions in the broadly syndicated debt market, financing terms did not see significant tightening. Unsurprisingly, lenders focused on protections against liability management transactions such as Serta, Envision, J.Crew and other similar terms.

Selected 2023 deal structure themes

Acquisitions around change of control

Under financing agreements, an outright acquisition of a target company by a new investor group typically constitutes a “change of control,” which, in turn, triggers an event of default or gives the debt holders a right to require the target company to repurchase the debt, typically at a 1% premium to par. Lenders make their credit decision not only on the basis of the borrower’s historical performance, but also based on the owner’s strategic vision and expertise. If there is a fundamental change in these factors, lenders generally expect to have an opportunity to exit the credit.

Due to the significant increase in the cost of debt capital over the last several years, buyers and sellers quickly realised that a debt capital structure that predated the increasing rate environment might be among a target’s most valuable assets. As a result, over the last 15 months, many buyers and sellers have sought creative ways to retain (and potentially leverage) the target company’s pre-acquisition debt capital structure following the closing of the acquisition. Two common paths to achieving this goal are complying with specific “portability” provisions and pursuing investments that are structured to comply with change of control provisions. Buyers and sellers would also consider debt and restricted payments capacity under the target company’s existing financing agreements to structure a transaction, in case incremental debt at the target company could be raised to facilitate the buyer’s investment.

Portable capital structures. During 2023, a small number of existing financing agreements, mostly from older large-cap financings, contained specific portability provisions, which allowed the buyer to retain the target company’s debt capital structure. Typically, these provisions require the satisfaction of certain conditions, which are designed to provide the debt holders with safeguards as to the target company’s financial performance and capital structure and the buyer’s reputation, expertise and strategy. A common set of such conditions includes:

• a leverage test, requiring pro forma total, and possibly also secured, leverage no greater than a specified level – often the respective leverage at the financing agreement’s effectiveness – to ensure that the debt is not ported in a downside scenario;
• an equity to total capitalisation test, requiring equity percentage of total capitalisation to be no lower than a specified level – often the equity percentage at the financing agreement’s effectiveness – to ensure, among other things, that the buyer has satisfactory “skin in the game”;
• a buyer “quality” test, requiring, for example, minimum assets under management in the case of a private equity sponsor or involvement in a related business in the case of a strategic corporate buyer;
• a limitation on the period (for example, two years from the financing agreement’s effectiveness) during which, and on the number of times that, the portability feature can be utilised; and
• satisfaction of know-your-customer requirements.

With the recent market conditions disturbing timely private equity exits and the rise of a private credit lenders’ willingness to hold debt in a company that has been fully diligenced, portability provisions have been increasingly on demand, for example, in refinancings.

As noted, credits with unexpired portability provisions are relatively rare. In the absence of specific portability provisions, buyers can look to acquire only a portion of the target company, such that the acquired interest does not trigger a “change of control.” While the list of basic change of control components and thresholds in different financing instruments is well known in the industry, the provisions are highly engineered, and differ in meaningful ways across instruments. As a result, doing a transaction around change of control provisions typically requires a detailed, multidisciplinary analysis and careful structuring of both economic and voting shareholder arrangements. Importantly, change of control provisions are typically keyed off of equity entitled to vote for the board of directors of the company. This can allow buyers and sellers to structure voting and economic ownership, together with veto rights in respect of certain fundamental corporate activities, to achieve their exit and investment goals while retaining the existing low-cost debt capital structure.

Use of fund-level facilities

Market conditions in recent years have brought considerable growth in the use of net asset value (NAV) facilities by private equity sponsors. Such facilities are being used primarily as a source of additional liquidity and/or leverage, especially when other capital is not available on satisfactory terms.

While single-asset back-leverage facilities that benefit from a fund guarantee have been common for some time – particularly for minority investments – utilisation of those facilities, including for majority interest buyouts, increased over the last two years. Recent years have also seen the development of fund-level facilities under which the loan is made against the entire portfolio. These facilities have provided private equity sponsors with additional flexibility to address challenging debt and M&A markets in recent years by (i) allowing sponsors to incur additional leverage (and, thereby, improve returns) that might not otherwise be available at a reasonable cost at the portfolio company, and (ii) accelerating returns to limited partners (LPs) in a weak M&A market in which exits are delayed. The principal considerations around portfolio-wide NAV facilities include the following.

