What were the key developments in loan documentation that you saw in the middle market in the first half of 2013?

Credit demand continued to exceed credit supply, which was the predominant driver of a number of developments. First, the flexibility typically found in the documentation for large syndicated financings continued to find its way into middle market transactions, including the lower end of the middle market. In particular, we saw:

  • More permissive add-backs to EBITDA than in the past, although still subject to caps and baskets or, in the lower end of the middle market, subject to approval rights.
  • Step-downs in leverage ratios and step-ups in fixed charge coverage ratios (if any) that are more spread out over time and smaller in amount.
  • Computation of leverage ratios on a net debt basis, with restrictions on what cash and cash equivalents can be netted against the debt.
  • A more general acceptance of equity cure rights, but with continued discussions around permitted amounts, use in consecutive fiscal quarters and the application of equity cure proceeds to repay debt.
  • Increased use and more liberal definitions of builder baskets, but with less flexibility for use for restricted payments.
  • Allowance for permanent changes to debt capital structures through incremental facilities (subject to dollar caps or leverage ratios), refinancing debt, repricings and amend and extend provisions, but less flexibility to document these arrangements as separate tranches within the same credit documentation or as a separate set of credit documents.
  • Prohibition on assignment to disqualified lenders and competitors more accepted in the lower end of the middle market.
  • Limitations on expense reimbursement by borrowers, particularly in sponsored transactions.
  • Standardization of carve-outs to indemnification provisions.

Second, covenant-lite structures (or covenant-lite structures with market flex rights to implement financial maintenance covenant(s)) became more common in the upper middle market, as the broadly syndicated loan market provided liquidity to smaller borrowers. Third, cushions on financial covenants tended to be more widely set, or "covenant almost-lite."

For financial sponsors making smaller equity contributions, there was less focus on fully committed certain funds financings at the portfolio company level to finance the acquisition of the portfolio company, and a greater reliance on more flexible fund level credit arrangements, which allowed financial sponsors to arrange for permanent debt capital structures on a post-closing basis.

Developments in the debt market for alternative capital sources (such as hedge funds, mezzanine funds, business development companies, small business investment companies and insurance companies) included:

  • willingness to provide more flexible debt structures (including unsecured or secured mezzanine, second lien, cross-lien and holdco debt) to suit the particular needs of borrowers, with a focus on:
    • mandatory prepayment events and associated prepayment premiums, with less uniformity in the lower middle market;
    • limitations on the ability of equity holders or affiliates to purchase the borrower's debt, and to the extent the purchase of a senior tranche of debt is not prohibited by the documentation governing a junior tranche (as it is in some lower middle market deals, along with the requirement that any such debt acquired be cancelled), restrictions as to amount, voting rights, access to information and rights in bankruptcy;
    • restrictions on the ability to layer additional debt into the capital structure; and
    • to the extent secured, collateral arrangements and associated lien subordination provisions tailored to the transaction.
  • In unitranche financings, an increased focus by borrowers on the terms and provisions of the "Agreement Among Lenders." In particular, the relationship between revolving first out and last out lenders in a downside scenario.
  • Intercreditor and subordination provisions that were less standardized in the lower end of the middle market, with greater protection for holders of the junior debt.

What factors do you see potentially affecting the level of deal activity in the loan market in the second half of 2013?

One factor is an increase in M&A and related loan activity, which we are already starting to see. Holders of debt and equity capital are willing to put money to work, but sellers and buyers seem to be apart on valuations in many instances because of weaker historical EBITDA numbers as a result of the last recession.

Other factors that may lead to increased deal activity include:

  • The continued economic recovery in the US, particularly in the housing sector.
  • The continued limited impact of the government sequester budget cuts on the economy in the US.
  • The stabilization of the European Union and an increased demand by emerging economies for US goods and services.
  • A smooth transition to more normalized interest rates, along with the tapering of the quantitative easing by the Federal Reserve Board.

There are a few additional large cap terms that some middle market borrowers have been seeking to include in their deals, but continue to be resisted by lenders:

  • No sponsor precedent. Middle market commitment letters do not typically specify a sponsor precedent for the loan documentation.
  • Restriction on refinancing facilities. Middle market loan agreements do not typically include refinancing facilities, which are common in large cap deals.
  • Builder basket restrictions. Middle market borrowers typically are not permitted to make restricted payments, fund investments or prepay junior debt using a basket (builder basket) based on the borrower's retained excess cash flow and any equity issuances (or, if this flexibility is included, it is much more restrictive than in large cap deals).
  • Application of default interest. In large cap deals, default interest generally is only charged on overdue amounts and can often be waived with a majority lender vote. In most middle market deals, default interest generally applies following certain defaults to all amounts outstanding, and often can only be waived with unanimous lender consent.

SECOND LIEN LOANS

Second lien loan volume reached $6.77 billion in the first quarter of 2013, a dramatic increase from the $1.34 billion during the same period in 2012, according to Thomson Reuters LPC. Despite second lien loan documentation being substantially similar to the related first lien loan documentation, issues that continue to be the focus of negotiations between first and second lien lenders include:

  • The standstill period (usually between 90 and 180 days) during which second lien lenders cannot exercise their rights against the borrower or the collateral, notwithstanding a default by the borrower under the second lien loan documents.
  • The amount of additional first lien debt the borrower can incur after closing that still has the benefit of the intercreditor agreement's terms.
  • The rights of each group of lenders to amend their respective loan documents.

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