2023 Cash Flow Covenant Trends
In Goldberg Kohn's mid-year update we noted that middle market lending activity in 2023 was leaning slightly more toward asset-based lending. That trend continued through the end of the year, with about 30% of total middle market deals using an ABL structure, versus about 20% in 2022. Since the mid-year update covered notable ABL trends, we will focus here on comparative cash flow covenant trends from 2022 to 2023.
Overall, the lower to core middle market was significantly more conservative than the larger middle market in both 2022 and 2023. A comparison of annual data on certain points from Goldberg Kohn-documented deals shows that some covenants loosened slightly, while others became slightly more restrictive or remained steady:
Incremental loans: In 2022, a little more than half of all deals had an incremental facility. For those that had a free and clear basket on the incremental, the basket was set at an average of about $23MM, equating to just over 1.0x EBITDA. In 2023, about two thirds of deals had an incremental facility. For those that had a free and clear basket, the amount of the basket was set at an average of about $15MM, equating to around .9x EBITDA.
Synergies addbacks: The percentage of deals with synergies addbacks stayed consistent in 2022 and 2023, with a little more than 60% of transactions in both years, including a synergies addback to EBITDA. In nearly all deals there was a cap on addbacks, either as a percentage of EBITDA or a fixed dollar amount, and the cap remained consistent across both years at an average of about 20% of EBITDA (in most cases calculated prior to giving effect to the addbacks). In both years, the majority of deals set the synergies look-forward period at 12 months (about 65% had this setting in 2022, and more than 85% had this setting in 2023).
Cash netting: In 2022, the vast majority (close to 85%) of deals allowed cash netting for leverage covenant calculations. Nearly all had a dollar cap on cash netting, with the average dollar cap equating to just less than 40% of EBITDA. In 2023, about 75% of deals allowed for cash netting. Consistent with 2022 data, nearly all had a dollar cap, with the average equating to a little over 30% of EBITDA.
Debt and investment baskets: In 2022, the average dollar cap on the debt basket equated to about 12% of EBITDA, and the dollar cap on the investment basket was about 13% of EBITDA. In 2023, this held steady for the debt basket at about 12% but increased slightly for investments to about 15% of EBITDA.
Restricted payment baskets: In 2022, just under a quarter of deals had restricted payment baskets tied to a builder basket, and nearly all of those had a leverage governor on availability of the basket, set at an average leverage of 4.0x. In 2023, the share of deals with a builder basket for restricted payments remained the same, however with a tighter average leverage requirement of 3.0x.
Covenant growers: In 2022, just over 20% of deals had one or more covenant baskets that included a grower component. In 2023, that share increased slightly to about 26%.
Unrestricted subsidiaries: In 2022, the majority (over 80%) of deals did not allow for unrestricted subsidiaries at all, and all that permitted unrestricted subs contained some form of J.Crew blocker. This remained consistent in 2023. However, as the following section notes, the lack of unrestricted subsidiary provisions by itself does not prevent similar types of liability management transactions that have emerged in the market.
Borrower Liquidity Tactics
Coercive Maturity Extensions and Double Dips: There were mixed results this year on litigation over liability management transactions, as borrowers continued to engage in ever more creative strategies to improve liquidity and avoid bankruptcy. In a significant win for borrowers, in June the Bankruptcy Court for the Southern District of Texas issued a ruling upholding Serta's 2020 uptiering transaction. The decision is currently on appeal to the Fifth Circuit. In separate uptiering disputes, the New York Supreme Court and the Bankruptcy Court for the Southern District of Texas issued similar rulings in December 2023 and January 2024 – in New York allowing nonparticipating lenders' contractual challenges to Mitel's 2022 uptiering transaction to proceed; in Texas, allowing certain of the nonparticipating lenders' contractual and tort challenges to Incora's 2022 uptiering to proceed. In both cases, though, the courts dismissed claims for a breach of the covenant of good faith and fair dealing. In the midst of these decisions, borrowers (and participating lenders) have become even more aggressive in structuring ways to increase liquidity and avoid debt maturity and default. New tactics that have surfaced recently include:
Double dip: First noted in connection with a transaction done by home furnishing company At Home Group Inc., a double dip involves incurrence of debt by a non-loan party subsidiary (often a foreign subsidiary), secured either by assets already owned by the sub or by assets transferred into the sub and guaranteed by its parent company. The borrower subsidiary then makes an intercompany loan to the parent company with the proceeds of the new debt, with the intercompany loan also secured on a pari passu basis by an all-assets lien from the parent company. The structure theoretically allows the creditors of the sub to have two separate claims against the company group – a direct claim against the parent operating company based on the guarantee, and a separate claim through a pledge of the secured intercompany note. This structure has not been tested in bankruptcy or through litigation. And it remains to be seen whether a court would consolidate the claims as an equitable matter. Notably, this structure requires looser covenants than are typically included in traditional middle market loans, as there must be sufficient basket capacity at the parent operating company level to allow for the incurrence of the intercompany debt and the making of the guaranty.
