A Practitioner’s Guide to

EUROPEAN LEVERAGED
FINANCE
Consultant Editor
Christopher Hall
Latham & Watkins LLP

First Edition

City & Financial Publishing

Chapter 8
Recent Trends in Senior Loan
Negotiation
Dominic Newcomb
Partner
Latham & Watkins (London) LLP

8.1 Introduction
At the time of writing, the “credit crunch” which commenced in the
summer of 20071 has already had a profound impact on global
economies and financial markets, including the leveraged finance
community of banks, financial institutions, private equity sponsors
and other investors and their respective advisers. This period will
undoubtedly be remembered for the many events of historical
proportions that occurred in 2008 – the bankruptcy of Lehman
Brothers, emergency takeovers of venerable institutions such as Bear
Stearns, Merrill Lynch and HBOS, the worldwide governmental
“rescue” of many financial institutions, insurance companies and
mortgage lenders etc. However, the effect of this macro event is
notable also in that it potentially marks a turning point, or at least a
new phase, in the balance of power between lenders and borrowers
in the leveraged finance market.

In general terms, at least until the onset of the credit crunch, the
deep pool of liquidity of both debt and equity had rendered the
marketplace acutely competitive over recent years. This resulted in
increasingly sponsor/borrower friendly commercial and legal terms
being obtained (most noticeably at the higher end of the market) as

1 This chapter regularly uses the term “credit crunch” to refer to the crisis in the global finan-
cial markets which started in August 2007 (and, at the time of writing, was continuing). The
crisis resulted in turmoil in the global financial markets, a huge liquidity shortage and drop-
off in deal flow (for example, the first six months of 2008 was the weakest first half-year in
five years (source: Standard & Poor’s LCD Q2 2008 LBO review)).

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deal-makers conceived a succession of innovative ways in which to

alter the dynamics between lenders and their clients. The participants
and products in this market became increasingly sophisticated, evolv-
ing over time based on past experiences (good and bad). It remains to
be seen how the credit crunch will impact the market in the longer
term. However, there is a palpable sense of a shift in bargaining
power back towards the lenders as the excess liquidity has evapo-
rated and world economies are faltering.

This chapter focuses on a variety of the structural and loan docu-

mentation issues which have constituted key battlegrounds for
lenders and sponsors and/or have been the subject of significant
market-driven changes over recent years.2 Specifically, the chapter
looks at changes to senior debt structures, security arrangements,
financial covenants, mandatory prepayment events, restrictions on
junior payments, the material adverse effect definition, voting provi-
sions and transfer/assignment clauses. A discussion of all of the dark
arts behind the underlying provisions in each of these areas warrants
very detailed analysis in its own right. However, the following will
give the reader an insight into certain of the more material issues that
have been debated late into the night on countless transactions over
recent years.

8.2 Structure and flex

This section is a review of the changes seen in the market with respect
to leverage in deals and structure for debt packages.

8.2.1 Higher purchase prices and more debt

Global private equity fund-raising has been the subject of an incredi-

ble boom, increasing from approximately $75 billion in 2003 to $324
billion in 2007, a phenomenon that was also mirrored in Europe

2 This chapter does not intend to analyse issues arising at the commitment paper stage of acqui-
sition financings (e.g., duration and conditionality of commitments; the use of interim loan
agreements or fundable term sheets, etc.) or process-related matters (e.g., determining the
scope of an acquiror’s due diligence; the use of sponsor standard form documentation, etc.).
Despite being of considerable interest in a review of the changing relationship between spon-
sors and lenders over recent years, these topics are beyond the scope of this chapter.

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which saw a rise from $23 billion to $66 billion over the same period.3
This “golden age” of private equity also saw individual funds raise
unprecedented levels of capital (e.g., among many other success
stories, in 2007 Apax Partners reported that its pan-European Fund
VII had raised over €11 billion; in 2006 Permira closed its fourth
European buyout fund raising €11.1 billion, with Kohlberg Kravis
Roberts & Co. raising $17.6 billion in the same year).

In parallel with this private equity avalanche, a revolution was occur-

ring in the financial markets, with heightened lender confidence
fuelled by consistently low default rates, coinciding with decreasing
interest rates and the entry into the market of a flood of new institu-
tional investors. For example, Standard & Poor’s reported that in
2000 there were only eight active loan investment vehicles in the
European leveraged finance market, but by March 2007 this had
risen to 275.

So, at least until the beginning of the credit crunch, year-on-year there
was increasingly fierce competition for buyout targets as private
equity firms looked to invest the funds raised whilst at the same time
taking advantage of the deep liquidity in the debt markets to increase
leverage. Consequently, it is no surprise that there was a huge leap in
company valuation multiples from on average 7.1× EBITDA4 in 2003
to 9.3× EBITDA in the first quarter of 2007.5 This increase was funded
through debt such that in European private equity deals average total
leverage rocketed from 4.5× EBITDA in 2003 through 6.1× EBITDA in
the first quarter of 20076 to a peak of 7× EBITDA in September 2007
(on a rolling three-month basis).7

8.2.2 The changing nature of the debt package, including the rise
and fall and rise again of amortising tranches

Aside from changes in the sheer size of leveraged finance transac-

tions, the constituent parts of the debt package itself altered signifi-
cantly during this period as sponsors took advantage of market

3 Source: Thomson Financial.

4 Earnings before interest, tax, depreciation and amortisation.
5 Source: Standard & Poor’s LCD Q1 2007 LBO review.
6 Source: Standard & Poor’s LCD Q1 2007 LBO review.
7 Source: Standard & Poor’s LCD Q2 2008 LBO review.

