We were delighted to sponsor last week's Debtwire European Mid-Market Forum which brought together the mid-market leveraged loans community, including many debt funds and other alternative lenders and banks. The agenda, which charted the course of the rapidly evolving mid-market leveraged finance space, included the "More than a unitranche" panel, chaired by Hogan Lovells partner Paul Mullen, which featured a lively debate between participants from funds and banks about the opportunities for them to work together on a variety of debt structures.
We summarise here the major themes discussed on the day.
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Documentation terms remain loose in favour of sponsor-backed borrowers. Whilst cov-lite deals remain less common in the European mid-market space, with the exception of the lower end of the market, most deals are cov-loose relying on a sole leverage test. However, participants reported a continued erosion of the benefit of that financial test citing demands for high headroom levels coupled with generous EBITDA add-backs incorporating FD nominated proforma adjustments and requests for 12 to 18 month covenant holidays. One panellist commented that "some covenants are not worth the paper they are written on". It could be argued that lenders are not being adequately compensated for this erosion compared to the higher margin carried by cov-lite loans. Lower mid-market deals do still tend to get two or more maintenance tests and generally less aggressive terms.
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It is vital to do full diligence. To be able to agree to the levels of flexibility being demanded by sponsors the lender has to be really comfortable that the business is sound and supported by a good equity cushion to ride any downturn. Obviously the sourcing of deals is the hardest part. One panellist commented that last year his fund only proceeded with 2.8% of the deals that they looked at. Several people stressed that it is vital to stay disciplined and to walk away from those deals where terms are just too aggressive for comfort.
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The alternative lender deal structure of choice continues to be senior term with super senior RCF. In Europe, fewer first-out / last-out (FO/LO) deals are done than in the US. Whilst banks are keen on the higher returns they can earn from taking on a FO piece as compared to super senior RCF tranches which (according to one panellist) "don't pay the salary bill", debt funds are much less keen. One fund commented that when the FO piece is a couple of turns of EBITDA or more, and ranks ahead of the debt fund's LO piece, "whichever way you look at it this is subordinated debt" and to be at all acceptable the debt fund will need to receive adequate margin, require the ability to take out the FO piece in a distress situation and to stay in control of decisions generally. If structured well though, the collaborative FO/LO product can work for the right types of transaction, carrying attractive pricing for the borrower compared to the more traditional structures. However time needs to be spent getting the intercreditor issues right.
Behind the scenes 'agreements amongst lenders' to which the borrower is not party ("AALs") remain much less common in Europe than in the US market.
Recently the number of mid-market deals being underwritten by a bank and then sold down in primary syndication to credit funds has increased. This structure can work particularly well for borrowers where the debt represents stretched senior meaning that its pricing challenges that of unitranche debt. However, sponsors will be keen to ensure that market flex rights are absent (or at least minimised) and that the underwriter retains material skin in the game.
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An important issue which was not aired at the Forum (at least not on the panels) is the fetters on transferability which are still being demanded by sponsors. Borrower consent rights for sales (other than to other lenders and affiliates and to white-listed institutions) prior to an event of default (and often with such consent rights surviving the occurrence of non-material events of default) as well as blanket prohibitions on sales to "competitors" (often defined extremely widely) have become the norm. Many of the documentation excesses discussed at the forum would be more palatable if at least lenders could freely transfer out of the investment should it no longer like the credit. After all, many of the more flexible terms being demanded by sponsors originate in the US market where leveraged loans are more freely transferable.
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Last year's prediction that ABL/senior debt structures would come increasingly popular has not come to fruition. The main inhibitors to this development are lenders' concerns that ABL lenders have so much control being so close to the business' receivables that lenders would be exposed to suffering lower recovery rates on any enforcement. Also, the necessary intercreditor arrangements are complex and time- consuming which makes them expensive to document. For such structures to work, both ensuring that the ABL is really non-recourse and incorporating sensible standstill arrangements are key.
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