Why the change?

The key driver for this change was neatly summarised by Gillian Tett in the Financial Times on 25 April. "American hedge funds and other non-bank credit investment groups now hold just over 50% of all lending to risky European companies – pushing banks into a minority role in this sector for the first time."

A covenant-lite credit agreement is one which includes a covenant and default package similar to or based on the covenant and default package used in high yield bonds. This high yield bond covenant and default package has a fairly set pattern, just as a traditional banking covenant and default package for a leveraged credit agreement has a reasonably set pattern. But this is not to minimise the fact that individual covenant and default packages will be individually negotiated. And there is a spectrum. Transactions are not necessarily based on the classic bank package or the classic covenant-lite package. They can also fall somewhere in the middle – what might be called covenant loose, or hybrid. And, even if the package looks similar and uses the same or similar defined terms, the actual definitions can vary. It is essential to understand the detail of the definitions.

The changing investor base

Key to these developments has been the growth of non-bank lenders in leveraged deals. The explosion of this class of lender has had a number of significant effects on deal structures and documentation, particularly in terms of tax and security issues, public/private side information issues and also in what have become known as the "syndicate management" provisions such as "snooze you lose" and "yank the bank". These syndicate management provisions seek to deal with the issues arising from having large syndicates where not all lenders are sufficiently well resourced to respond promptly to requests for consents or waivers.

If the main group of investors who are going to invest in a particular credit are funds that:

• may not want to receive the non-public information on the basis of which the banks would have granted amendments or waivers
• may not respond to a request for an amendment or waiver, then there may be good reasons to use a covenant-lite package; particularly if most of those investors are also frequent buyers of high yield bonds and, therefore, presumably comfortable with a high yield covenant and default package. But that does not mean it is the best option for all credits – for instance, the suitability of a covenant-lite package will need to be carefully considered in the case of a credit that includes large revolving credit facilities or capex lines, which are typically provided by banks rather than non-bank lenders.

Elements of the "lite" covenant package

Set out below is a brief overview of a typical high yield bond covenant package as it applies to a covenant-lite deal.

Restricted and unrestricted subsidiaries

In most high yield deals there is an underlying concept of a "restricted" group consisting of the borrower and those of its subsidiaries that are designated restricted, and the rest of the subsidiaries that are "unrestricted". There may be a requirement that subsidiaries accounting for at least a defined percentage of EBITDA or assets be restricted. The idea is relatively straightforward. There must be a core group of restricted companies (including the borrower), and it is the financial position of that group that forms the basis for any financial ratio test. Subject to conditions, the borrower is free to designate a subsidiary as unrestricted.

The financial ratio used as a basis for a number of provisions is likely to be either the fixed charges coverage ratio (EBITDA to interest expense and dividends) or the leverage ratio (debt to EBITDA). Whatever test is used it is necessary to examine the detail of the definitions. What goes into EBITDA? Typically the borrower can disregard exceptional, unusual or non-recurring items in establishing defined EBITDA, which gives the borrower some scope for designating items of expense in a way which allows it to maximise the defined EBITDA. The definition of debt or, more particularly, the types of debt incurrence that are to be disregarded, will also give the borrower considerable freedom. It is essential to understand the definitions and how they are used.

Debt incurrence

Borrowers do not want a fixed charges cover ratio or a leverage ratio that is tested all the time – a "maintenance" covenant, which exposes the borrower to the risk of default if, for example, EBITDA declines as a result of trading conditions or a delay in the delivery of the sponsor’s business plan.

High yield bonds use an "incurrence" covenant. This will provide that the borrower cannot incur debt (as defined, and subject to a long list of exceptions) unless the chosen financial ratio is below a stated level. Therefore, as EBITDA increases, the ability to borrow increases. Conversely, the covenant is not tested unless the borrower seeks to incur further "ratio debt". If the borrower lists out all possible incurrences of debt that are likely to occur and provides that these are all to be disregarded, it may be a long time before the covenant is tested (if it is tested at all).

The treatment of any revolving credit or capex facility is key. Given that institutional investors will have limited appetite for undrawn facilities, these facilities need to be structured in a way that attracts sufficient liquidity from the bank market. In some deals a quarterly maintenance covenant applies to these facilities, and in others, an incurrence covenant must be complied with as a condition to any drawdown of these facilities. Both these solutions give additional comfort to the bank lenders, but somewhat dilute the benefit of a covenant-lite deal for the borrower. One solution has been to grant "super priority" status to the revolving credit and capex facility, so trading maintenance covenant protection for a higher ranking in a workout or enforcement.

The chosen ratio also applies to restrict other actions, such as making a restricted payment, as considered below, as these actions are prohibited unless the borrower and its restricted subsidiaries would be able to incur an additional nominal amount of indebtedness at the time (and after) those actions are taken.

Negative pledge and additional secured debt

In an unsecured high yield bond deal the negative pledge will provide that no security can be given to any other lender (apart from the senior credit facility and certain limited carve-outs) unless equal and rateable security is given to the bondholders. If the other secured obligations are discharged, then the security for the note holders is discharged as well. A borrower may now focus on the possibility of raising additional debt if the debt incurrence ratio allows. It will know that, if it is to do that, the chances are that it will have to grant security for the additional debt. So additional carve-outs are needed to the negative pledge to allow the borrower to raise unsecured, second secured or equally secured debt. The amounts the borrower can raise by each method will be limited by its ability to meet a pro-forma ratio. In some deals, different ratios are set for the unsecured, second secured and equally secured amounts.

There are also practical issues regarding security that have to be thought about. How, mechanically, will the new money get the benefit of the security? The most straightforward and structurally best way is for the new money to share in the security already held by the senior lenders. Hence the inclusion of "accordion" facilities within the senior credit agreement. These can either be uncommitted lines, or mechanics to facilitate the incorporation of additional facilities at a later date.

