Incremental debt holds steady in uneven loan market

With incremental loan activity accounting for an outsize share of the leveraged lending market over the past year, we explore the top trends, insights and structuring considerations for lenders and borrowers

Although syndicated lending activity was cool for much of 2023, incremental loan deals proved resilient, offering one of the few bright spots in a relatively subdued market. According to Debtwire Par, overall leveraged loan activity in 2023 was down 46% by volume and 17% by value year-over-year, while total incremental volume dropped only 14% and total incremental value rose by 6%. The share of the US leveraged loan market attributable to incremental loans increased 59% by volume (to 29% of lending activity) and 28% by value (to 12% of lending activity) compared to 2022.

For borrowers with preexisting loan facilities predating the interest rate hikes over the past two years, incremental loans offer an attractive path to obtaining additional liquidity without having to renegotiate existing terms, and with significantly lower transaction expenses when compared to establishing a new, standalone facility. However, access to an “accordion” does not guarantee that borrowers will save on the interest rate relative to the current market, as the terms of the incremental loans are uncommitted and therefore must be satisfactory to the lenders at the time of the upsize.

With incremental loans serving as an increasingly important source of capital, it is essential for lenders and borrowers to consider the following key trends and factors when contemplating or negotiating an incremental transaction.

I. Most favored nation provisions

“MFN” terms are one of the most heavily negotiated aspects of accordion provisions. These terms provide that if the yield on an incremental loan exceeds the yield on the existing loans by more than the maximum allowable difference (or “cushion”), the interest rate margin on the existing loans must be increased to remain within the permitted range.

For example, if the existing loans are priced at SOFR+350 bps and are subject to MFN protection set at 50 bps, pricing on the incremental loans cannot exceed SOFR+400 bps without triggering a requirement to raise the pricing on the existing loans. If the incremental loans have to be priced at SOFR+425 bps in order to clear the market, then pricing on the existing loans would need to be increased to at least SOFR+375 bps. (For ease of illustration, this example assumes that no other types of yield are involved. As described below under “Scope and flexibility”, an actual MFN determination would account for certain other types of yield (e.g., original issue discount (“OID”) or upfront fees).)

MFN terms vary from deal to deal, particularly as to the types of debt that will trigger the MFN, the cushion amount, and whether the MFN terms remain in effect for the life of the existing loans or “sunset” beforehand. Generally, a cushion of 50 bps is the most common in the US loan market, according to CovenantReview (although cushions of 75 or 100 bps have been seen when market conditions favor the borrower).

Meanwhile, MFN sunsets have declined in use since Q3 2022, when sunsets appeared in 75% of deals. In CovenantReview’s U.S. Trendlines report covering Q4 2023, only 31% of syndicated loans had a sunset, meaning more than two-thirds of loans featured MFN protection for life. For deals with a sunset, about two-thirds of those deals featured MFN protection for a six- or 12-month period, with the remainder featuring protection for 18 months or longer.

For borrowers looking to obtain incremental loans to finance an acquisition or other investment, finding a way to do so without triggering an MFN adjustment on their primary tranches of debt—especially if those tranches were established when interest rates were significantly lower—could make or break the economic rationale for the transaction. Borrowers in this position will want to carefully analyze what types of debt could be incurred without triggering MFN restrictions.

Scope and flexibility

In many cases, an MFN provision might only apply to incremental loans that are broadly syndicated, USD-denominated, floating-rate term loans, and (i) have the same priority in terms of both payment and security as the existing loans and (ii) mature within twelve months of the maturity date of the existing loans. A borrower subject to an MFN provision of this nature could incur other types of debt, such as secured or unsecured bonds, junior secured or unsecured term loans, payment subordinated term loans, fixed-rate loans or later-maturing term loans, without any pricing-related limitations.

Borrower-friendly deals might also exclude from MFN protection any incremental loans that (i) are incurred to finance acquisitions and other investments, (ii) are incurred under the fixed or “free-and-clear” basket and/or (iii) have a principal amount less than a specified level. Other, more creative approaches to incurring debt outside the customary MFN scope can also be envisioned. For example, if the MFN provision does not apply to debt that is junior in right of payment or security, partial subordination (e.g., a single mandatory prepayment that is subordinated or a lower-ranking lien on a single shared collateral asset) could be used to achieve a technically unequal ranking.

