Welcome to Collateral, MJ Hudson’s quarterly newsletter focusing on the latest restructuring, turnaround and debt matters with insight aimed at institutions at all levels of the capital structure.
While a company is solvent and able to meet its payment obligations to its creditors, the show goes on and the terms of the intercreditor agreement regulating the priority of creditors are unlikely to be tested. Unfortunately, if the situation deteriorates, many mezzanine lenders realise too late that they paid insufficient attention to the terms of the intercreditor at the time at which they lent. The effect of this can be fatal to any effort to protect value. In this latest edition of Collateral, we take a look at 8 important intercreditor issues that mezzanine lenders should be aware of.
Which payments the mezzanine lenders should be permitted to make in the ordinary course of business can be contentious from the outset. It is generally accepted that payments of principal and PIK interest are not permitted but that fees, cash interest and increased cost payments should be.
In addition, it is usually the case that the triggers allowing senior lenders to send a notice of default to the mezzanine lenders in order to suspend these payments are: insolvency of the company; breach of a financial covenant; and non-payment to the senior lenders.
But once a notice of default has been issued by the senior lenders, there is divided opinion as to which payments to mezzanine lenders should be suspended. The Loan Market Association (LMA) form of intercreditor agreement provides that certain payments to mezzanine lenders should be halted.
From a mezzanine perspective, it is vital that payments should be permitted to cover reasonable legal fees, so that the mezzanine lenders can obtain independent legal advice and protect their position in a default scenario. On the flip side, senior lenders tend to be naturally concerned about value leakage to mezzanine lenders who, in effect, will be spending the cash to prepare and mount a legal defence to senior lenders’ actions. A capped amount is normally agreed, but the size of that cap will vary from deal to deal.
The LMA form of intercreditor agreement gives mezzanine lenders (as well as sponsors) a cure right by injecting new money as equity in order to cure a breach, such as breach of a financial covenant in the senior debt.
It is in the interests of the mezzanine lenders to be given an equity cure right, so that in instances where the sponsor does not wish to inject further capital into the company, they can step in to remedy a default. Although, in principle, most senior lenders are not usually opposed to this, if the mezzanine lenders exercise their cure right, then the event of default will be waived and the company continues to be liable to make payments to the mezzanine lenders. That may not be commercially acceptable to the seniors.
It is assumed that the senior lenders and the mezzanine lenders will share the same security package. But often, the mezzanine lenders request additional security over the shares in the HoldCo, so that they can enforce that security, even in the face of a standstill at the OpCo level.
From a mezzanine perspective, this additional security acts as protection against the sponsor doing a deal with the senior lenders to the detriment of the mezzanine lenders. The additional rights give the mezzanine lenders further leverage in negotiations with the sponsor and the senior lenders and gives them a seat at the table in a workout situation, as “owners” of the borrower group.
But, from the senior perspective, if the mezzanine lenders are granted the additional share security, there is a danger that they may enforce over the shares in HoldCo and take control of the company. This often has the effect of triggering a change of control in the senior lenders’ facility agreement, which can then lead to a mandatory prepayment – consequences which are seldom in the interests of either creditor group.
Most forms of intercreditor agreement allow the senior lenders to lend further debt to the company without first seeking the consent of the mezzanine lenders. Typically, these provisions are relied upon during times when the company has liquidity issues.
From a mezzanine perspective, if the additional debt is genuinely being used to provide further liquidity for the business, this is generally acceptable. However, given that any such additional lending has the effect of further subordinating the mezzanine debt, it makes sense that the amount of headroom should be limited to, say, 10% of the original senior debt.
It is relatively common in the terms of intercreditor agreements for mezzanine lenders to want to force the senior lenders to sell them their debt at par (“taking the seniors out”). However, it remains a contentious issue (especially for a debtor) given that this would give the mezzanine lenders control of the enforcement process and they may have a different strategy in mind than the senior creditors. However, there are very few instances where such a right has actually been exercised by the mezzanine lenders in a distressed context, because mezzanine lenders often have the ability to buy out the senior lenders on the secondary market (and, sometimes, at below par).
There is much debate from mezzanine lenders about whether senior lenders have too much power when it comes to controlling the enforcement process, should the transaction become distressed. Lack of information and a lack of prescribed valuation requirements are commonly cited by the mezzanine community as problems.
Giving the mezzanine lenders access to reports commissioned by the senior creditors or the ability for them to jointly instruct the report provider are therefore common requests when the intercreditor is first being negotiated.
If, or when, the senior lenders come to sell the assets over which they have security, they will generally want to sell them free of the mezzanine debt. The mechanism by which that mezzanine debt is released is a contentious issue, as the intercreditor agreement tends to give the security agent flexibility to release the principal debt, security and guarantees.
However, many mezzanine lenders argue that their debt should only be released if it is repaid, restructured on a consensual basis or discharged through an insolvency process. From their point of view, release provisions in a standard sale should pertain only to the security and guarantees and not the principal debt claim, given that they will only receive any surplus proceeds after the prior ranking creditors have been repaid in full. This is particularly relevant in the context of the senior lenders trying to effect a pre-packaged sale of the secured assets free from the claims of lower ranking creditors…
On this contentious topic, few intercreditor agreements place restrictions on the senior lenders selling the secured assets to an SPV owned by the senior lenders.
Before the credit crunch, it was unusual to specify criteria with which the senior lenders had to comply during an asset enforcement process. But since that time, mezzanine lenders have been campaigning for restrictions to be placed on senior lenders trying to implement a pre-packaged sale of the secured assets to themselves.
In order to avoid circumstances where the sale price is such that the mezzanine debt is entirely written off, there is now a move for standard requirements to be enshrined in intercreditor agreements, so that disposal proceeds must be received in cash (given it is not uncommon to see intercreditor agreements which enable a security agent to accept non-cash consideration) and a fair market value is established (through a requirement for independent valuations and a proper marketing process). This trend is helpful but whether it becomes standard market practice remains to be seen.
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