Executive Summary

• Throughout the COVID-19 pandemic many terms in U.S. law governed credit facilities, ranging from financial definitions to fee structures, have adapted to market disruptions, new laws and regulatory and accounting changes.
• With the light seemingly at the end of the pandemic tunnel, some U.S. loan market terms have evolved to address COVID-related heightened risks and legal and regulatory changes, while others have rewarded thriving areas.  Trends have emerged in these terms as further described below.
• These trends have not been limited to the syndicated loan market, and have also permeated the private credit markets, particularly in several recent record-breaking unitranche facilities.

 

Overview

The U.S. loan market has seen rapid growth in 2021, which is continuing in Q4. Private credit in particular has witnessed meteoric growth, including several record-breaking unitranche facilities, during this time period. Throughout this growth, financial definitions and calculations, as well as pricing structures, have evolved based on regulatory, legal, accounting, and market changes, impacting key metrics under financial covenants and incurrence tests. Such developments have appeared in the growing private credit markets as well, with the mega-size unitranches containing features previously limited to large cap / sponsored syndicated or institutional bank-led credit facilities. Still, market participants remain somewhat cautious given the continuing uncertainty and rapid change experienced during this timeframe. Recently, extended commitment periods have returned to the U.S. loan market from their temporary COVID-related hiatus, but now may be accompanied by more lender favorable ticking fee structures. As we move through Q4 in the U.S. loan market, it seems likely more change is on the horizon.

1. How Recent Changes to Reg S-X May Impact EBITDA and Other Financial Calculations

Not so long ago, pro forma cost-savings and synergies add-backs in EBITDA were limited to top-tier sponsored and large cap deals. Now such add-backs are a fixture in many middle market deals, but are typically subject to a 20% – 30% cap and a specified period in which the actions giving rise to the cost-savings or synergies must be taken or the effects realized. Large cap deals and some middle market deals also may permit adjustments to EBITDA made in accordance with Regulation S-X without a cap. Regulation S-X addresses various financial tests and pro forma calculations for accounting purposes. 

Several amendments to Regulation S-X were adopted in 2020 and became effective as of 2021. Those most likely to be significant with respect to credit agreement terms (such as EBITDA) are: (1) changes in the investment and income tests used to determine the significance of acquisitions and dispositions (including expanded permissions for use of pro forma financials in connection therewith) and (2) modifications to requirements for pro forma adjustments that include (i) “transaction accounting adjustments” that reflect estimated purchase accounting under GAAP or IFRS; (ii) “autonomous entity adjustments” that permit reflecting the operations and financial position of a company as an autonomous entity, even if it was previously part of another entity or corporate group; and (iii) “management’s adjustments” that facilitate reflecting projected cost-savings and other synergies following acquisitions and dispositions that the company’s management plans to implement.  Item (iii) is in essence a pro forma cost-savings / synergy add-back to EBITDA that is not capped or subject to a specified look-forward period. 

In credit facilities that permit adjustments in accordance with Regulation S-X without a cap, EBITDA might be higher than expected. Accordingly, the borrower may find it easier to meet its financial covenants or leverage ratio based tests for making investments and restricted payments or incurring debt. To date, there has been limited responsive activity in loan market terms, though a trend is slowly starting to develop in the middle market whereby market participants are asking for a cap on adjustments in accordance with Regulation S-X or to treat Regulation S-X as in effect prior to the recent amendments.

2. Record-Breaking Unitranches

Direct lending post-COVID has reached record levels, in part due to its more straight forward capital structures, covenants, and documents, low syndication risk, and often faster timelines. When direct lenders first became a fixture in the U.S loan market, they largely operated in unitranches in the middle market (particularly for deals they led or agented) and, in some cases, participated as lenders in large cap / syndicated deals. However, the past year has shattered unitranche records, with several multi-billion unitranche facilities led / agented by direct lenders closing in the U.S. and European loan markets. During COVID, the streamlined negotiations and documentation of unitranche facilities and lack of syndication cost and risk proved particularly valuable. Some market participants sought unitranche structures to consummate some of the largest acquisitions in the market. 2Q21 and 3Q21 both saw the two largest such deals in the U.S. loan market, Bloomberg reported that Owl Rock Capital Partners (advised by Paul Hastings) led a $2.3 billion financing for Thoma Bravo’s buyout of Calypso Technologies Inc. and Blackstone and Ares led the financing for Thoma Bravo’s $6.6 billion take-private of Stamps.com (for more information on the Stamps.com transaction, see “Paul Hastings Advises Blackstone Credit and Ares Corporation in the Largest Unitranche Debt Financing in History”).

3. What Is Debt Anyway?

Nearly every credit agreement specifies what items constitute debt for leverage ratios. This is important because it will impact leverage calculations for financial covenant and incurrence tests. Some debt definitions still include items typically thought of as “debt”. However, other debt definitions include carve-outs for obligations that are either “debt” or are “debt” like, such as: (1) outstanding revolving borrowings; (2) contingent obligations under letters of credit or reimbursement obligations under letters of credit unless not paid within 3 – 5 days of the due date; (3) trade payable or similar obligation to a trade creditor in the ordinary course of business or consistent with industry practice; (4) earn-out obligations until any such obligation is reflected as a liability on the balance sheet in accordance with GAAP and  not paid within 5 - 60 days after becoming due and payable (or, if applicable, following expiration of any dispute resolution mechanics set forth in the applicable agreement governing the applicable transaction); (5) liabilities associated with customer prepayments and deposits; or (6) hedge obligations. 

The U.S. loan market has seen market participants agreeing to more and more carve outs to what constitutes debt, though they have historically looked to revolving borrowings and incurrence of additional debt as a potential marker of distress (hence, covenant lite structures where revolving borrowings beyond a specified threshold trigger financial covenant testing). Leverage ratios that include a debt component with extensive carve-outs may not paint a complete picture of the borrower’s financial health and performance and may increase transactional capacity subject to incurrence tests. Furthermore, as most market participants know, unrestricted cash and cash equivalents can often be subtracted from the debt calculation (occasionally with a cap or control agreement requirement). This can have the effect of further reducing the debt component of leverage and there is also trend in the market to allow debt proceeds that are not “promptly applied” to be considered unrestricted cash or cash equivalents for the cash netting exercise.

4. The Return of Ticking Fees

When COVID began and the U.S. loan market temporarily paused, certain facets of the loan market, such as extended commitment periods that included ticking fees, nearly disappeared given the inherent risks of delaying closings by six months of more.  However, in late spring of this year, fueled by optimism of a “return to normal”, market participants appeared to feel more confident that extended commitment periods were once again becoming less risky (as long as they were accompanied by appropriate fee structures). Prior to COVID, ticking fees often: (1) only accrued if the commitment period exceeded 120-150 days; (2) included a fee equal to 50% of the margin required for the 1-30 days thereafter and (3) included a fee equal to 100% of the margin required for the 31-60 days following. Post-COVID ticking fee structures have shifted, at least in several deals, often kicking in for commitment periods exceeding 30 days, and, in some cases, in amounts equal to 100% of the margin for the entire ticking period. These changes are likely related to the perceived increased risk of providing extended commitment periods after emerging from the darkest COVID-related periods where supply chain disruptions, evolving governmental health and safety regulations, and other uncertainties still persist.