Given the sharp contraction in buyout activity in the past 12 months and the challenging macroeconomic environment, private equity sponsors are paying close attention to their portfolio companies’ loan documents, with a particular focus on flexibility.
Being more mindful of flexbility can have a meaningful impact on managing a portfolio company’s capital structure, including ensuring adequate headroom when calculating compliance with financial covenants and maintaining flexibility when evaluating the feasibility of potential transactions that are subject to restrictions under the loan agreement.
Buyout and secondary buyout deal value in the US dropped to US$394.3 billion in 2022, down 45% year-on-year. Leveraged loan and high yield issuance for buyouts has been on a similar downward trajectory, falling 32% year-on-year from US$231.2 billion to US$157.3 billion in 2022.
The picture was similar in Western Europe, with buyout deal value in the region down 35% year-on-year at US$266.7 billion in 2022, and leveraged loan and high yield issuance for buyouts falling in Western and Southern Europe by just over a quarter year-on-year to US$71.8 billion in 2022.
Borrowing costs in both jurisdictions have climbed higher as deal activity has contracted, adding additional headwinds for sponsors. In the US, the weighted average margin on first-lien institutional loans in the primary market climbed as high as 4.85% in 2022, compared to less than 4% at the start of 2022, according to Debtwire Par. In Europe, average margins on first-lien institutional loans climbed from 4.29% at the end of 2021 to 4.75% by the end of 2022, peaking at 5.26% in Q3 2022.
Portfolio company management in the spotlight
As liquidity has tightened and deal flow has cooled, sponsors have dedicated additional resources to managing their portfolio companies’ credit facilities and to ensuring that they are well positioned to take advantage of certain terms and flexibility that were often negotiated with lenders during buoyant market conditions.
One way sponsors may unlock meaningful value is by focusing on the financial calculations submitted in their portfolio companies’ quarterly compliance certificates. Borrowers provide these certificates to lenders and administrative agents under the loan facilities along with their annual audited and quarterly unaudited financial statements. Lenders then use the information contained in the certificates to, among other things, evaluate a borrower’s performance and monitor whether a borrower is in compliance with certain leverage-based or interest coverage-based financial covenants. The information in these certificates is also used to determine whether borrowers have met certain financial tests before undertaking certain transactions such as debt and lien incurrence, investments, acquisitions, asset sales and dividends, among others.
Specifically, the compliance certificates, which are prepared and approved by a chief financial officer or another senior management member (and attached as exhibits to the loan agreement), provide lenders with an update on how borrowers are performing against certain financial metrics, typically through calculations of EBITDA, debt, debt-to-EBITDA leverage ratios, interest coverage ratios and excess cash flow. Importantly, the quarterly compliance certificates outline the various add-backs made to EBITDA and exclusions made to net income that are permitted when borrowers calculate the EBITDA figures reported to lenders. These financial adjustments are negotiated with lenders during the closing of the loan transaction and can have a material impact on the borrower’s reported adjusted EBITDA (which is often higher than the EBITDA reported in the borrower’s financial statements).
While quarterly reporting and the delivery of accompanying compliance certificates have always been a fundamental part of lending, portfolio companies and sponsors in buoyant markets may have the luxury of not always focusing on maximizing the impact of each adjustment that is available to them. If company earnings are growing steadily and borrowing costs remain low, borrowers often have ample headroom when determining compliance with their financial covenants and if they have greater flexibility under the other covenants contained in the loan agreement.
However, as market and industry conditions become more challenging, it is important for borrowers to review the flexibility provided by the financial definitions contained in their loan documents and to make sure they fully capture such flexibility, including maximizing any adjustments to EBITDA and net income, and ensuring that those adjustments are reported accurately in their quarterly compliance certificates.
In addition, working through these adjustments in detail can also enable borrowers to take advantage of other flexibility included in their loan agreements based on the calculation of the financial metrics reported in the compliance certificates, including interest rate margin step-downs (which allows a borrower to reduce its interest costs) and excess cash flow sweep percentages (which allows a borrower to allocate a smaller proportion of their free cash flows to pay down loans) if leverage levels are lowered.
Moreover, in a challenging market, it has become crucial for borrowers to understand the flexibility contained in their loan documents, including adjustments to financial metrics—and doing so before a covenant testing event or another potential transaction puts borrowers in the best position possible to manage their capital structure, avoid default and preserve flexibility going forward.
Bumpy ride for buyouts ahead
Financing for buyouts is expected to remain choppy in 2023 and sponsors will continue focusing on their portfolios as interest rate and inflationary headwinds persist.
Some sponsor-backed companies were able to secure financing early in 2023. However, for most buyout-backed issuers, syndicated loan and bond markets have remained effectively shuttered. Many underwriting banks are still unable to sell down debt to investors, clogging up pipelines for new deals. Bloomberg estimates loans worth around US$40 billion are still stuck in the system.
In 2022, direct lenders stepped in to fill the gap, taking on jumbo deals that would have otherwise been financed with syndicated loans or high yield bonds. A group led by Blackstone, for example, provided US$5 billion to help finance the buyout of software company Zendesk, while Ares and Blackstone, among other lenders, participated in a US$4.5 billion loan to finance an investment in Information Resources.
There are signs, however, that direct lenders are now starting to slow deployment after putting large amounts of capital to work in 2022. Direct lenders are still open for business but are more selective about the credits they will back and are scaling down the amount of debt they are willing to lend. They are also charging borrowers higher interest rates and asking for more covenant protection in loan documents.
Signs that inflation may be peaking in the US and Europe offer some light at the end of the tunnel, but credit supply is likely to remain tight in the near-term. Making sure that portfolio companies are focusing on any flexibility that their loan documents offer in connection with the delivery of compliance certificates or otherwise will remain a priority for buyout sponsors for some time.