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conditions to reduce their overall cost of funds. Deals that a few years
previously would have been structured with senior and mezzanine
facilities, or senior, mezzanine and payment-in-kind (“PIK”) facilities,
were now capable of being funded by way of all senior debt struc-
tures or senior and second lien financings (with the second lien incor-
porated as a tranche of the senior facilities rather than being a
stand-alone facility). However, with the advent of the credit crunch,
structures started to revert to those more reminiscent of prior years,
not least due to the collapse of the second lien market. For example,
in the second quarter of 2008 senior/mezzanine deals accounted for
68 per cent of the European market (up from just 14 per cent in the
second quarter of 2007) and deals with second lien as the only addi-
tional debt below the senior facilities accounted for just 3 per cent of
transactions in the market (down from 27 per cent a year previously).8

In addition, the context of this ever-changing environment, senior

debt packages themselves have been varied, reflecting the identity of
investing lenders. As explained in Chapter 2, the traditional senior
acquisition term loan structure has three tranches (as described in
Table 8.1) with different investors being attracted to amortising or
non-amortising tranches.

Before the influx of institutional investors into the leveraged loan

market described above, the A tranche was likely to have constituted
approximately 50 per cent of the aggregate senior acquisition term
loan structure, with the remaining 50 per cent being split equally
between tranches B and C. However, the pre-credit crunch increase in
liquidity amongst collateralised loan obligations (“CLOs”)/collater-
alised debt obligations (“CDOs”), hedge funds and other institutional

Table 8.1 Traditional senior acquisition term loan structure

Facility Tenor Amortising Typical investor

A 7 years Yes “Traditional” banks

B 8 years No Institutional investors
C 9 years No Institutional investors

8 Source: Standard & Poor’s LCD Q2 2008 LBO review.

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lenders resulted in sponsors being able to take advantage of financing

packages incorporating only B/C loan tranches such that the borrower
group just had to service its interest payments with no amortising debt
payments to make over the life of the facilities. This development was
also welcomed by arrangers as these “new” lenders required little or
no fees in order to participate in a transaction, with the result that the
arrangers’ profit margin increased. In contrast, however, at times
when these investors are much less active (such as during the credit
crunch) and/or if lenders are looking to impose more operational
discipline on the borrower group by using amortising debt to ensure
a reduction in leverage over the life of a financing package, structures
return to the more traditional approach outlined above.

8.2.3 Adding further leverage into the structure

So far this chapter has been concerned with that part of the debt pack-
age which is to be used for the acquisition of the target group, but
sponsors have also examined strategies over the last few years to
increase the (initially) unfunded commitments of the lenders. In the
prior stages of the development of the leveraged finance market, the
only unfunded commitments would in all likelihood have been a
small revolving credit facility for working capital purposes and
potentially a capital expenditure/acquisition facility (although this
might have required further equity investment at the time of drawing
so as to ensure that leverage levels were maintained) (see further
Chapter 2). However, in times of increased liquidity, not only did the
magnitude of exposure under these unfunded facilities start to
increase (with equity requirements often dropped), but sponsors
requested, and frequently obtained in loan documentation, further
“incremental facilities” or “accordions”.

Incremental facilities are initially uncommitted but are pre-approved

by the syndicate as capable of being incurred over the life of the trans-
action at the election of the borrower as a newly created tranche of the
senior debt (provided of course that it finds one or more lenders will-
ing to provide the new commitments on the pre-agreed terms). The
borrower’s entitlement to utilise these facilities is typically subject to
certain limited conditions, the most significant being a hard cap
and/or a cap through a leverage covenant (i.e., the borrower can only
obtain new further commitments if, as a result, its leverage ratio on a

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pro-forma basis is not more than “X” times EBITDA). Upon satisfac-
tion of these conditions, no further lender consent is required in order
to introduce this further leverage into the existing structure, whereas
without the “pre-approving” of this concept into the documentation
the consent of all lenders is likely to be required under standard
syndicate voting arrangements (see 8.8 below). If the principle is
conceded, the key areas for negotiation are therefore the conditions to
use of funds, in particular (and most obviously) the cap and the
manner in which it is calculated.

8.2.4 Selling the debt – the need for market flex provisions

A further consequence of this ever-evolving marketplace has been the

impact it has had on market flex provisions. A market flex clause is a
provision (that is usually heavily negotiated) included in the commit-
ment papers for a transaction. It allows the arrangers and underwrit-
ers of the debt financing package to make certain amendments to the
originally agreed terms in order to sell loan commitments to incom-
ing lenders as part of syndication of the facilities and thereby bring
the underwriters’ hold levels down to desired amounts (i.e., a
successful syndication).

In earlier phases of the leveraged finance market, arrangers could

perhaps legitimately argue that the requirements to make transac-
tions appealing to investors were not necessarily identical across all
deals. Therefore, whilst precedent was important and often the start-
ing point when structuring and pricing a new deal, the arrangers still
required the ability to amend the terms, structure and/or pricing of
the debt financing to the extent required to attract the necessary
number of commitments.

This argument became less tenable over time, or at least when lender
interest was intense for almost any transaction. As a result, when
liquidity was high, market flex provisions were occasionally elimi-
nated or, if not eliminated, they were invariably restricted to a pricing
flex (i.e., no right to change the structure or other terms agreed in the
commitment papers and/or long-form financing documentation)
with a negotiated cap on possible pricing increases (either by refer-
ence to individual tranches or on a weighted-average basis across all
tranches).

