Move Over, Boilerplate: PE Sponsors Continue to Spice Up Financing Provisions

After a summer often described as a slow M&A market and with interest rates remaining higher than expected, the acquisition finance market is finally gaining momentum, fueled by the return of lower borrowing costs. Lenders in the leveraged finance space should be ready for private equity sponsors to reignite their efforts to include aggressive terms in financing documents—picking up where they left off at the start of the year.

“High water marking”

“High water marking” is a concept imported from the European loan market that allows a growing covenant basket to become fixed at a level linked to the borrower’s peak performance—typically measured by adjusted EBITDA—during the life of the facility. If the borrower’s performance later declines, the basket does not decrease. In other words, once the borrower achieves a higher percentage of adjusted EBITDA, the basket is set at that level for the remainder of the credit facility, even if performance falls.

It is important to carefully review the financing documents to check if a “high water mark” (sometimes called a “greatest of all time” or “G.O.A.T.”) clause applies, as this feature is not always mentioned specifically in the term sheet. It is often tucked away in the interpretation section of the credit agreement, rather than in the covenants themselves, making it easy to overlook. Because “high water marking” is a relatively new concept without a standard formulation in the U.S. loan market, it can be easily missed.

The “inside man” loophole

Some credit agreements allow the sponsor and its affiliates to purchase the borrower’s term loans in one of two ways. First, a debt fund affiliate of the sponsor may acquire up to a certain percentage of such loans and, in certain limited cases, vote on them as a lender. Second, the borrower, or its parent and subsidiaries, may buy back the borrower’s term loans; however, any term loans repurchased by these entities are immediately and automatically cancelled.

The “inside man” loophole refers to language in (or missing from) certain credit agreements that would allow an unrestricted subsidiary of the borrower – the “inside man” – to acquire the borrower’s term loans and exercise full lender voting rights on them. This construct can enable the sponsor to circumvent the affiliated lender voting restrictions and the repurchase requirements, potentially enabling the sponsor to tip a vote in its favor (for example, in a liability management transaction). 

Credit agreements implementing this loophole do so by using a combination of techniques:

• Excluding the borrower and its subsidiaries from the definition of “Affiliated Lender” (i.e., affiliates of the sponsor acting as lenders);
• Permitting the borrower and its subsidiaries to repurchase term loans (which is common); and
• Requiring only loans bought by the borrower and its restricted subsidiaries (rather than all subsidiaries) to be immediately and automatically cancelled.

Given the often boilerplate nature of the assignment provisions and the commonplace use of the phrase “restricted subsidiaries” vs. “subsidiaries,” it is important for lenders to now carefully scrutinize these provisions to ensure that the loophole does not exist, whether by design or by oversight.

Portability

“Portability” refers to the ability of a borrower to maintain its existing debt despite a change in ownership. This concept has been more common in the European loan market but has gained increased popularity in the U.S. loan market with certain similarities (like KYC requirements and default blockers), but there are also some notable differences.

Since portability is still relatively new for the U.S. loan market, it is important to review the conditions for portability carefully and to benchmark them against the latest trends and developments in both the U.S. and European markets.

Other Emerging Terms to Watch?

Recent transactions have introduced terms in the loan market that have the potential to become increasingly popular. For example: 

• The “snooze-you-lose” voting limitation, which is commonly used in European loans to disenfranchise lenders who do not respond to amendment, waiver or consent requests within a specified period, may soon appear in the U.S. market.
• In a recent deal, the sponsor was given veto power over the lenders’ choice of legal counsel, further restricting lenders from freely selecting who represents them.
• “Pick your poison” debt / restricted payment capacity toggles (allowing borrowers to use additional availability in one category to incur or make the other) and the return of the 200% contribution debt basket (allowing borrowers to incur debt in an amount equal to double any equity contributions received from its sponsor) are terms to watch.
• Finally, as credit agreement language continues to address liability management transactions, parties interested in these strategies may be forced to adopt even more tailored and complex deal structures.

Key Takeaways

Both lenders and sponsors should ensure they fully understand the detailed terms embedded in their financing documentation, particularly as features such as “high water marking,” the “inside man” loophole, and portability evolve and become more prevalent. Where any of these next-generation provisions are requested or considered, it is essential to assess carefully whether they are appropriate and commercially justified in light of the transaction’s overall structure and objectives. Diligent negotiation and review can help all parties avoid unintended consequences and ensure the financing terms align with their respective interests and expectations.