In this month’s On Target we look, from a borrower’s perspective, at 10 potential flashpoints with lenders that can arise when leveraging an acquisition.
When borrowing to fund an acquisition, leveraged loans have long been an active and robust asset class given the available liquidity in the market and the returns such loans can generate for lenders despite relatively low default rates.
Although financing structures often reflect the bargaining strength of borrowers, it is crucial that borrowers pay close attention to specific leveraged lending terms to avoid being caught out.
1. Use of model forms
The borrower’s advisers often argue for the use of a shorter-form leveraged facility agreement. Some pragmatic lenders are prepared to adopt this approach with smaller funding requirements. But the lender’s lawyers, who typically produce the first draft, are more likely to opt for the Loan Market Association (LMA) form as their starting point. Having adopted the LMA precedent, the lender will argue against moving from what it will argue are market standard terms. But the LMA precedent is best seen as a starting point for negotiation, which should always be tailored and negotiated to reflect the specifics of the transaction.
2. Due diligence and facility terms
Due diligence on the acquisition will highlight a variety of risks and issues relating to the underlying business of the borrower which lenders are likely to want addressed in transaction documentation (at least to the extent they are material). The manner in which such risks are dealt with may be a key aspect of negotiations. Borrowers should try to ensure that representations are given subject to any matters disclosed in due diligence reports, and that restrictive and/or financial covenants include appropriate carve outs for matters arising out of due diligence.
3. Lender’s reliance on reports
Lenders will expect to be granted a right to rely on technical, financial and legal due diligence reports. This means a lender will have a direct claim against the report provider, typically subject to agreed limits including a financial cap. Reliance letters will therefore need to be agreed with report providers as a condition precedent to funding. Although this is a standard request, borrowers should not underestimate the time it can take to agree the form of reliance letter and the level of liability associated with it. It is advisable to deal with this issue upfront by establishing the report provider’s and the lender’s requirements and agreeing the form of reliance letter at an early stage so that it does not become an obstacle nearer to closing.
Hot topics are (i) when arrangement fees are payable (usually on the first utilisation of the facility), (ii) the point at which commitment fees start to accrue and (iii) “no deal, no fee” arrangements. This final concession may prove particularly important in competitive auction situations where committed funds are required to give the bidder a competitive advantage but where there is no guarantee that the bidder will end up using the facility.
5. Flexibility of cancellation and prepayment provisions
Facility agreements typically provide a variety of options for both mandatory and voluntary prepayment and cancellation. These provisions are likely to be negotiated. If there is more than one tranche of debt, borrowers will often seek to agree as much flexibility as possible in terms of the application of prepayment amounts as between the various tranches or that voluntary prepayments should be applied in such manner as the target company may direct. Lenders usually resist this flexibility. The LMA leveraged facilities agreement envisages that mandatory prepayments will be paid into a separate holding account held by the borrower with the lender. Many borrowers successfully resist this requirement as they do not welcome the additional burden of administering a separate account.
6. Excess cash flow sweep
It is customary for leveraged loans to contemplate mandatory prepayments out of the target group’s ‘Excess Cashflow’. This is a contentious provision and borrowers will be focused on how ‘Excess Cashflow’ is defined. Borrowers will often seek to limit the amount of the target group’s excess cash applied to prepayments on the basis that it should be applied at their discretion. But remember that there is a relationship between the cash sweep and the restrictive covenants. If the restrictive covenants already leave the target very little leeway in terms of how ‘Excess Cashflow’ can be spent (for example, the covenants may already prohibit distributions, or state that capital expenditure has to be funded from the proceeds of a dedicated facility), then restrictive cash sweep provisions may have a limited impact on the operations of the target in practice.
7. Financial covenants
Financial covenants always need to be adapted to the transaction. They must reflect the deal structure, the target group’s business sector, revenue, earnings and cashflow profile. But this is not an exhaustive list. The devil is most certainly in the detail and there are always intricacies to consider in relation to the definitions and how the covenants operate.
So-called “covenant-lite” structures have emerged in the context of increased competition among lenders and a significant supply of capital in what is still a low interest rate climate. But borrowers should be aware that, as a starting point, lenders will seek a full set of financial covenants in most circumstances. It is up to the borrower to negotiate these down so that they do not restrict the operations of target business.
8. Information covenants
On-going provision of financial information to the lender during the loan period tends to be a sensitive subject for the borrower. The borrower team will need to confirm whether financial information delivery covenants can be met from a practical standpoint. A borrower may agree to provide management accounts, usually on a quarterly basis, but the form of those, the applicable accounting rules (particularly in cross border borrower groups) and the relevant time periods that apply will all be subject to negotiation. A lender may also want other non-standard items to be included such as management commentaries and performance indicators, which may be onerous for borrower management to produce.
9. Scope of representations, undertakings and events of default
This is a topic in itself! Leveraged agreements will typically contain a very wide list of representations, undertakings and events of default. Not all of them will be appropriate for all deals, and some agreements will need to include additional tailored provisions to deal with specific commercial or legal aspects. Key issues for borrowers to grapple with include materiality and other qualifications, financial thresholds and baskets, repeating representations and grace periods for events of default.
10. Permitted security
Upstream, cross-stream and downstream guarantee and security packages are widely used in leveraged acquisition financings. The definition of “Security” in a lender-drafted facility agreement tends to cover not only the traditional forms of security such as mortgages and charges, but sometimes “any other agreement or arrangement having a similar effect”. This last phrase is likely to catch a wide range of arrangements, such as sale and leaseback, debt factoring and retention of title. Borrowers will seek to add exceptions to the ‘negative pledge’ in order to relax restrictions on the creation of additional security over new or existing assets in the ordinary course of business, which lenders will often resist.
Is this brief too brief? Do you need any help with your next acquisition? MJ Hudson’s corporate and transactional practice frequently advises on leveraged acquisitions. The firm emphasizes a team approach to leveraged acquisitions, drawing on the knowledge and experience of our M&A and finance practice.
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DEAL OF THE MONTH:
MJH’s M&A and Private Equity Transactions team advised a US based multilateral corporation on its acquisition of First Scottish Group, a leading Scottish independent professional search firm.
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