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During this period strong sponsors also typically considered a

number of further ways to limit the ability of arrangers to exercise
these flex rights, for example:

(a) limiting the time period following closing of the acquisition

during which any flex provisions can be implemented;
(b) requiring a period of prior consultation with them before
changes can be implemented, during which time arrangers need
to prove by reference to market feedback why the pricing
increase is justified;
(c) requiring that the arrangers pre-agree that they will offer a mini-
mum percentage of their underwriting/arrangement fees to
potential participants before they are able to request the exercise
of their flex rights; and
(d) specifying that any changes can only be made if they are (objec-
tively) necessary (not just advisable) in order to ensure that the
arrangers achieve their agreed hold levels (which would be
negotiated to as high a level as possible).

Sponsors also requested “reverse flex” provisions whereby the

arrangers agree to use best or reasonable endeavours to reduce the
transaction pricing if it was still possible after such reduction to have
a successfully syndicated deal. A good indicator of a changing market
is that in the first quarter of 2007, 50 per cent of institutional tranches
were reverse-flexed. This percentage reduced to 28 per cent in the
second quarter of 2007, 2 per cent in the third quarter of 2007 (with a
corresponding huge increase in the number of deals which were
flexed up based on broader market flex clauses) and 0 per cent during
the first six months of 2008.9

8.3 Security
In the structures described above, what security have the lenders had
the benefit of and how has this changed?

9 Source: Standard & Poor’s LCD Q2 2008 LBO review.

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8.3.1 Legal and practical considerations and the use of “agreed

security principles”

At a time when borrower groups in the London acquisition finance

market had operations based exclusively (or almost exclusively) in
the UK, taking security was easy. Lenders would request, and
borrowers would generally be amenable to provide, full fixed and
floating charge debentures from all (or material) group companies.
Aside from the need for target group companies to complete a finan-
cial assistance “whitewash” procedure, this was a relatively time- and
cost-efficient process.

However, as the market expanded with sponsors targeting companies

located (or with major subsidiaries incorporated) across continental
Europe and the rest of the world, this approach became increasingly
problematic given the difficulties of taking equivalent security in
other countries. Accordingly, sponsors argued that when structuring
guarantee and security packages in non-UK transactions it was neces-
sary to reflect the different legal requirements across relevant juris-
dictions which prevented or otherwise limited the borrower’s ability
to deliver to the lender’s full guarantees and security for reasons such
as lack of corporate benefit; financial assistance laws; thin capitalisa-
tion issues; excessive costs, etc.

The ground rules for this would be recorded in “agreed security prin-
ciples” and a sample set of these principles is now contained in the
standard form leveraged loan documentation of the Loan Market
Association (“LMA”).10 Their general considerations are set out in
Table 8.2. (The LMA principles also include sections relating to the
obligations to be secured, some general principles for negotiation and
provisions relating to the undertakings and representations/
warranties to be included in the security documents.)

These basic principles are often further extended and supplemented

by the sponsors in a number of ways, including to specify:

10 The Loan Market Association was formed in 1996 and is Europe’s trade association for the
syndicated loan markets.

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Table 8.2 Extract from LMA agreed security principles

In determining what Security will be provided in support of the Facilities (and

any related hedging arrangements in respect of interest rate liabilities [and/or
any exchange rate [or other] risks]) the following matters will be taken into
account. Security shall not be created or perfected to the extent that it would:

(a) result in any breach of corporate benefit, financial assistance, fraudulent

preference or thin capitalisation laws or regulations (or analogous
restrictions) of any applicable jurisdiction;
(b) result in a significant risk to the officers of the relevant grantor of
Security of contravention of their fiduciary duties and/or of civil or
criminal liability; or
(c) result in costs that, in the opinion of the Agent, are disproportionate to
the benefit obtained by the beneficiaries of that Security.

For the avoidance of doubt, in these Agreed Security Principles, “cost”

includes, but is not limited to, income tax cost, registration taxes payable on
the creation or enforcement or for the continuance of any Security, stamp
duties, out-of-pocket expenses, and other fees and expenses directly incurred
by the relevant grantor of Security or any of its direct or indirect owners,
subsidiaries or Affiliates.

(a) which assets the lenders cannot take security over;

(b) the (limited) circumstances when they can exercise their rights
in respect of any guarantees and security (i.e., post acceleration
of the debt facilities only);
(c) how the borrower group can use assets pending enforcement; and
(d) the limited scope of representations, undertakings and other
terms of the security documents.

More specifically, commonly requested further terms have often

included:

(a) Agreement that guarantees/security will not be required from

joint ventures and other non-wholly owned subsidiaries and
that security does not need to be granted over assets subject to
existing third-party arrangements which prevent the charging of
those assets.
(b) Agreement that perfection of security will not be required if it
would have a material adverse effect on the ability of the rele-
vant charging company to conduct its business in the ordinary

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course or if it requires action to be taken outside of the jurisdic-

tion of incorporation of the charging company.
(c) Agreement that costs of taking guarantees and security (includ-
ing any notarial, registration and similar expenses) above an
agreed cap will be for the account of the arrangers.
(d) The principle that the terms of the security documents will not
be unduly burdensome on the charging company and that any
further representations or undertakings will only be included if
required to confirm any registration or perfection of the security
unless otherwise necessary as a matter of local law.
(e) That where notice is required to be given to a third party in
order to perfect or protect security (e.g., with respect to security
over bank accounts, insurance policies and the acquisition docu-
ments), the relevant charging company will have discharged
any obligations to obtain an acknowledgment of any such notice
by using reasonable endeavours for an agreed period (typically
around 20 business days).
(f) That where security is being taken over trade receivables, notice
to each trade counterparty is not required to be given until accel-
eration of the debt facilities and that where lists of such receiv-
ables are requested to be provided, they will only be made
available to the extent required to ensure perfected security
under applicable local law.

