The demand by asset managers, CLOs and other investors for leveraged loans continues to fuel the market for cov-lite loans that include other terms that are attractive for sponsors. These terms often allow for liability management transactions by permitting transfers of assets to unrestricted subsidiaries, or the non-pro rata uptiering of debt and incurrence of super-priority debt with mere majority lender consent. While the onset of Covid in the first quarter of 2020 offered some opportunity for lenders to impose greater discipline on borrowers in exchange for relief (such as amends and extends, forbearances or covenant relief), this discipline was relatively short lived. Below is a summary of the trends we have seen in the leveraged loan market during the past year.
1. Cov-Lite Remains the Rule
Except for the most distressed issuers, cov-lite deals continue to be the order of the day.
2. Covenant Holidays Not Permanent
During the first six months of the pandemic, there were borrowers that needed waivers. In exchange for temporary waivers of financial covenants, lenders insisted that these borrowers restrict dividends, investments and additional debt. Many of these concessions, however, abated once borrowers became able to comply with their financial covenants.
3. Expanding EBITDA Definitions
Prevalent definitions of EBITDA generally were broad enough to allow addbacks for increased costs, and sometimes also for lost revenues, associated with the pandemic. Some new leveraged loan agreements expressly allowed addbacks for such expenses. Generally, caps on addbacks loosened incrementally across the board (including caps on addbacks for synergies, savings, and one-time expenses). Some post-March 2020 credit agreements allowed the borrower to adjust EBITDA for cost savings that were “reasonably foreseeable” for up to a three-year period.
4. Reallocation of Capacity for Additional Debt
The recent market has increasingly permitted borrowers to convert capacity in one bucket into capacity in another bucket, typically with the effect of increasing borrowers’ ability to incur new secured debt. Some sponsor deals now allow significant amounts of restricted payment capacity to be repurposed into secured debt capacity, subject to any applicable leverage or ratio tests.
5. Status of J.Crew Blockers
In 2017, J.Crew relied on its investment capacity and restricted payments capacity in its term loan agreement to transfer at least $250 million of intellectual property securing its term loans to an unrestricted subsidiary, and then borrowed against the transferred assets to repay structurally subordinated debt of its parent. While “J.Crew blockers” are not widespread, several credit agreements contain provisions attempting to prevent borrowers from engaging in a J.Crew-like transaction, and there are a variety of J.Crew blockers in the market. The most protective J.Crew blocker seeks to prevent the transfer of material IP or other valuable collateral outside of the credit group (e.g., “no Material Intellectual Property owned by any Loan Party may be contributed as an Investment by any Loan Party to any non-Loan Party”). However, sponsors generally have been successful in pushing against these blockers.
6. Status of Chewy Blockers
In June 2018, PetSmart, Inc. announced that it had transferred a portion of its equity in Chewy, Inc.—a key subsidiary of PetSmart—to a newly formed unrestricted subsidiary. Because PetSmart’s loan documents allowed non-wholly owned domestic subsidiaries to be released from the guarantees and pledges securing PetSmart’s secured term loan (the debt PetSmart incurred to acquire Chewy), Chewy was released from these guarantees and pledges, and its assets were no longer available to satisfy PetSmart’s secured loans.
PetSmart relied on its capacity to make investments in a “Similar Business” to transfer the equity it owned in Chewy to a newly created shell subsidiary. The current trend in sponsor deals is to expand the definition of “Similar Business” to include unrestricted subsidiaries, the parent of the issuer, and restricted subsidiaries. This gives portfolio companies greater ability to rely on their investment baskets to take collateral out of credit support. By contrast, a small number of recent deals have included provisions attempting to prevent the release of credit support when there is a partial transfer of equity of a guarantor to an affiliate.
7. Nieman Marcus Boosters?
Nieman Marcus Group Inc. spun out subsidiary MyTheresa (which allegedly owned approximately $1 billion of Nieman’s valuable IP) to its ultimate sponsor owners by (1) using investment capacity to un-restrict MyTheresa, and (2) using an exception to a restriction on dividend payments that permitted dividends of capital stock to unrestricted subsidiaries. We understand that this exception, which allows borrowers to dividend the stock of unrestricted subsidiaries, is becoming slightly more common in leveraged loan agreements.
8. Status of Serta/Trimark/Boardrider Blockers
The Serta Simmons, Boardriders and Trimark transactions each involved the consent by existing majority lenders to have the majority lenders only extend new debt on a superpriority basis, up-tier their existing debt into the super-priority tranche, and effectively subordinate existing minority lenders to that super-priority tranche. The uptiering of the existing loans was accomplished through provisions in the credit documents allowing the borrowers to engage in non-pro-rata exchanges with existing lenders through “open market purchases.”
A minority of deals done in the market since Serta have adopted “Serta blockers.” Some of these blockers require a supermajority or unanimous vote to subordinate the lien or change the priority of the first lien notes. Other Serta blockers incorporate caps on borrowers’ open market purchases, require that such purchases be for cash, or prohibit open market exchanges from being executed substantially contemporaneously with the issuance or exchange of additional debt.
The Serta, Trimark and Boardriders liability management transactions are all being challenged in litigation. Given the absence of Serta blockers in the market generally, if these transactions are permitted to stand, we expect there will eventually be an onslaught of similar transactions – with lenders competing to be in the majority group.
About the Authors
David Almroth is a partner in the financing and capital markets team at Freshfields’ New York office. David advises corporations, equity sponsors and strategic investors, as borrowers, and investment banks, commercial banks, hedge funds and other institutions, as agents and lenders, in a wide range of financing transactions.
Kyle Lakin is a partner in the financing and capital markets team at Freshfields’ New York office. Kyle advises equity sponsors and investment funds, as well as corporations, agents and lenders on a wide range of financing transactions, with a focus on leveraged financing and restructuring transactions.
Madlyn Gleich Primoff is a partner on the restructuring and insolvency team at Freshfields’ New York office. Madlyn has more than 25 years of experience representing companies, lending groups, syndicate agents, global financial institutions, and private credit investors in complex US domestic and cross-border out-of-court restructurings, prepackaged Chapter 11 cases and contentious Chapter 11 cases as well as related litigation matters.
Henry Hutten is a senior associate in the restructuring and insolvency, and dispute resolution teams at Freshfields’ New York office. Henry services clients’ litigation needs arising out of complex cross-border mandates, including bankruptcy cases, commercial credit disputes, and securities and other commercial litigation.