Moreover, MFN provisions may not capture all the various types of financial incentives that may be paid to lenders. Most MFN provisions only capture “all-in” or “effective” yield, which typically includes interest rate, margin, OID and upfront fees. MFN provisions often expressly exclude fees that are not customarily paid to all lenders such as arrangement, structuring, commitment, underwriting, ticking, success, advisory, placement, consent and amendment fees. However, whether a fee payment is considered an upfront fee versus an excluded fee may be open to interpretation. For example, in some cases, parties may consider re-characterizing an upfront fee as a “structuring fee” to exclude it from the yield calculation. This approach is not without risk of a disagreement among the parties, especially if the fee is paid as compensation for providing the incremental commitments and not for bona fide structuring or similar services.

Additionally, yield definitions are usually silent about the treatment of make-whole payments and other call premiums, while customary incremental provisions permit most terms of the incremental loans—including as to voluntary and mandatory prepayments—to be as agreed among the borrower and the incremental lenders. Accordingly, the parties could potentially use this flexibility, if available, to allocate a portion of the economics for an incremental loan to a make-whole premium in an amount that would have required an MFN adjustment if it had been paid as OID at the time of incurrence. In this example, the make-whole premium would need to apply to any voluntary or mandatory loan payment, including repayment at maturity. Though this payment structure may be subject to significant scrutiny and uncertain recoverability if the borrower files for bankruptcy, and these types of fees would be paid at maturity rather than upon the initial funding, incremental lenders who are confident in the strength of the credit and willing to defer their upfront economics might take on that risk.

Though less common, the yield definition in some credit agreements may only capture interest and other applicable economics that are “payable in cash”. This means that any paid-in-kind interest would not be subject to the MFN yield limitations, providing another potential pathway for compensating incremental lenders without triggering a pricing adjustment on the existing loans.   

Lastly, there has been a push from some financial sponsors to limit the yield definition to interest rate margin only. This idea originated from the European syndicated loan market but, as of February 2024, it has not gained meaningful support in the US loan market. That said, this will be a point to watch in the US loan market in 2024. If adopted, it will provide borrowers with substantially more latitude in structuring pricing terms to avoid the impact of MFN provisions.

Drafting considerations

The flexibility in typical MFN provisions described above could be reduced or eliminated with careful drafting. However, many current market formulations leave room for the incurrence of various types of debt and creative structures that are beyond the scope of MFN limitations.

Nonetheless, there are certain technical aspects of MFN provisions where all parties could benefit from more precise drafting to minimize the risk of future disagreements. For example, in deals where the interest rate margin is dictated by a leveraged-based grid, with margin step-ups at higher leverage levels and step-downs at lower leverage levels, it may be unclear whether an MFN determination should be based on the margin in effect when (i) the original transaction closed, (ii) the incremental transaction is signed, (iii) the incremental transaction closes or (iv) otherwise.

Similarly, it may be unclear whether it is permissible for the incremental loans to use a pricing grid with margins beyond the cushion amount for levels not then in effect, or how a multi-level pricing grid that applies to the initial loans will be treated in situations where the incremental loan is subject to a single, fixed margin. Though a fixed margin may initially fall within the MFN cushion, the spread could widen beyond the cushion if there are changes in the margin on the initial loans due to leverage fluctuations.

Another example is a “PIK toggle”, where a borrower may elect to convert all or a portion of the interest to be paid-in-kind, typically in exchange for a margin increase. As with pricing grids, loan terms may be unclear about how a PIK premium is to be accounted for in an MFN determination. One potential solution when dealing with pricing grids, PIK toggles and similar mechanisms is to clarify that, for MFN purposes, the yield determination is based on the interest rate margin in effect when the incremental loans are incurred, without giving effect to any potential future pricing changes.