During any period when the ability to close transactions in the lever-
aged loan market is more difficult (e.g., during the credit crunch), it is
of course harder for lenders to accept these exclusions to the scope of
their security package given the additional scrutiny being given to
collateral coverage.

8.3.2 The use of guarantor coverage tests

As a further part of the cost/benefit analysis undertaken with respect to

the granting of guarantees and security by borrower groups, coverage
tests were introduced so as to ensure that non-material companies were
not obliged to become guarantors and provide security, whilst at the
same time ensuring that the lenders had appropriate collateral protec-
tion. Such a test would specify that the borrower group only had to
ensure that the guarantors/security providers account for not less than
an agreed percentage of the group’s total assets, turnover and EBITDA.

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The key issues that have been debated with respect to this concept are
as follows:

(a) At what level is the threshold set? Lenders might start at 95 per
cent but the stronger sponsors would be looking for 80 per cent
or lower.
(b) What are the components of the test? As noted above, lenders
would argue for EBITDA, assets and turnover components,
sponsors for just EBITDA.
(c) Does the coverage test apply before or after application of the
agreed security principles described above? For example, if the
coverage test is set at 90 per cent and a subsidiary generating 10
per cent of the group’s EBITDA is legally prevented from giving
a guarantee/security for the financing, does the test now require
90 per cent coverage in respect of the remainder of the group
even though this means a “true” coverage test of 81 per cent?
(d) Which entities count towards satisfying the threshold? It could
be assumed that just the actual guarantors/security providers
count, but sponsors have argued that entities whose shares have
been pledged should also be included, notwithstanding that
their assets are not secured and no direct guarantees have been
given and therefore the lenders would not rank in priority to
trade and other creditors of the relevant entity.

These are all issues where there is typically merit on both sides of the
argument and therefore need to be negotiated on a deal-by-deal basis
based on factors specific to the parties and deal in question and the
market environment at the time of the transaction.

8.4 Financial covenants

A key difference with the incurrence style covenants of high yield
debt (explained in Chapter 5): what do senior lenders test and what
is there to negotiate?

8.4.1 Purpose

Unlike high yield debt instruments which contain only “incurrence”

covenants (i.e., where generally a group company must take an action

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to cause a default and which are only tested when the particular action
is being taken), typically in leveraged loan agreements there will be
“maintenance” covenants which require the borrower group to main-
tain a certain level of financial health in order to avoid a default.

Financial covenants were designed to (hopefully) assist the lenders in

monitoring the financial performance of a borrower group during the
lifetime of the financing, providing them with a meaningful test of
this performance and a realistic early warning signal that a borrower
might be in trouble. If the covenant is breached when tested (typically
quarterly), the lender group then has the ability to call a default and
exercise its rights and remedies.

8.4.2 The different approaches

Table 8.3 summarises in general terms the various options that have
been taken by lenders with respect to financial covenants in lever-
aged finance transactions. Whilst the use of “full” covenants has
generally been the accepted approach, covenant “lite” and covenant
“loose” were both adopted in a number of deals at the height of the
pre-credit crunch environment (albeit less frequently in Europe than
in the market in the US). Their attraction for sponsors is obvious,
though they should be viewed as the product of a very liquid and
competitive market.

Further details on these covenants can be found in Chapter 2.

Table 8.3 Financial covenant package options

Full covenants Leverage (debt to EBITDA), interest cover

(EBITDA to interest), cash-flow cover (cash flow
to debt service) and capital expenditure
Covenant “lite” Leveraged loans with high yield style incurrence
covenants only (i.e., no financial covenants)
Covenant “loose” Leveraged loans with high yield style incurrence
covenants plus one or two financial covenants
from the full covenant package described above
Full covenants but with As per full covenants but certain covenants drop
fall-away/suspension away or are suspended following a listing
and/or on reaching an agreed leverage level

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8.4.3 Providing headroom

As explained in Chapter 2, the levels for the financial covenants are

set by building a certain amount of headroom into the performance
ratios specified in the business plan for the group which has been
agreed between the sponsor and the arrangers. One of the main areas
for debate is therefore how much this headroom is and, at the height
of the market, a strong sponsor would be looking for at least 30 per
cent, whereas in a tighter/weaker market, the arrangers will proba-
bly require closer to 20 per cent. This headroom of course needs to be
based on a suitable underlying business plan (i.e., one that does not
underestimate expected performance thereby providing a further
inbuilt headroom before the “official” headroom is agreed) and dili-
gence work is required by the arrangers to ensure that this is the case.

Finally, it is of course important for the lenders to be satisfied that the

definitions used in the loan documentation accord with the method-
ology used in the preparation of the business plan. Otherwise, once
again, the agreed headroom can be distorted easily.