Limit on restricted payments

This is essentially a dividend restriction, but it also controls investments in entities that are not restricted subsidiaries or the retirement of debt subordinate to the bonds.

The basic rule can be: no dividends unless:

• no Event of Default
• after paying the dividend the borrower would still be able to incur a nominal amount of indebtedness (which brings in the debt incurrence test)
• the dividend can be paid out of a defined cash and profit pool. The cash and profit pool is made up of the aggregate of
  
  • a specified percentage of net profits
  • specified percentages of disposal proceeds from specified assets (less any amount invested by the borrower in specified assets). Cash available for dividends and most investments has to come out of the same pool.

Limit on sales of assets

These are permitted, but only if the disposition meets certain criteria: a stated minimum percentage of the consideration must be cash, the value obtained must be fair value, and the proceeds must be used in a specified way. The proceeds must either be used to re-invest (but often only in specifically allowed kinds of asset or investment) or pay down debt. How debt reductions are to be applied between senior and junior debt will be defined.

Limit on selling interests in subsidiaries

Apart from an outright sale of a subsidiary (which would have to comply with the covenant dealing with sales of assets) the borrower is not allowed to dispose of shares in subsidiaries except in circumstances where it retains more than a 50 per cent interest.

Limit on guarantees

Neither the borrower nor any restricted subsidiary can guarantee the obligations of an unrestricted subsidiary. Guarantees of the obligations of the borrower or restricted subsidiaries are allowed but:

• the notes debt must be guaranteed as well and
• if the guaranteed debt is subordinated, the guarantee must be subordinated.

Limit on restrictions on distributions by restricted subsidiaries

The borrower and its subsidiaries may not enter into arrangements that might restrict the flow of dividends up from subsidiaries.

Change of control

In a traditional leveraged senior deal, a change of control triggers an automatic mandatory prepayment of all lenders. In a classic high yield bond deal, a change of control obliges the borrower to offer to prepay, so that those bondholders that wish to exit the credit may do so, typically receiving a premium of 1 per cent of the amount prepaid. The difference between the two approaches is that in a classic senior deal the starting position is that the borrower has to prepay all lenders – it has to seek a waiver from the lenders to avoid prepaying them all; but in a bond deal it only has to prepay those who want to be prepaid. The covenant-lite deals that have appeared to date in Europe have taken the classic senior route on change of control.

Limit on merger, consolidation and sale of assets

Consolidation and merger is allowed, but only if the successor company can meet defined requirements which will include a requirement that a nominal amount of debt can be incurred, so as to activate the incurrence ratio test.

Limit on transactions with affiliates

There are provisions designed to make sure that transactions with affiliates are on arm's-length terms and, if for more than certain amounts, approved by the board of the borrower or an independent financial adviser.

Anti-layering

In senior subordinated deals, the borrower will not be allowed to layer in debt between the senior and senior subordinated debt. There may be requirements to bring newly incurred debt into an existing intercreditor arrangement. Otherwise, existing layering or subordination must be maintained.

No payments for consents

The borrower is not allowed to make any payments to lenders to induce consents unless they offer to pay the same amount to all lenders who give the consent in the time requested.

Changes to business activities

There will often be a general limit on the kind of business the borrower and its restricted subsidiaries (as a whole) can undertake. This is no different to a typical bank deal.

Cross-default v cross-acceleration

Bank loan agreements classically include cross-default rather than cross-acceleration. A covenant-lite deal which is based on a high yield package is likely to provide for cross-payment default, and cross-acceleration for other defaults.

Achieving investment grade status

There will sometimes be provisions suspending a significant part of the covenant package if the obligations are given an investment grade rating.

Transferability

As noted above, the covenant-lite package in a credit agreement is designed to appeal to (or at least be acceptable to) non-bank investors who are used to investing in high yield bonds. Lenders will therefore want to be sure that they can transfer their interests in the loans to that type of investor. But borrowers have been looking to restrict transfers with a view to preventing distressed and other "value" investors purchasing debt in a workout, with a view to obtaining control of the borrower group. Therefore, there is presently a tension between borrowers pushing for covenant packages that are more acceptable to non-bank investors than traditional bank lenders and, at the same time, seeking to control the access of non-bank lenders to their lender groups. In a high yield bond, there would be no restrictions on transfer.

An evolving market

The covenant-lite market is currently in its infancy in Europe, and a market standard approach to covenant-lite documentation has not yet emerged. Some deals have taken a traditional senior bank deal as their starting point, with covenant-lite elements added in, such as the removal of maintenance financial covenants, and the inclusion of the ability to incur ratio debt. Other deals have gone further towards the high yield model, with all the undertakings heavily based on a high yield package. The market is likely to continue to evolve before a "standard" approach emerges, and in any event, the suitability of a particular approach will in part depend on the other elements of the capital structure of a particular deal. For example, if a deal has a high yield bond, then sponsors are likely to be attracted to having a senior bank piece with a consistent covenant package. In other cases, the size of revolving credit and capex facilities will demand other solutions to ensure that bank market liquidity remains available for the undrawn parts of the deal.

Covenant-lite represents another step in the convergence of the loan and bond markets. It has been made possible by the changing investor base in the European leveraged loan market and the strong distribution focus of the leading debt arrangers. Given the obvious attractions for sponsors of freedom from maintenance covenants and the ability to incur additional debt on the upside, it is likely that we will continue to see covenant-lite deals coming to market for as long as there is sufficient liquidity in the institutional investor base. There are a number of variations on the covenant-lite theme currently in the market, but as more of these deals continue to come to market it is likely that we will start to see the emergence of a European market standard for the way these deals are documented.