An additional example is when a borrower wishes to incur additional incremental loans when one or more series of incremental loans exists. Though both the initial loans and preexisting incremental loans may feature the same margin and be considered “fungible” (i.e., treated as a single tranche for trading and tax purposes), their yields may be slightly different due to differing OID. In these cases, it may be unclear from the loan agreement whether the MFN determination is to be made based on the yield of the original loans or the preexisting incremental loans, or some blend of the two. The agreement should at least make it clear that the yield on the incremental loans cannot exceed the level permitted by the MFN protections applicable to the initial loans, regardless of the yield on any intervening incremental loans. Otherwise, the original lenders would have their MFN protection diluted due to subsequent transactions that may have been implemented without their consent.

Lastly, in cases where incremental loans may have a lower yield than existing loans, one protective measure for incremental lenders is to provide that future MFN determinations are to be made based on the lowest yield on the initial loans and the incremental loans, in order to prevent the spread between the different series of incremental loans from exceeding the agreed upon MFN cushion (though borrowers may assert this approach could provide the lenders of the initial loans with a windfall).

“Life to Maturity” conventions

Parties may also encounter uncertainty regarding the treatment of OID and upfront fees in MFN determinations arising from “life to maturity” conventions.

Customarily, the yield definition for MFN purposes provides that OID or upfront fees are to be equated to interest rate assuming a four-year life to maturity. For example, consider a series of initial loans priced with a 350 bps margin, featuring 100 bps of OID, and subject to MFN protection set at a 50 bps cushion. The yield definition would treat that OID amount as additional margin spread across a four-year period (i.e., 25 bps per year)—regardless of the actual remaining time until maturity—resulting in a total yield of 375 bps for MFN purposes. With a 50 bps MFN cushion, the yield on incremental loans that are subject to MFN limitations could be as high as 425 bps without triggering an adjustment.

Now, imagine that incremental loans are being incurred with only two years remaining until the maturity date of the loan facility. Despite the shorter actual life to maturity, the yield definition would still deem any OID on the incremental loans to be spread across a four-year period. Therefore, if the incremental loans feature a 350 bps margin and 300 bps of OID (which equates to 75 bps of margin) for an all-in-yield of 425 bps, they would technically be within the MFN cushion.

Although loan agreements now often address this point by providing that the treatment of OID and upfront fees is to be based on the lesser of a four-year life to maturity and the actual remaining life to maturity, this approach is not universal and is especially uncommon in older agreements.

Moreover, in the European syndicated loan market, there have been attempts to shorten the default life-to-maturity period from four years to three years. Even though this change would have little impact on agreements featuring the “lesser of” construct noted above, for other agreements, it would mean that any OID would be spread over a shorter period, resulting in a higher yield calculation. In the above example, if the yield definition used a three-year life-to-maturity convention, the initial loans would have a yield of 383.34 bps (rather than 375 bps), meaning that the incremental loans could have a yield of up to 433.34 bps (rather than 425 bps) without triggering MFN protection (although, assuming the margin of the incremental loan remained the same, the incremental loan would have to be priced with no more than 250 bps of OID (rather than 300 bps) to remain within the MFN cushion).

II. Accordion basket sizing and construction

In addition to MFN terms, the structure and sizing of baskets governing incremental loan capacity are key focus points in loan agreement negotiations. Typically, these baskets provide that incremental debt can be incurred up to a specified “free-and-clear” amount (i.e., capacity that is not subject to a leverage test, which usually includes a “starter” based on the greater of a (i) dollar amount and (ii) percentage of EBITDA, and then adds the amount of certain voluntary debt prepayments), or in an unlimited amount subject to pro forma compliance with certain leverage ratio tests.

According to CovenantReview’s U.S. Trendlines reports, the average “starter” amount in US syndicated loan transactions in Q4 2023 was set at a dollar amount equal to 1.01x pro forma LTM EBITDA. This level represents an increase over the average level from the same period in 2022 when it dipped to 0.94x, but a decrease from the highs of Q1 2022 when it approached 1.40x. Moreover, the “greater of” construct mentioned above—with an EBITDA-based grower prong in addition to the fixed amount—appeared in 85% of US syndicated deals in Q4 2023, continuing the trend over the past couple of years of this construct appearing in the vast majority of US syndicated deals. There has, however, been some tightening of the grower level over that period. In Q4 2021, over 80% of deals with a grower prong used a setting at or above 100% of EBITDA. Recently, only a handful of deals included a grower set above 100% of EBITDA, with the setting right at 100% of EBITDA being the most common.