8.4.4 Mulligans: what are they?

Most social golfers will at one point in their golfing lives have no
doubt had recourse to a mulligan – that is, the opportunity to retake
their first shot of the round. This concept of a “second chance to get
things right” found its way into the financial covenant provisions of
certain European leveraged finance transactions and allowed the
financial covenants to be breached without being treated as a default
unless the same covenant was breached a second time. The mulligan
had added impact when considered alongside significant equity cure
rights (see 8.4.5 below) as the potential second breach could always be
cured with an injection of new equity or subordinated shareholder
debt. This is perhaps the most infamous example of the pro-borrower
market of 2006 and 2007 and is unlikely to be seen in the market in
the near future.

In recent years sponsors have also often requested a “soft” mulligan

(or “deemed cure”) provision. This provides that a prior breach of a
financial covenant is deemed to be cured as soon as the borrower
group is back in compliance with that covenant provided that the

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lenders have not taken enforcement action in the meantime with

respect to the prior breach. Accordingly, it provides clarification to all
parties regarding when a financial covenant default is continuing for
the purposes of the rights of the lenders to accelerate the debt and
exercise their remedies. This provision is typically less contentious
and more easily accepted by lenders when compared to the “hard”
mulligan described above, although care is still required to ensure
that the lenders’ rights with respect to the breach are properly
protected and that they can take action before the deemed cure occurs
and can continue pre-existing action after it has happened.

8.4.5 Equity cure provisions

A further feature of the developing market has been the introduction

of equity cure provisions. A sponsor would argue that it was possible
that a financial covenant could be breached for one financial quarter
only as a result of a temporary or one-off event or minor downturn in
performance and that, notwithstanding this lack of long-term materi-
ality, the lenders would nevertheless be entitled to exercise all of their
remedies under the finance documents. Accordingly, the concept of
an equity cure was developed whereby sponsors are allowed to
“cure” a financial covenant breach by the injection of further equity
(or deeply subordinated shareholder debt). These provisions of
course give rise to numerous issues to consider for borrowers and
lenders alike:

(a) How should the new cash injection be used/treated? Should the
borrower be required to reduce the senior debt through a
prepayment (more advantageous for the lenders) or should the
group be allowed to retain the cash and count it as an increase to
cash flow or EBITDA as required to cure the breach? (An addi-
tion to EBITDA in particular is a significantly better result for the
sponsors given the impact that this has across all of the
covenants and the “multiplier” effect of an addition to EBITDA
in comparison to a repayment of debt.)
(b) How often can the cure provisions be used? Whilst in theory
lenders should be agreeable to all additional equity contribu-
tions, it is obvious that they do not want a sponsor “drip-feed-
ing” equity into a business which is under-performing just to
prevent a breach of the financial covenants and disenfranchise

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the lenders in respect of remedies which would otherwise be

available. Typically, therefore, these provisions have a cap on
overall usage plus an inability to use the cure more than once in
any 12-month period.
(c) How much can the cure amount be? Some lenders maintain
that the cure amount should never be more than that needed to
cure the covenant breach on the basis that an over-injection of
equity would help to cure a potential covenant breach in the
following three quarters (on the basis that a cure amount is
treated as cash flow and EBITDA for all testing periods in the
rolling 12-month period following the receipt of that cure
amount). A further argument is that an overall cap on the
amount of any cure is required so that very significant breaches
cannot be cured.
(d) How quickly must the cure amount be provided? The lenders
clearly want to know if the sponsor is intending to cure a
default or not and therefore a period of not more than approxi-
mately 20 business days following the delivery of the compli-
ance certificate evidencing the underlying breach is typically
agreed.
(e) Can the cure amount be counted in the calculation of the lever-
age ratio for other purposes in the loan documentation (e.g., the
margin ratchet, excess cash flow mandatory prepayment obliga-
tions and so on)? From a lenders’ perspective, the desire would
be, of course, to limit the impact of any cure payments to the
calculation of the financial covenants.

8.5 Mandatory prepayment provisions

What rights do senior lenders have to require early prepayment of the
loans?

8.5.1 Taking excess cash flow

The concept of the excess cash flow mandatory prepayment require-

ment was explained in Chapter 2. However, as the leveraged market
has evolved, so these requirements can in certain circumstances be
seen to have ceased to fulfil their intended objectives, with sponsor-
friendly negotiated positions rendering such requirements largely

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ineffectual in ensuring a degree of amortisation. The key issues that

are the subject of such negotiation include:

(a) Definitions: the definition of “excess cash flow” and related defi-
nitions became more and more complicated in certain deals,
with an increasing number of deductions from cash flow
included in the calculation (many of which were not necessarily
justified) such that the resulting number bore little resemblance
to true “excess cash”.
(b) The percentage for prepayment: historically, the lenders took
100 per cent, or a minimum 75 per cent, of excess cash flow in
prepayment. At the height of the bull market, this percentage
was often as little as 50 per cent, decreasing quickly to 25 per
cent and then to zero when certain leverage ratios were
obtained, with increased flexibility to distribute the excess cash
that has not been required to be used in mandatory prepayment
out of the credit group by way of a dividend or repayment of
shareholder debt to the sponsor.
(c) Size of basket and manner of calculation: it became typical to
include a basket of cash which is never swept. This was origi-
nally intended as a de minimis number but was increased over
time. In addition, in certain transactions this basket exception
was deducted after having calculated the notional amount
required for prepayment, thus the true basket amount became
even higher (see Table 8.4 for a worked example).
(d) Fall away/suspension: certain transactions have benefited from
a provision which results in the excess cash flow prepayment
obligation being disapplied following the occurrence of certain
trigger events – typically either the leverage ratio reaching an
agreed level or upon an initial public offering.

