In today's economic environment, the investors' search for yield has been well documented, as the demand for debt investments has outstripped supply. This has increased the pressure to limit debtholders' protections. Coupled with price compression, this trend has helped reduce the risk to private equity firms and other buyers in making acquisitions. The use of "covenant-lite" debt structures gives buyers more latitude in dealing with acquired businesses.
Historically, high-yield debt has required only that a company satisfy a financial covenant as a condition of entering into a transaction, typically the incurrence of additional debt.
While high-yield debt uses such incurrence covenants, leverage loans require that a company maintain compliance with a leverage ratio, interest coverage ratio, fixed-charge coverage ratio or other financial covenant measured at the end of each fiscal month or quarter, referred to as maintenance covenants.
High-yield debt uses incurrence covenants because its longer term needs to allow for the possibility of more significant changes in the underlying business, it is harder to obtain waivers since it is usually widely held, and the higher quality of companies using the high-yield debt and the higher pricing of high-yield debt has warranted more risk for holders of that debt.
Regardless of the reasons for this distinction between high-yield debt and leverage loans, the use of covenant-lite structures for leverage loans has recently skyrocketed.
The availability of leverage loans with this structure provides an additional incentive to buyers of businesses to access the leverage loan market as a source of funding for acquisitions since it lowers the risk of default should trouble occur.
In addition to using incurrence tests as a condition for allowing additional debt, they are also used in leverage loans to allow a company to pay dividends or make optional prepayments of debt or an acquisition. When term loans are paired with a cash flow revolving facility, in a covenant-lite structure, the revolving facility may have a springing financial covenant that is tested only when certain conditions occur, most commonly when the outstanding loans under the revolving facility exceed a specified amount.
While perhaps overshadowed by the convergence of high-yield debt and leverage loans in the use of covenant-lite structures, the use of such structures is also the most striking point of convergence between leverage loans and asset- based lending.
The use of incurrence tests and springing financial covenants has been commonplace in the large, syndicated asset-based lending market, but with some differences.
Historically, asset-based lending made limited use of financial covenants. Today, in the larger asset-based transactions such limited use has led to a fixed-charge coverage ratio as the only financial covenant often set only at a level of 1:1 or 1.1:1, and tested when excess availability is less than an agreed amount. Excess availability, a critical tool for asset-based lenders, is the amount that a company may borrow under its asset-based facility based on the difference between its borrowing base and the then outstanding loans. The borrowing base is derived from a specified percentage of eligible accounts receivable, eligible inventory and/or other assets that are acceptable for such purpose.
Other aspects of leverage finance adopted by asset-based lenders in the higher end of the market will include versions of incremental facilities, unrestricted subsidiaries and equity cures, just as in the leverage loan market. In larger asset-based facilities used to finance acquisitions, "SunGard" provisions, material adverse-effect conditions using the definition from the merger or stock purchase agreement and limited flex rights for the arranger appear, just as in a leverage finance commitment. Asset-based facilities will commonly incorporate defaulting lender and tax provisions from the "Model Credit Agreement Provisions" published by the Loan Syndication and Trading Association.
Despite these similarities there are some key differences between the leverage loan and the asset-based loan. One difference, besides the use of excess availability rather than usage to trigger the springing financial covenant, is that the financial covenant in an asset-based facility will most often be monthly.
Another difference is that while a covenant-lite structure may only be available to the higher-quality cash flow borrower, an asset-based facility using a springing financial covenant and incurrence tests will be available to a wider range of companies. In this fashion, a potential business acquirer may be able to get the benefit of a covenant-lite structure using an asset-based facility, while it would not if it were to use a leverage loan.
An asset-based facility will require regular reporting of the borrowing base and periodic field examinations and appraisals, giving the company an opportunity to develop a working relationship with the lender, which is not necessarily the case for a leverage loan. As with the financial covenant, here too, asset-based lending offers companies flexibility so that the frequency of such reporting may vary depending on the amount of excess availability, with less frequent reporting if excess availability is above an agreed level. However, the asset-based lender will most often require receipt of monthly financial statements. In an acquisition, the discipline of such reporting may be particularly desirable for a new owner as it works with the newly acquired business.
In a commitment letter, leverage finance and asset-based lending often treat the company's obligations to reimburse the lender for expenses differently. In leverage finance, the arranger will absorb its expenses if the transaction does not close.
In an asset-based transaction, the company will be expected to reimburse the lender regardless of whether the transaction closes since the initial expenses for an asset-based facility are significantly greater than for a cash flow facility. This requires legal work from third parties to address collateral issues. Not to mention that fees paid to the arranger in a cash-flow facility are significantly greater and the asset-based facility is less expensive. Accordingly, it is easier in a cash flow facility to absorb the costs of transactions that do not close.
While the value of the collateral is the basis for asset-based lending, cash flow is still important. It is a common misconception that liquidity is not relevant. A lender will not provide a credit facility if it anticipates that the company will run out of money. The pricing, the exceptions from the negative covenants, the term of the facility and other provisions of a credit facility are based on the relative risk of the facility which is driven by the probability of a liquidation, which in turn relates to liquidity. A facility might have not have been approved or might have been approved on different terms if the projections had not shown the ability to generate a certain amount of Ebitda relative to fixed charges.
While there has been a convergence of attributes of high-yield debt, leverage loans and asset-based lending, in examining financing alternatives, a business acquirer should understand the similarities and differences, particularly when some of the additional monitoring of an asset-based facility and lower risk of financial covenant default may be advantageous.
David Morse is a member of New York law firm Otterbourg PC and head of the firm's finance practice.