The ability to grow the “free-and-clear” amount through certain voluntary debt prepayments is also a negotiated point, specifically as to the types of debt that may be eligible for credit if prepaid. In the most conservative examples, credit is given only for prepayments of the initial loans and any pari passu incremental debt previously incurred in reliance on the “free-and-clear” amount, with prepayments in the form of buybacks credited at the amount paid by the borrower in cash (rather than par value of the purchased debt) and with no credit given for prepayments funded with other long-term debt. More flexible formulations might give credit for prepayments of any pari passu debt (creating the theoretical possibility that a borrower could incur pari passu debt under a ratio-based basket, prepay it shortly thereafter, and reserve the resulting additional “free-and-clear” capacity for a time when it may not be in compliance with a ratio-based basket) and/or credit buybacks at par value of the purchased debt even if bought at a discount.

Additionally, some borrowers in the syndicated loan market have successfully added the ability to reallocate available capacity under general, dollar-capped debt baskets to the “free-and-clear” incremental amount. Since these general debt baskets can sometimes only be used to incur junior secured or unsecured debt (depending on the existence and construction of any applicable lien baskets), this feature allows a borrower to bypass any limitations on ranking and instead use the capacity to incur pari passu secured incremental debt.

III. The incremental lender pool

Notwithstanding the degree of incremental pricing flexibility and incurrence capacity that a borrower may have secured in its initial loan agreement, it will still need to find one or more lenders willing to provide incremental loans. To that end, in 2023, there was significant growth in the number of private credit and “direct” lenders providing incremental debt.

Given that direct lenders typically hold their loan positions rather than selling down through a syndication process, they may, in certain cases, expect more conservative terms and/or higher pricing relative to any initial loans that were broadly syndicated. As noted above, most of the terms of incremental loans are permitted to be as agreed among the incremental lenders and the borrower. Traditionally, loan agreements do not allow an incremental facility to have a covenant package that is more favorable to the incremental lenders (often measured “in all material respects”) than the terms in the original credit facilities without the consent of the agent or lenders. However, many modern loan agreements allow for this flexibility if the more conservative terms (i) are also provided for the benefit of the existing lenders, (ii) only apply after the initial maturity date and/or (iii) reflect “market terms”. For loan agreements without this flexibility, borrowers may not want to shoulder the cost and administrative burden of seeking consent to add lender-favorable terms to existing tranches if not otherwise required, especially if fungibility between the tranches is not a priority.

Where more conservative terms only apply to the incremental tranche, questions may arise about what impact this misalignment might have on the enforcement regime for the entire facility. For example, if a borrower defaults under a provision that solely applies to the incremental tranche, are all the lenders still entitled to accelerate and/or pursue remedies? Or do the incremental lenders have sole authority to take enforcement actions on the basis of that type of default?

If the terms are unclear, different interpretations are possible, which could lead to disagreements within the lender group. One solution is to provide in the incremental amendment that the incremental lenders have sole authority to amend any terms that apply only to the incremental tranche but that, if a default occurs thereunder, remedies can only be exercised by the broader lender group. Thus, incremental lenders receive the stricter terms they expect, while (i) avoiding the onerous consent process that may be required to add those terms for the direct benefit of other tranches and (ii) reducing the potential risk that could arise from an amendment that arguably modifies the enforcement mechanics applicable to the entire facility.