Snooze drag: As amend-to-extend activity picked up in 2023, the ability of some borrowers to extend maturity has been hampered by investment limitations of CLOs that have invested in the borrowers' debt. The snooze drag circumvents some of these limitations by binding lenders to a maturity extension if they fail to object to the extension within a certain amount of time. In most cases where this has been exercised, the negative consent mechanism is already provided for in the underlying loan agreement. However, in a few cases maturity has been extended simply by inclusion of the negative consent in the extension amendment. So far, this structure appears to be more common in Europe than in the United States. And it has caused backlash from CLO investors who are now insisting on language in new investment documents that requires managers to affirmatively vote against maturity amendments unless certain conditions are satisfied.
Coercive extensions: In November 2023, loan research provider Covenant Review reported on an even more aggressive tactic to further strong-arm lenders into a maturity extension. Covenant Review noted that at least one deal has surfaced in which the borrower proposed an amend-to-extend transaction that would coerce existing lenders into the extension by issuing a substantially identical, but longer, dated term loan, and subsequently strip collateral and covenants from the existing loan. Lenders were given the choice to continue with the same covenant and collateral package on the new loan or stay behind with the stripped facility. Ostensibly, the rationale for this is similar to the snooze drag, as it would allow most CLOs that are otherwise past their reinvestment period to consent to the new loan as an enhancement of their credit position (as compared to the old, stripped loan).
Notable Lending Cases
Syndicated Loans and Securities Regulation: The U.S. loan market breathed a sigh of relief in August when the Second Circuit issued a decision in Kirschner v. JPMorgan Chase Bank holding that a syndicated term loan B was not a security for purposes of state securities laws. The decision stemmed from a case brought against JPMorgan and other banks by Marc Kirschner as trustee representing a group of institutional investors who had purchased term loan B notes issued by Millennium Health LLC. After the borrower filed for bankruptcy, Kirschner sued certain of the financial institutions that had participated in the arrangement of the loan, alleging that the notes constituted securities and should have been subject to securities registration and disclosures. The Second Circuit's decision applied a four-factor test from a 1990 U.S. Supreme Court case, Reves v. Ernst & Young. The factors include (1) whether the seller and buyer had commercial or investment motivations, (2) whether the debt was offered to a broad segment of the public, (3) the reasonable expectations of the investing public, and (4) whether there were other risk-reducing factors (including another regulatory scheme). Though the court noted that the first factor weighed in favor of classifying the notes as securities, the other factors weighed against such a classification. In Kirschner, the dispositive characteristics of the notes were: (1) they contained restrictions on assignment that rendered them unavailable to the general public, including that they could not be assigned to a natural person or without consent from the borrower and the agent, (2) the assignment documents contained certifications that the purchaser had experience extending credit to similar entities and was making an independent credit decision and (3) risk was mitigated by the fact that the notes were secured by a first lien on the borrower's assets and were covered by regulatory guidance from the OCC, FDIC and Federal Reserve. The arguments will not end there, however, as Kirschner has filed a petition asking the U.S. Supreme Court to review the case, arguing in part that the Court should reconsider the Reves framework and replace it with a test that more closely reflects the statutory text. A determination that syndicated term loans are subject to regulation as securities could impact not only new loans, but existing loans that have already been trading in the market, and would have an extremely disruptive impact on the syndicated loan market.
Basel III: On July 27, 2023, the Fed, OCC and FDIC jointly issued a notice of proposed rulemaking intended to modify U.S. bank capital requirements to bring them in line with the Basel III "endgame" international banking standards. Since introduced, the proposal has brought unprecedented pushback – not only from interests within the banking sector, but by bipartisan groups that have expressed concern about the impact of the regulations on lending to small businesses and minority communities, and on sustainability financing. In a first for banking regulations, an advertisement opposing the regulations aired during a Sunday night NFL game. In response to the pushback, Federal Reserve Vice Chair Michael Barr has strongly indicated that the agencies are open to updating the proposed rules based on the concerns and comments received. Of particular concern for the lending industry is the rules' failure to address the value of non-financial collateral often taken for commercial loans, such as receivables and inventory, for credit risk calculations. Goldberg Kohn has worked closely with the Secured Finance Network, the trade organization representing asset-based lenders, to obtain clarity from the regulatory agencies on the proposal and to coordinate comments. The SFNet comments were submitted to the agencies on January 10, and are available on the SFNet website here.
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 Based on data collected by GK.
 The leverage levels generally reflect some required decrease from closing date leverage.