- Throughout the COVID-19 pandemic, many terms of US law governing credit facilities, ranging from financial definitions to fee structures, have adapted to market disruptions, new laws, and regulatory and accounting changes. .
- With light seeming at the end of the pandemic tunnel, some US loan market conditions have evolved to cope with heightened risks from COVID and legal and regulatory changes, while others have rewarded prosperous areas. Trends have emerged in these terms, as described in more detail below.
- These trends were not limited to the syndicated loan market, but also permeated the private credit markets, particularly in several recent unitranche units that broke records.
The US loan market experienced rapid growth in 2021, which continues into the fourth quarter. Private credit in particular has experienced tremendous growth, including several record unitranche installations, during this period. Throughout this growth, financial definitions and calculations, as well as pricing structures, have evolved in response to regulatory, legal, accounting, and market changes, impacting key metrics under financial covenants and testing. ‘occurrence. Such developments have also appeared in growing private credit markets, with large units containing features previously limited to large cap / sponsored syndicated or institutional bank-led credit facilities. Nonetheless, market participants remain somewhat cautious given the lingering uncertainty and rapid changes that have taken place during this period. Recently, extended commitment periods have returned to the US lending market after their temporary disruption due to COVID, but can now be accompanied by more favorable listing fee structures for lenders. As we move through the fourth quarter in the US loan market, it looks likely that more changes are on the horizon.
1. How Recent Changes to Reg SX May Impact EBITDA and Other Financial Calculations
Not so long ago, cost savings and pro forma synergies in EBITDA were limited to leading sponsored and large-cap transactions. These additions are now an integral part of many middle market transactions, but are usually subject to a cap of 20% to 30% and a specified period during which actions resulting in cost savings or synergies must be taken or effects achieved. . Large cap transactions and certain middle market transactions may also allow EBITDA adjustments made in accordance with SX regulation without capping. The SX rule deals with various financial tests and pro forma calculations for accounting purposes.
Several amendments to the SX Regulation were adopted in 2020 and entered into force in 2021. The most likely to be significant with respect to the terms of credit agreements (such as EBITDA) are: (1) changes in investment and income tests used to determine the significance of acquisitions and disposals (including extended authorizations for the use of pro forma financial data related thereto) and (2) changes in related requirements pro forma adjustments which include (i) âtransaction accounting adjustmentsâ which reflect the estimated purchase accounting under GAAP or IFRS; (ii) âstand-alone entity adjustmentsâ that reflect the operations and financial position of an enterprise as a self-contained entity, even if it was previously part of another entity or group of companies ; and (iii) âmanagement adjustmentsâ that facilitate the recognition of projected cost savings and other synergies from acquisitions and divestitures that the management of the company plans to implement. Element (iii) is essentially an addition of pro forma cost savings / synergy to EBITDA that is not capped or subject to a specified prospective period.
In credit facilities that allow adjustments in accordance with SX Regulation without a cap, EBITDA could be higher than expected. As a result, the borrower may find it easier to meet their financial covenants or leverage ratio-based tests to make limited investments and payments or incur debt. To date, there has been limited reactive activity in terms of the loan market, although a trend is slowly starting to develop in the mid-market for market participants to ask for a cap on adjustments in accordance with SX Regulation or to treat the SX regulation as in force prior to the recent amendments.
2. Record unitranches
Post-COVID direct loans have reached record levels, in part due to its simpler capital structures, commitments and documents, low syndication risk and often faster turnaround times. When direct lenders became a staple in the US lending market, they largely operated in mid-market unitranches (especially for the transactions they led or commissioned) and, in some cases, participated as lenders in large cap / syndicated transactions. However, the past year broke unitranche unit records, with several multi-billion unitranche facilities run / managed by direct lenders shutting down the US and EU lending markets. During COVID, the streamlined negotiations and documentation of unitranche facilities and the lack of syndication costs and risks proved particularly valuable. Some market players have sought unitranche structures to complete some of the most significant acquisitions in the market. 2Q21 and 3Q21 both saw the two largest such transactions in the US loan market, Bloomberg reported as Owl Rock Capital Partners (advised by Paul Hastings) led $ 2.3 billion in financing for Thoma Bravo’s takeover of Calypso Technologies Inc. and Blackstone and Ares led the financing of Thoma Bravo’s $ 6.6 billion acquisition of Stamps.com (for more information about the Stamps.com transaction, see “Paul Hastings advises Blackstone Credit and Ares Corporation on Largest Unitranche Debt Financing in History“).
3. What is debt anyway?
Almost every credit agreement specifies what elements constitute debt for leverage ratios. This is important because it will impact the leverage calculations for the financial covenant and occurrence tests. Some definitions of debt still include items generally considered to be âdebtsâ. However, other definitions of debt include exclusions for obligations that are either “debts” or “debts”, such as: (1) revolving loans outstanding; (2) any obligations under letters of credit or repayment obligations under letters of credit, unless they are not paid within 3 to 5 days of the due date; (3) a commercial debt or similar obligation to a commercial creditor in the ordinary course of business or in accordance with industry practice; (4) earn-out obligations until such an obligation is reflected as a liability on the balance sheet in accordance with GAAP and not paid within 5 to 60 days after it becomes due and payable (or, as the case may be applicable, after the expiration of any dispute resolution mechanism set out in the applicable agreement governing the applicable transaction); (5) liabilities associated with prepayments and customer deposits; or (6) hedging obligations.
The US loan market has seen market participants increasingly agree to exclude what constitutes debt, although they have historically looked to revolving borrowing and rising debt as a potential marker of distress ( hence the covenant lite structures where revolving loans beyond a specified threshold trigger the test of financial covenants). Leverage ratios that include a debt component with extended exclusions may not paint a full picture of the borrower’s financial health and performance and may increase transactional capacity subject to occurrence testing. In addition, as most market participants know, unallocated cash and cash equivalents can often be subtracted from the debt calculation (sometimes with a requirement to agree a cap or control). This may have the effect of further reducing the debt component of leverage and there is also a tendency in the market to allow debt products which are not “immediately applied” to be considered cash or unallocated cash equivalents for the cash compensation exercise.
4. Return of ticking fees
When COVID started and the U.S. loan market temporarily halted, some facets of the loan market, such as extended commitment periods that included ticking fees, all but disappeared given the inherent risks of delaying loans. closings of six months or more. However, by the end of the spring of this year, fueled by optimism of a ‘return to normal’, market participants seemed more confident that extended engagement periods would become less risky again (as long as they were accompanied by appropriate tariff structures). Before COVID, ticking fees often: (1) only accrued if the commitment period exceeded 120-150 days; (2) included a charge equivalent to 50% of the required margin for the next 1 to 30 days and (3) included a charge equivalent to 100% of the required margin for the next 31 to 60 days. Post-COVID pricing structures have changed, at least in several transactions, often taking effect for commitment periods greater than 30 days and, in some cases, for amounts equal to 100% of the margin for the entire ticking period. . These changes are likely related to the perceived heightened risk of providing extended engagement periods after exiting the darker periods of COVID where supply chain disruptions, changing government health and safety regulations. security and other uncertainties persist.