IV. Fungibility and amortization adjustments

In many cases, the parties may want to ensure that the incremental loans are fungible with the existing loans for U.S. federal income tax purposes. If fungibility is a priority, the incremental lenders must be willing to lend on the same exact terms as the existing loans. Accordingly, if the incremental loans are fungible, the incremental lenders may not be able to obtain improved terms or pricing (subject to a limited amount of OID permitted under U.S. tax laws). Nevertheless, achieving this treatment may be preferable. For example, a single pool of fungible debt tends to trade more freely than separate smaller tranches, enhancing liquidity and therefore pricing. Also, fungible debt is preferable for tax reporting and accounting purposes. An overview of the U.S. tax fungibility rules is beyond the scope of this article, and parties will typically need to consult with financial advisors and tax counsel to provide guidance on each situation.

For fungible incremental loans, the parties also usually need to make appropriate adjustments to the amortization payment amount for the combined tranche. Unlike the fungibility determination, the amortization adjustment is not a tax issue, but is necessary to ensure that the incremental loans comply with the loan agreement terms. Without an adjustment, the dollar amount of the existing lenders’ pro rata share of amortization payments may be less than what they received prior to the incremental loan transaction, as it is calculated based on the aggregate tranche size and then divided among the existing and incremental lenders. Such a reduction would typically violate the amendment provisions of the credit agreement (absent unanimous consent of affected lenders, which is not likely to be obtained). To resolve this issue, the amortization rate needs to be increased to a percentage that results in the initial lenders receiving amortization payments in the same dollar amount as they did prior to the incremental transaction. The calculations must account for previous amortization payments and any voluntary or mandatory prepayments that have been made and should be determined in consultation with the borrower’s financial advisors.

V. Incremental delayed draw term loans

The parties should also exercise care when negotiating the ability to establish delayed draw term loans (“DDTLs”) pursuant to incremental provisions. In certain transactions, the borrower has been granted the discretion to decide whether capacity for the incurrence of incremental DDTL commitments is to be tested at the time of (i) funding or (ii) commitment. Both options raise potential concerns for existing lenders.

If capacity is only tested at the time of funding, a borrower could obtain incremental DDTL commitments regardless of when or if the borrower is able to draw on them in compliance with a permitted ratio-based incremental amount. A borrower could use this flexibility strategically to overcome hurdles in obtaining lender consent by diluting the voting power of existing lenders. For example, if the calculation of the lender majority includes undrawn DDTL commitments, a borrower could secure those commitments from new, cooperative lenders to obtain approval for a transaction that lacks sufficient support from existing lenders. To address this risk, some loan agreements (i) expressly exclude any undrawn incremental DDTL commitments from majority lender consent determinations, (ii) provide that undrawn incremental DDTL commitments can only be included in a “Required Lender” vote if the borrower would be able to draw on those commitments at the time of determination or (iii) require compliance with the ratio incurrence test at the time of the establishment of the DDTL commitments.

If capacity is only tested at the time of commitment, “debt stacking” rules could result in the borrower carrying a more significant debt load than lenders anticipated. For example, a borrower could: first, obtain a DDTL commitment up to the permitted ratio-based incremental amount, as tested at the time of commitment; second, incur debt under a general, ratio-based basket that may not pick up the DDTL commitment if it remains undrawn; and third, draw down the DDTL commitment without any further ratio test (i.e., even if the intervening debt incurrence and/or other circumstances mean the borrower would no longer be in compliance with the ratio test that governed the creation of the DDTL commitment). To avoid the drawing of DDTLs at a time when the business may already be over-levered, some incremental lenders have sought to impose a leverage ratio-based draw condition on incremental DDTLs that aligns with the ratio-based incurrence test for incremental facilities (with the waiver of such condition requiring majority incremental lender consent). Lenders may also seek protection by requiring that all ratio-based debt incurrence tests deem any undrawn commitments to be fully drawn, which could limit the borrower’s ability to stack debt in the manner described above.

Outlook for 2024

Looking ahead in 2024, ease of execution will continue to make incremental debt a compelling option for borrowers seeking debt capital, especially if high interest rates persist. In situations where borrowers face a challenging MFN profile, it may become more common for the limits of flexibility in these provisions to be tested. And if the syndicated lending market continues to experience volatility, there will likely be more examples of incremental loan funding coming from private credit lenders sitting alongside broadly syndicated debt.

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