Table 8.4 Calculations of excess cash flow

Basket is deducted first: Basket is deducted last:

Excess cash flow is €20,000,000 Excess cash flow is €20,000,000

Basket of €5,000,000 is deducted 50 per cent of this = €10,000,000
= €15,000,000 Lenders sweep this less basket of
Lenders sweep 50 per cent of this €5,000,000
Prepayment obligation of €7,500,000 Prepayment obligation of €5,000,000

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8.5.2 Other

Chapter 2 also describes the other typical mandatory prepayment

events – a change of control, listing, receipt of proceeds from certain
asset disposals, receipt of proceeds from certain insurance claims and
receipt of proceeds from claims under the acquisition documents and
acquisition-related due diligence reports. Against this background,
this chapter just mentions some of the more contentious issues for
consideration by the parties in this context:

(a) Change of control: what level of ownership should trigger a

change of control, in particular post-listing? The lenders are
likely to want voting and economic control to be maintained by
the sponsor over the group at all times, whereas a strong spon-
sor will argue for voting control before a listing and thereafter
control of a lower percentage of the votes, for example 30 per
cent provided that they are still the largest shareholder. In addi-
tion, can other sponsors be “pre-approved” into the change of
control such that the financing becomes a “portable” deal (or a
“transferable recapitalisation”), surviving a change in sponsor?
This concept has typically not been received enthusiastically in
the market and remains extremely unusual.
(b) IPO: does this trigger full prepayment (i.e., as per the occurrence
of a change of control) – the position adopted in the LMA lever-
aged loan documentation – or should only a set percentage of
the net proceeds (decreasing with reduced leverage) be required
to be used in prepayment (the typical sponsor request)?
(c) Disposal proceeds, acquisition proceeds and insurance
proceeds: what disposals/events trigger a prepayment obliga-
tion? How long is any reinvestment period? (A strong sponsor
will be looking for 12 or more months from receipt of proceeds
before being required to repay debt.) What size is any basket
exception? What deductions can be made from the proceeds to
calculate “net proceeds” required for prepayment?

8.6 Restrictions on junior payments

This section describes how the ability to get cash out of the credit
group to the sponsor (or to repay junior debt) has changed.

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8.6.1 The “traditional” approach

It is a basic principle of leveraged lending that no payments can be

made to the shareholders of the borrower group until the debt is
repaid in full. Further, in capital structures with multiple layers of
financing, it is also generally accepted that no repayment of junior
debt can be made until all of the more senior monies are repaid in full.

8.6.2 Fall-away/suspension of the “traditional” approach

However, as the leveraged finance market developed, sponsors

sought to look for exceptions to this including to allow flexibility to
receive cash benefits themselves by virtue of permitted payments. A
list of permitted payments typically requested is set out in Table 8.5
(although it is not exhaustive).

With respect to repayment of junior debt, it is not surprising that

borrowers would prefer to have the flexibility to repay the more expen-
sive debt first. Accordingly, many transactions in the pre-credit crunch
period would allow second lien and mezzanine facilities to be repaid
once leverage reached an agreed level even if the senior facilities were
still outstanding. Further exceptions to this also include repayment of
junior lenders in the event of an illegality event or as a result of a
borrower exercising its rights to repay a lender claiming increased costs
or tax gross-up or under a “yank-the-bank” provision (see 8.8.5 below).

Table 8.5 Requested permitted payments

(a) Payments to the sponsor if leverage is below an agreed level or with

proceeds from a listing which are not required to be used in mandatory
prepayment;
(b) Payments to holding companies above the credit group for reasonably
and properly incurred administrative costs, directors’ fees, tax, profes-
sional fees and regulatory costs;
(c) Payment of a monitoring or advisory fee to the sponsor not in excess of
an agreed annual amount (increasing in each year in line with the Retail
Price Index);
(d) Payments to the sponsor or an adviser to the sponsor for corporate
finance, M&A and transaction advice actually provided to the group on
bona fide arm’s-length commercial terms; and
(e) Payments to fund the purchase of any management equity and/or to
make other compensation payments to departing management.

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8.7 Material adverse effect

This section examines one of the key definitions in a leveraged loan

agreement.

8.7.1 The importance of the definition

The concept of “material adverse effect” is typically used in two types

of circumstances in a European leveraged loan agreement:

(a) It is used as a qualification to a number of the representations,

covenants and events of default contained in the loan agreement
where this level of materiality is deemed to be appropriate to a
specific situation (e.g., a covenant would provide that each
member of the group must do “X” unless failure to do so does
not, or could not reasonably be expected to, have a material
adverse effect).
(b) Unlike in the US market, almost all European leveraged loan
agreements will contain a generic event of default which is trig-
gered if any event or circumstance occurs which has, or is
reasonably likely to have, a material adverse effect.

Accordingly, it is of paramount importance for both borrowers and

lenders that the definition is acceptable.

8.7.2 Changes over time and implications

Table 8.6 shows the definition of material adverse effect currently

contained in the standard leveraged loan documentation of the LMA.

There are a number of elements to this definition that a strong spon-

sor (or indeed any sponsor in a bull market) would be keen to nego-
tiate and which, as a result, are often excluded or amended in agreed
documentation:

(a) The test being subjective in the reasonable opinion of the major-
ity lenders rather than objective.
(b) The reference to the “prospects” of the group being adversely
effected, creating a forward-looking and uncertain element to
the test.

