Bulk loan documentation to put to the test

LONDON, April 24 (LPC) – Exceptionally aggressive documentation obtained by sponsors on portfolio companies in recent years is set to finally be put to the test as borrowers seek to boost liquidity in the wake of the Covid-19.

Loan documentation has become increasingly slack as banks and investors squabble over deals amid a supply-demand imbalance that has dominated the leveraged loan market in Europe these past few years. last years. This gave private equity sponsors great flexibility to take on additional debt and gave them greater control over assets.

Investors fear sponsors will use up everything in their arsenal as companies face liquidity issues caused by the foreclosure.

“The problem is, the bulk documentation has never been tested,” said one debt investor. “Everyone should assume that sponsors will take advantage of all the baskets and bulk documentation points if they need to inject money or find titles to support new funds.”

Under the “free baskets” in most loan agreements, borrowers are allowed to incur additional debt of the same rank, without the approval of existing lenders.

“We are seeing sponsors starting to use it. Either they are looking to use it for additional bank loans, or they are potentially looking to provide senior debt themselves. Said David Gillmor, sector manager of European leveraged finance at S&P Global Ratings.

While additional liquidity is positive for many borrowers, it could turn out to be negative for many lenders as leverage increases and collection rates decline.

“The additional debt would inevitably increase the company’s leverage ratio and dilute the position of senior lenders,” said Gillmor at S&P.

Analysts believe loan holders would recover much less in this current economic downturn than they have in the past.

S&P estimates that the average first lien recovery rate in the European leveraged loan market will be around 60% of face value, compared to the recovery rate of 70% to 75% over the last two cycles. .

HATCH J CREW

However, one of the situations that most horrifies investors is a borrower’s ability to pledge or transfer valuable assets in an attempt to obtain additional liquidity.

One of the alarming examples was J Crew Group in late 2016. Private equity firm TPG took advantage of a loophole in the debt conditions of the US clothing retailer to transfer some intellectual property rights to a subsidiary.

Following the transfer, the assets no longer served as collateral for the secured loans and, instead, the transferred assets were used to secure new debt issues and buy back bonds.

In Europe, security packages have also eroded in recent years. Most of them have a limited scope of collateral assets and the documentation gives sponsors flexibility in controlling these assets.

“There is a long list of baskets, exclusions and provisions buried in 500-page legal documents. Lenders are probably not even aware of the number of gaps, ”one lawyer said.

However, analysts believe sponsors are unlikely to withdraw assets for liquidity purposes, due to reputational risk.

“This could be viewed by the market as a nuclear option, as no private equity firm wants to be the first to be labeled as the equivalent of J Crew in Europe,” said Gillmor at S&P.

In addition, investors have stated that the flexibility that financial sponsors have enjoyed over the years is based on trust and that breaking that trust could seriously cost sponsors in the future when they return to capital markets. to raise funds.

“Sponsors will have to be very careful how they act, otherwise they will break the market,” said a second investor. (Edited by Claire Ruckin and Christopher Mangham)


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