The proportion of mid-market leveraged (and increasingly corporate) deals done on a super senior / unitranche basis has increased dramatically over the last few years. However, there are dangers in revisiting precedent deals and applying the intercreditor principles from those deals to future transactions in which the intercreditor dynamics and the characteristics of the underlying credit may vary significantly.
The rise of unitranche financing
In recent years, the UK mid-market has seen a proliferation in the number of sponsor-backed (and increasingly event-driven corporate) transactions which are financed on a super senior – unitranche basis. Such structures typically involve provision of non-amortising term debt by a credit fund (the 'unitranche' provider), with such facility ranking junior (in a post-enforcement scenario) to 'super senior' facilities. These are typically either a standalone RCF or a combination of working capital, capex and/or drawn term debt (the so-called 'first out' facility) provided by a clearing bank. The less risky 'first out' position of the super senior facilities following enforcement is reflected in the relatively low returns (in terms of margin) that the super senior lender can expect to receive as compared to the returns to which the unitranche lender is entitled.
There are clear advantages from a deal execution perspective in ensuring that there is no risk of 'the tail wagging the dog'. Super senior vs unitranche points will be of peripheral concern to the sponsor / borrower (the customer of both the super senior lender and the unitranche lender) but may cause execution risk, especially in a competitive auction scenario. The temptation is therefore to take as agreed the intercreditor position from a previous deal – whether or not involving the same super senior lender / unitranche lender combination.
In this article, we highlight three common pitfalls of such an approach (as have been witnessed in the market), and the potential for the day one commercial position to be eroded by holes in precedent documentation not being redressed in subsequent deals.
A super senior lender will often take comfort from the fact that disposals of assets or companies in excess of a certain level in any financial year, or over the life of the facilities, will amount to a Material Event of Default and therefore trigger the ability for the super senior lender to drive the enforcement process (following expiry of a standstill period). Further reassurance will be gained where amendments / waivers in relation to such Material Event of Default cannot be made without all lender / Majority Super Senior Lender consent.
However, a point that is frequently missed (especially where precedents have been rolled from historic deals) is that such Material Event of Default only triggers if there has been an Event of Default under the general 'Disposals' covenant. No such Event of Default will occur where the disposals referred to are 'Permitted Disposals'. We frequently see the ability for the unitranche lender to either consent to disposals through a specific limb in the definition of Permitted Disposals, or to consent (by way of Majority Lender vote) to amendments to the definition of Permitted Disposal.
It may be argued that such concerns are minor where the nature of the business in question is such that piecemeal disposals of assets / companies would be tricky. However, where such documentation is rolled out for transactions where there is greater scope to make disposals, there is clear danger for the super senior lender if a unitranche lender is potentially able to consent to large scale disposals. This danger is exacerbated by the fact that the proceeds of such disposals would pass through the mandatory prepayment waterfall, which is typically drafted so that the term lender(s) is/are paid out ahead of the super senior lender.
We would typically see 'new money' (i.e. non-rollover) RCF loans being capable of drawstop only upon an actual Event of Default. However, a point that unitranche providers are sometimes not as focused on as they might be is that early deals in the mid-market often featured drawstop upon Default (in practice, at the earliest sign of an Event of Default). The practical difference that can be made by such a small difference in drafting has been starkly illustrated by recent examples where the super senior lender's ability to drawstop the RCF, and thereby choke off working capital, has afforded the super senior lender a far stronger negotiating position than the documentation might otherwise have suggested.
Conversely, we also see precedent documentation that effectively negates the super senior lender's ability to drawstop by allowing the unitranche provider a right to waive / consent to the remedy of any Event of Default for all purposes. Clearly this is an area that each of the borrower, the unitranche provider and the super senior lender will want to focus on in order to preserve the rights that they may assume have been granted to them under current market expectations.
One area of discussion on various recent deals has been whether the definition of Permitted Financial Indebtedness should be something that is only capable of amendment with all lender / majority super senior lender consent. The view that has been expressed is that, without such safeguard, a situation could arise whereby a malevolent participant acquires the term debt and/or the equity, and could amend the definition of Permitted Financial Indebtedness in order to allow the incurrence of unlimited third party debt.
Where the super senior lender is not protected by a leverage covenant (often a Minimum EBITDA covenant is the super senior lender's only financial covenant), such debt could be incurred and subsequently used by the borrower to voluntarily prepay the term lender (who is typically entitled to first prepayment in such a scenario). The super senior lender would then be left in the structure alongside only third party term debt that is not bound by the intercreditor. The viability of such a series of events in most structures is questionable but it is at least worth considering at the point of negotiating the intercreditor terms.
Mind the gap
While it is important to be aware of the three points discussed above, they are far from the only potential pitfalls where precedent intercreditor principles are used as a template for future deals. The underlying credit, the particular positions of the super senior and unitranche lenders, and evolutions in market practice, will all affect specific points that may seem less critical at the time but can have significant effects down the line.
Osborne Clarke is a full-service, sector-focussed, international law firm. Our leveraged finance and private equity teams are amongst the most experienced and active across the breadth of the UK mid-market. For further details of our capabilities and experience, to discuss any of the issues raised in this update, or to explore how our team might be able to help you, please contact Laurie, Max or your usual Osborne Clarke contact.