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Table 8.6 LMA definition of material adverse effect

“Material Adverse Effect” means [in the reasonable opinion of the majority
lenders] a material adverse effect on:

(a) [the business, operations, property, condition (financial or otherwise) or

prospects of the Group taken as a whole; or
(b) [the ability of an Obligor to perform [its obligations under the Finance
Documents]/[its payment obligations under the Finance Documents
and/or its obligations under Clause 26.2 (Financial condition) of this
Agreement]]/[the ability of the Obligors (taken as a whole) to perform
[their obligations under the Finance Documents]/[their payment obliga-
tions under the Finance Documents and/or their obligations under
Clause 26.2 (Financial condition) of this Agreement]]; or
(c) the validity or enforceability of, or the effectiveness or ranking of any
Security granted or purporting to be granted pursuant to any of, the
Finance Documents or the rights or remedies of any Finance Party under
any of the Finance Documents.]

(c) Paragraphs (a) and (b) of the test being listed as alternatives
rather than being cumulative criteria (i.e., the test should only be
triggered if there is a material adverse effect on the business of
the group such that it is reasonably likely to be unable to
perform its payment obligations. In tighter markets, this is likely
to be the most controversial (and often rejected) request).
(d) All of the options in paragraph (b) of the test being too wide and
that a material adverse effect should only relate to an impact on
the ability to meet payment obligations.
(e) Paragraph (c) of the test containing neither an element of mate-
riality nor a carve-out for “legal reservations” (i.e., any general
principles which are set out as qualifications as to matters of law
in the deal legal opinions), a concept which is typically found as
a qualification to representations relating to enforceability.

Finally, it is worth noting in the context of any references in this defi-

nition to compliance with financial covenant obligations, that the
impact of liberal equity cure provisions and mulligans (as explained
above) make this limb of a material adverse effect test that much
harder to breach.

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8.8 Voting and related provisions

This section covers amendments and waivers: what to look for.

8.8.1 The “traditional” and LMA approach

The traditional approach to voting in syndicated loan agreements, as

reflected in the current LMA standard leveraged loan documentation,
is that, subject to certain exceptions which require the approval of all
lenders, amendments and waivers can be agreed upon by the
borrower and the majority lenders (typically being two-thirds by
commitments of the syndicate in European transactions). Table 8.7
below summarises the customary all-lender decisions in typical loan
documentation.

Table 8.7 Typical all-lender decisions

(a) Changes to the definition of “majority lenders”.

(b) An extension to the date of payment of any amount under the finance
documents.
(c) A reduction in the margin or a reduction in the amount of any payment
of principal, interest, fees or commission payable.
(d) A change in currency of payment of any amount under the finance docu-
ments.
(e) An increase in or an extension of any commitment or the total commit-
ments.
(f) A change to the borrowers or guarantors other than as contemplated by
the loan agreement.
(g) Any provision which expressly requires the consent of all the lenders.
(h) The clauses dealing with the several nature of the finance parties’ rights
and obligations, with the transfer mechanics and with amendments/
waivers.
(i) The nature or scope of any guarantees, the secured property or the
manner in which the proceeds of enforcement of the transaction security
are distributed.
(j) The release of any guarantees or of any transaction security unless
permitted under the loan agreement or any other finance document or
relating to a sale or disposal of an asset which is the subject of the trans-
action security where such sale or disposal is expressly permitted under
the loan agreement or any other finance document.
(k) Any amendment to the order of priority or subordination under the
intercreditor agreement.

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However, this “traditional” approach does have some obvious limi-

tations, and a lender holding only a very minor stake in the capital
structure has a veto over these all-lender matters notwithstanding the
possibility of overwhelming support from the rest of the syndicate.
This has led to a number of refinements to this approach over time
which are regularly used by sponsors and are described in more
detail in the following paragraphs.

8.8.2 Introduction of a super-majority concept for security

releases

One of the first ways in which sponsors looked to introduce a

greater degree of flexibility to voting arrangements was through the
use of a super-majority of lenders concept, constituted by lenders
holding 95 per cent of loan commitments of the syndicate and more
recently reduced to as low as 85 per cent. The most common deci-
sion placed in the hands of this super-majority is the release of secu-
rity or guarantees.

8.8.3 Structural adjustments

The “traditional” approach to voting has been further (and most

significantly) altered pursuant to the adoption of a permitted “struc-
tural adjustments” concept. This typically encompasses the various
matters set out in Table 8.8.

Table 8.8 Structural adjustments

(a) The provision of any additional tranche or facility under the finance
documents in any currency or currencies (whether ranking senior to, pari
passu with or junior to the existing facilities).
(b) Any increase in or addition of any commitment, any extension of a
commitment’s availability, the redenomination of a commitment into
another currency and any extension of the date for or redenomination of,
or a reduction of, any amount owing under the finance documents.
(c) Any changes to the finance documents (including changes to, the taking
of or the release coupled with the retaking of security and consequential
changes to or additional intercreditor arrangements) that are conse-
quential on, incidental to or required to implement or reflect any of the
foregoing.

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Each of these are matters which under the “traditional” model

would require all-lender approval. However, documentation incor-
porating a “structural adjustments” concept would provide that
these amendments be permitted with the consent only of the major-
ity lenders and each lender participating in the relevant additional
tranche or facility or changing its commitments or any amount owed
to it.

