An important building block of mid-market leveraged finance documentation is the concept that certain activities of a sponsor portfolio group are restricted. These include: disposals, incurrence of financial indebtedness, granting security over assets, providing guarantees, lending, and payment of dividends / subordinated debt. However, the market standard documentation recognises the need for operational flexibility and for certain categories of “leakage” which ought to be permitted. Hence the inevitable focus of negotiations on the list of exceptions or “Permitteds”, as set out in the definitions clause.
These Permitteds typically fall within three broad categories:
- those that are market-standard and universally accepted as being necessary in order for any business to operate effectively, comply with regulation or trade day-to-day;
- those that are business-specific and are accepted by the lenders on the basis that they are justifiable leakages given the nature of the group and its assets and trading operations; or
- broad general baskets for leakages not falling within a specific permitted under the first two categories but with which lenders are comfortable on the basis that such leakages are capped at a fixed amount (or, more unusually in the UK mid-market, as a percentage of the then prevailing EBITDA).
It is the third category that is commonly referred to as the “basket” (and is typically the final limb in the relevant Permitted). To take the restriction on incurrence of financial indebtedness as an example, the lender group may decide that a number of specific exceptions to the general prohibition are acceptable, such as the debt specifically subordinated under the intercreditor, non-speculative treasury transactions, legacy debt incurred by an acquired entity if removed within three months, and finance leases in line with the group’s operations. The lenders will also then permit a basket of a set monetary amount for all financial indebtedness not falling within such categories. The size of this basket will depend on the size of the business.
As with much of the terminology that has its origins in the US large-cap market, there can be some merging of related but distinct terms, with the danger that, once they cross the Atlantic and/or the large-cap/mid-market threshold, the best features of each are cherry-picked to the advantage of the party drafting the relevant clause. It is therefore important to be clear about the differences between terms that are often used interchangeably.
Although the term “builder basket” is often used in the mid-market, it is relatively rare to see a true “builder” basket. In its pure form, a builder basket measures available cash (or retained excess cashflow) and permits the use of such funds as an additional exception to the covenants that would otherwise restrict their use. The Permitteds to which such funds might be applied are typically limited to payment of loan notes and dividend payments out of the group.
The clear tension in the UK mid-market is that borrowers would typically be looking to minimise the excess cashflow amount (from which retained excess cashflow is derived) in order to minimise the amounts that are required to be used to service principal payments under the senior debt under the mandatory prepayment clause. However, given that many lenders are now relaxed about (and averse to in the case of some credit funds) receiving prepayment, we do see builder baskets “by the back door” through a more relaxed Permitted Acquisition/Permitted Payments regime where the source of funds for such Permitteds is “Unrestricted Cash” (one component of which might be Retained Excess Cashflow).
Infuriatingly at times for those participating in the mid-market, the term “grower basket” is used most frequently to describe a “scalable basket” (see below). In its true form, a grower basket simply adapts a hard-cap basket amount by making that amount variable only to the extent that it is lesser than a given percentage of EBITDA. So, for example, if the hard cap is set at £500,000 at the outset, with opening EBITDA of £5,000,000, for argument’s sake, the basket cap might be the greater of the hard cap and 10% of EBITDA, such that any increase in EBITDA from £5,000,000 to £6,000,000 will allow the borrower to increase the basket cap from £500,000 to £600,000.
By far the most common tool in this area, the scalable basket takes the capped basket referred to above and allows it to fluctuate with EBITDA. For example, if the Permitted Financial Indebtedness basket is £500,000, the scalable basket mechanism would allow that hard cap to increase upon EBITDA growth reaching a threshold amount, such that if, for example, EBITDA increases by 10% or more, the basket will increase by a proportion amount.
The crucial point here is that, unlike grower baskets, scalable baskets require scale; for instance EBITDA has to increase above a given threshold before the basket increase is activated. In this sense, it resembles a “staircase” movement with upward growth available at set intervals, distinct from the slope-like movement of grower baskets. The main variable that we see in the market is that increases in EBITDA can either be tied to EBITDA as at a previous date (12 months prior or the last quarter date) or (less commonly) against EBITDA as predicted by the base-case model.
Carry forward/carry back
The ability to “carry forward” those baskets which are measured on the basis of a set amount for a given financial year is well-established in the mid-market, and is often combined with a scalable basket. A built-in ability to “carry back” basket amounts from future years is a much more controversial flexibility. Lenders often view this as facilitating a borrower group in living beyond its means and are therefore much less likely to accommodate such a request.
What to watch out for in mid-market negotiations around scalable baskets
- Although an ability to “carry forward” is commonly seen in documentation, the key focus for lenders in relation to this concept is an ability to restrict continuous rolling of surplus basket from year to year, hence the familiar (and generally-accepted) idea that carried forward amounts should be used last in the next following year (in other words, after the basket allocated specifically to that year), and not carried forward more than once.
- It will be important at the outset to agree the baskets to which any scalability will apply. This is particularly true where there is already an ability to aggregate baskets (for example, Obligor Leakage Amounts across Obligor to Non-Obligor baskets). A combination of basket aggregation, carry forward and scalability could – if manipulated in a certain way – give rise to greater than expected leakage in any given year from a single limb of a Permitted.
- An obvious (but not always noted) point is that, regardless of whether scalable (or builder/grower) baskets are present, lenders and borrowers will still wish to ensure that the day one basket amount is appropriate to the business. From a lender’s perspective, an overly generous day one basket could, especially in the presence of scalability, give rise to excess leakage from the group over the course of the life of the facilities. From a borrower’s perspective, the flexibility that scalable baskets can introduce should not be relied upon, as the EBITDA growth on which they are based is not guaranteed.
- Where documentation allows an ability for baskets to increase in line with percentage increases in EBITDA, it will be important to be specific as to the base from which such percentages are calculated. For example, if baskets can increase by 10% if EBITDA increases by 10%, and then subsequently by 10% upon a further 10% increase in EBITDA, it may make a material difference over the life of the facilities whether the 10% increase is always measured against the opening basket amount or (much more flexible) against the new increased compound amount.
- If receptive to the idea that baskets should flex over the course of the life of the facilities, lenders will be keen to ensure that such basket flexibility also tracks any downward movement in performance of the group. Although that may be conceptually acceptable to sponsors and borrowers, they will be wary of any such mechanism which allows flexing of baskets below the initial cap negotiated at the outset. Furthermore, borrowers will want to make sure that transactions, which have already taken place/been agreed to, should be grandfathered. For example, borrowers would typically view it as unjust for indebtedness incurred at a time when baskets were at a certain level to subsequently trigger a default as a result of a subsequent dip in EBITDA (and therefore basket size).
Scalable baskets (and their related concepts) can be useful tools in the UK mid-market in order to facilitate the flexibility that fast-growing companies need, but in a way that lenders are able to monitor, control and ultimately accommodate. Please get in touch with Laurie Keel, Max Millington or your usual OC leveraged finance contact if you would like to discuss further.