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Navigating the Evolving Landscape of Incremental Financing and Syndicated Facilities

In today's dynamic credit environment, private and public companies, private equity funds, and lenders face a myriad of opportunities and challenges when it comes to incremental financing and syndicated facilities. As the economic landscape shifts and interest rates fluctuate, it is crucial for all parties involved to understand the intricacies of credit agreements, Term Loan B syndicated markets, private credit, and revolving credit facilities. This article will delve into the world of incremental facilities, a common feature in lending markets that allows borrowers to efficiently raise new debt financing while maintaining compliance with existing debt arrangements.

The Current Credit Environment

The past few years have been marked by significant changes in the credit market, largely driven by the substantial increase in interest rates. As of April 2024, interest rates have reached an all-time high, coinciding with a period of inflation. While the Federal Reserve is expected to reduce interest rates around March, it remains uncertain whether the European Central Bank or the UK will follow suit. Despite these challenges, the robustness of the economy and markets has led to an uptick in re-pricing transactions and increased activity in the syndicated markets.

Prior to 2022, the lending landscape was characterized by low interest rates and favorable conditions for leveraged buyout (LBO) financials. However, as interest rates soared, the influence of higher borrowing costs caused a shift towards alternative markets, such as direct lenders and less syndicated lending. As we move forward, the hope is that 2024 will see a return to more traditional financing markets, although it is unlikely that we will revert to the pre-2020 era of zero or low interest rates.

The Impact on M&A Activity

The higher interest rates have had a significant impact on mergers and acquisitions (M&A) activity, with 2023 seeing M&A volume drop to its lowest level in a decade. This decline can be attributed to the substantial valuation gap between buyers and sellers, as evidenced by the shrinking average leverage multiples for M&A deals and the historically low purchase price multiples. To facilitate transactions, private equity sponsors have been putting in a larger percentage of equity relative to debt, reaching 67% in the first portion of 2023.

As a result of the challenging economic conditions, certain companies may face difficulties in servicing their debt, leading to an uptick in corporate defaults and restructurings. Forecasters predict that this trend will continue and worsen, at least through the first half of 2024, although not to the extent of the global financial crisis. Default rates are expected to rise slightly to 3.5-4% in 2024, compared to 3-3.5% in the previous year, before falling to 2-3% in 2025.

One interesting consequence of increased corporate defaults is the declining recoveries for first lien lenders, a trend that has been ongoing but continues to accelerate. This is primarily due to the top-heavy nature of many capital structures, where senior secured facilities are often the sole or primary debt class. Additionally, the continued rise of covenant-lite loans contributes to this situation, as companies are not required to maintain ongoing compliance with financial maintenance covenants.

Incremental Facilities: A Key Tool for Borrowers

Incremental facilities, also known as accordions, are a vital tool for borrowers seeking to raise new debt financing quickly and efficiently. These provisions, embedded within credit agreements, allow borrowers to increase debt under the credit facility itself without needing to seek consent from existing lenders. The flexibility provided by incremental facilities is crucial for companies looking to pursue acquisitions, fund general corporate purposes, or enhance liquidity.

When considering an incremental facility, borrowers must be aware of the conditions and limitations set forth in the credit agreement. These guardrails, negotiated at the original closing, are designed to protect lenders and maintain their status in the capital structure. Borrowers should carefully review the incremental provisions to understand the maximum incremental amount, which is often determined by a formula that takes into account a fixed prong (free and clear basket) and a ratio prong (subject to meeting specified leverage ratios).

It is important to note that incremental facilities are not the only way for companies to incur additional debt. Other common methods include sidecar facilities, ratio debt baskets, and acquisition debt baskets. Each of these options comes with its own set of advantages and disadvantages, and borrowers must carefully consider which route best suits their needs.

Lender Protections and Credit Enhancements

As companies seek to raise new debt financing, lenders may require certain credit enhancements to protect their interests. One of the most common and crucial protections is the most favored nation (MFN) provision, which ensures that existing lenders are not disadvantaged by the terms of the new debt. If the new debt is priced outside of a specified threshold (often 50 basis points), the MFN clause requires the existing debt to be repriced to within that threshold.

Borrowers can negotiate certain exceptions to the MFN provision, such as sunset clauses (which cause the MFN to expire after a specified period), limitations on the types of debt subject to the MFN (e.g., excluding non-syndicated debt or debt with a longer maturity), and carve-outs for a portion of the incremental debt. The applicability and scope of these exceptions will depend on market conditions and the relative bargaining power of the parties involved.

In addition to MFN protections, lenders may seek other credit enhancements, such as higher pricing, additional fees, expanded guarantees and collateral packages, and enhanced voting rights. Borrowers must carefully consider the implications of these enhancements and weigh them against the benefits of the new financing.

Navigating the Complexities of Credit Documentation

One of the most significant challenges in navigating incremental financing and syndicated facilities is the complexity of the credit documentation. Credit agreements can span hundreds of pages, and a single transaction may involve multiple facilities (e.g., asset-based lending, term loans, unsecured bonds) and inter-creditor agreements. It is essential for borrowers, lenders, and their legal counsel to thoroughly review and understand the various provisions, definitions, and cross-references within these documents.

Subtle differences in language, particularly in the documentation principles and conditionality, can have a significant impact on the parties' rights and obligations. For example, the terms of a new financing may be limited to being "no less favorable" to the borrower and its subsidiaries, or they may be required to be "substantially consistent" with the documentation precedent. Careful attention must be paid to these nuances during the negotiation and drafting process.

Looking Ahead: Trends and Expectations

As we look ahead to the remainder of 2024 and beyond, several key trends and expectations emerge in the world of incremental financing and syndicated facilities:

1. Interest rates are expected to remain high but begin to fall, with the Fed's target benchmark rate leading the way.
2. Leverage levels will likely continue to be relatively low, as companies and lenders adjust to the new economic reality.
3. Refinancings and maturity extensions will continue to have a strong impact on the market, as companies seek to manage their debt obligations.
4. Liability management transactions, such as up-tier exchanges and drop-down financings, may become more prevalent as companies explore alternative ways to raise capital and manage their balance sheets.
5. Private credit will play an increasingly significant role as an alternative to traditional syndicated lending, particularly for middle-market and lower middle-market borrowers.
6. New loan issuances are anticipated to increase compared to the previous two years, but not to the levels seen three to five years ago.

Conclusion

The landscape of incremental financing and syndicated facilities is constantly evolving, shaped by economic conditions, regulatory changes, and the ever-shifting balance of power between borrowers and lenders. As companies and investors navigate this complex terrain, it is crucial to stay informed, adaptable, and strategic in their approach.

By understanding the intricacies of credit agreements, the various options for raising new debt financing, and the potential pitfalls and protections involved, borrowers and lenders can make informed decisions and achieve their financial objectives. At the same time, legal counsel plays a vital role in guiding clients through the complexities of credit documentation, negotiating favorable terms, and mitigating potential risks.

As we move forward in this challenging and dynamic environment, it is more important than ever for all parties involved in incremental financing and syndicated facilities to remain vigilant, proactive, and collaborative in their efforts to achieve success.