This concept is often supplemented by a provision which states that

any amendment or waiver relating to the rights and obligations
applicable to a particular loan, facility or class of lenders, and which
does not materially and adversely affect the rights or interests of
lenders in other loans or facilities or another class of lender, shall only
require the consent of two-thirds of the participating lenders.

8.8.4 “Snooze-you-lose”

As the investor base for leveraged loans moved outside of the estab-
lished banking community, certain sponsors became concerned that
more recent entrants into the market were not necessarily well
disposed to respond to urgent requests for amendments or waivers.
In addition, certain of these investors were “public” investors and
therefore did not want to receive any information regarding the
borrower group which was not otherwise in the public domain,
including such requests. As a result, “snooze-you-lose” clauses were
introduced requiring lenders to vote on amendments or waivers
within 10 or 15 business days of being notified of the relevant request
otherwise their vote would not count. This is contrary to the “tradi-
tional” approach which contains no such deadline, although this does
of course run the risk of receiving “no” responses as the deadline
approaches if the relevant lender(s) have not been able to complete all
internal approval processes required before voting positively. The
LMA has recently introduced suggested optional wording for a
“snooze-you-lose” clause in its recommended form of leveraged loan
agreement.

8.8.5 “Yank-the-bank”

A further way in which borrowers have looked to introduce greater

flexibility into voting arrangements is through “yank-the-bank”

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provisions. Subject to certain conditions, these allow borrowers to

force lenders to transfer their commitments, or (if negotiated) accept
a prepayment, if they did not agree to the relevant requested
amendment or waiver. In certain circumstances, the threat alone of
using these powers might be sufficient to persuade a lender to vote in
favour of the relevant decision. However, it should be noted that at
times when loans in leveraged finance transactions are trading below
their par value in the secondary market (e.g., during the credit
crunch), the benefit of this clause has been diluted significantly given
that transfers and prepayments need to be made at par.

The issues for debate with the arrangers on these clauses are typically:

(a) Should the provision allow just a forced transfer or should the
borrower also be permitted to use free cash in order to repay the
relevant lender, noting that this reduces cash in the group and
potentially encourages hold outs? The LMA “yank-the-bank”
provision only allows forced transfer.
(b) Can a lender only be a “non-consenting lender” on matters
which require unanimous approval (as per the LMA proposal)
or should the “yank-the-bank” apply to all decisions (i.e., even if
a majority lender decision has been approved, can the borrower
still “yank” a dissenting lender even though this is not actually
required in order to ensure the approval)?
(c) What level of consents are required from the lender group before
a lender can be “yanked”? When this clause was initially used in
the European market, it was not uncommon for a borrower to be
required to obtain 95 per cent approval from its syndicate (and
therefore that it could only “yank” up to 5 per cent) such that it
only applied with respect to a very small dissenting minority of
lenders. Subsequently, sponsors have in recent years been able
to negotiate that any lender can be “yanked” once majority
lender approval has been obtained, thereby potentially applying
the clause to one-third of the syndicate.

8.9 Transfer and assignment clauses

This section is a review of the issues for negotiation in the transfer
provisions.

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8.9.1 Consent versus consultation: can the borrower block transfers?

Most lenders (and the LMA) would typically argue that a borrower
should have no consent rights to transfers as this fetters the free trans-
ferability of loans, which is a key component of the syndicated lend-
ing market and essential at times of reduced liquidity including
following the onset of the credit crunch. However, from the perspec-
tive of a borrower, the borrower wants to ensure that its syndicate is
composed of “friendly” banks willing to listen objectively to requests
for amendments or waivers. In addition, as the market developed
and many sponsors established debt trading funds looking to invest
in leveraged loans, a concern arose that competitors would invest in
transactions in order to receive the benefit of all of the information
rights given to lenders. These competing tensions need to be resolved
in the debate as to whether or not a borrower has consent or consul-
tation rights over transfers.

8.9.2 Transfers and sub-participations

A further question that will often arise relates to the scope of the consent
or consultation rights described above. If the borrower has been
successful in obtaining consent rights but this just relates to actual trans-
fers of the position of lenders of record, any form of sub-participation or
other “behind-the-scenes” transaction whereby the voting rights are
passed on by these lenders will mean that the hard-fought battle over
consent rights is a pyrrhic victory. Therefore, certain borrowers will
argue that their consent rights should also extend to these further trans-
actions, although this type of extended consent right is unlikely to be
capable of capturing all risk allocation techniques adopted by lenders.

8.9.3 When consent/consultation rights are suspended

The typical circumstances in which any consent or consultation rights

are suspended would be:

(a) if the proposed transfer is to another existing lender or an affili-

ate of a lender;
(b) if the transferring lender is a fund, when the proposed transfer
is to a related fund of that lender; or
(c) when an event of default is continuing.

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These are not often the subject of much debate although certain spon-
sors have tried to limit the last of these to certain of the more “mate-
rial” events of default (non-payment, financial covenant breach,
insolvency, etc.).

8.10 Conclusion
This chapter has hopefully highlighted and explained a number of
the key topical areas of debate among borrowers and lenders, and
sponsors and arrangers, with respect to leveraged loan agreements.
Clearly the chapter is neither intended to be (nor can it be) an exhaus-
tive account nor are the issues raised necessarily applicable to all
deals. However, it will serve as a useful introduction to, or reminder
of, certain of the more material issues that have over recent years been
considered to be worthy of much debate.

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