• Fund compliance – a NAV facility must be permitted under the fund’s limited liability partnership agreement (LPA). While older LPAs did not contemplate these facilities, the flexibility to incur NAV facilities is nowadays a part of the conversation with LPs at the time of fundraising, and newer funds may seek to build in flexibility for these in the fund documentation.
• Structure – NAV facilities are typically provided to one or more bankruptcy-remote special purpose vehicles (SPVs) on a joint and several liability basis. The borrower SPVs then, in turn, hold, indirectly through wholly-owned investment vehicles, the fund’s portfolio companies. If there are circumstances that do not allow the borrower SPVs to hold equity in the portfolio companies, parties may utilise an “off to the side” structure, mostly prevalent in Europe, in which the borrower SPVs hold a preferred interest in the portfolio-generated cash streams.
• Collateral and guarantees – NAV facilities often benefit solely from a pledge of bank accounts and the right to receive distributions from the various portfolio companies. Depending on the circumstances, some facilities may benefit from a broader defined collateral package, frequently consisting of a pledge of equity (to the extent permitted, for example, under the investment vehicle’s constitutional documents). However, even if an equity pledge is permitted, its enforcement may be complicated by a number of factors, including change of control provisions in the portfolio-level credit facilities. The facility is typically non-recourse to the fund.
• Loan to value (LTV) ratios – the ratio of loan obligations, possibly net of certain cash or parent-guaranteed amounts, to eligible investments, net of amounts exceeding any agreed concentration limits, is the core negotiated metric for the size, and certain principal credit events during the life, of a NAV facility. Given the illiquid nature of the underlying assets, the size of a NAV facility typically reflects a fairly low LTV and is largely based on expected cash flows from portfolio distributions.
• Valuations – as the net asset value of the fund’s portfolio investments is the NAV facilities’ premise, valuation methodology and reporting – including the timing thereof – occupy the centre stage during negotiations. Basic valuation and reporting thereof will generally come through the fund’s quarterly reports, but lenders commonly negotiate challenge and third-party appraisal rights.
• Cash sweeps – because lenders generally rely on cash flows from portfolio distributions, cash sweep parameters and mechanics are another NAV facility cornerstone, and lenders will typically require that all such cash, possibly other than tax distributions and cash reserved for a limited number of upcoming interest payments, be applied to facility repayment. In the earlier years of some NAV facilities, sweeps may only be required upon LTV exceeding agreed thresholds.

Infrastructure financings

With their essential and non-cyclical nature, infrastructure assets have been traditionally seen as an inflation buffer. In recent years, the interplay of macroeconomic, market and regulatory factors – including the 2022 Inflation Reduction Act – has resulted in an expansion of infrastructure asset classes and investor base, on both equity and debt sides, changes to the traditional single-asset project finance structures and changes to the traditional process, including an increase in competitive auctions. These circumstances, in turn, have led to a noticeable infiltration of traditional leveraged finance terms and processes into the project finance space. For example, infrastructure transactions – including diligence – are increasingly executed on an accelerated schedule with terms typically seen in leveraged acquisition financings, including limited conditionality similar to SunGard conditionality, operating covenants providing increased flexibility for additional acquisitions and leverage, financing definitions and covenants incorporating pro forma adjustments, and transfer provisions disqualifying competitors or investors pursuing specified investment strategies.

Early 2024 macroeconomic conditions

Despite persistent geopolitical risks, 2024 started on an optimistic note from a macroeconomic standpoint. Data from the second half of 2023 and early 2024 projections had suggested falling inflation at close to, albeit a bit lower than, expected pace and modest but steady growth of the economy at large, opening a path to soft landing. However, data from the first three months of 2024 shows a pause in the trend of falling inflation.

Early 2024 market conditions

Institutional loan and high-yield bond markets opened strong betting on, and pricing in, expected interest rate cuts, with the Federal Reserve initially signalling three such cuts in 2024. Despite firmer than expected macroeconomic readings and related closely-watched monetary policy risks, technicals of the debt market have been strong, with healthy CLO issuance and investor demand outpacing net deal supply. While M&A activity remains lukewarm, market participants have been hopeful that 2024 will see a convergence of buyer and seller valuation expectations. Looking ahead towards continuing geopolitical and policy risks – including uncertainties linked to the upcoming US presidential and congressional elections – borrowers have been enthusiastically taking advantage of the window of opportunity to address mounting maturities, improve pricing and/or provide returns (by way of dividend recapitalisations). Despite the refinancing activity, the maturity wall of 2025 and 2026, together with the broader macroeconomic factors and elevated interest rates, compared to those on offer in 2020 and 2021, could result in increasing default rates.

Selected early 2024 terms and themes

Favourable market conditions reopened the door to borrower-favourable terms, with some addressing experiences from not-too-distant constrained market conditions. For example, in response to experience on “hung” bridges coming out of the end of 2021/early 2022 M&A boom, the market recently accepted enhanced safeguards against negative tax implications for the borrower on the exercise of a securities demand and borrower consent rights with respect to participations of loans and commitments by lenders. Other more market-driven terms include requiring less deleveraging for restricted payments made under a leverage ratio basket and asset sale prepayment leverage step-downs.

The early optimistic macroeconomic outlook, coupled with lowered pricing, enabled the return of junior-lien debt, including specifically syndicated junior-lien debt. For example, as of early March, the USD1.9 billion Truist Insurance Holdings second-lien term loan priced at the lowest spread on a syndicated second-lien term loan for an LBO since the 2008 financial crisis.

The robust return of institutional loan and high-yield bond markets and lowered pricing also reignited the market share competition with private credit, which continues to have a great amount of dry powder to deploy. Recent months have seen a number of borrowers successfully refinancing more expensive private debt in the reopened institutional loan market. These conditions put pressure on private credit to continue to provide, and build upon, solutions that the broadly syndicated market may not be best suited to provide, such as fast execution without public ratings, delayed draw term loan facilities, extended maturities, portability, payment-in-kind (PIK) interest and credit for certain idiosyncratic businesses. The reopening of the broadly syndicated market also has the potential to reopen a space for private junior debt.