December 31, 2018 - In its final CLE program of 2018 on December 20th, the LSTA hosted an expert group of speakers to discuss current market trends in the middle market. “Understanding Current Market Trends in the Middle Market: What’s In / What’s Out?”, moderated by Linda Filardi of Capital One, offered diverse perspectives, including those of arranger, direct lender, investor and borrower, which were represented by Carolyn Alford of King & Spalding, Michael Blumberg of Varagon, Brad Charchut of Bain Capital Credit, Martha Gurwit of Antares Capital, Nanette McNally of AEA Investors, LP and Josh Tinkelman of Latham & Watkins. Looking back, 2018 was a year of document awareness. Years of a borrower-friendly market environment have undeniably led to a loosening of terms. J. Crew, Chewy/PetSmart and other transactions brought special attention to the nuances in current covenant packages and particularly how flexibility across baskets could be used in unexpected ways. While the degradation of terms has been most pronounced in the large cap syndicated loan market, there has been a migration of many of these terms into the middle market which continued in 2018. Looking at developments with specific terms, the speakers addressed a number of areas: EBITDA adjustments, investment baskets, the role of restricted and unrestricted subsidiaries, restricted payments and additional debt baskets and asset sale provisions. Generally speaking, lenders have come to understand that EBITDA has become a “point in time number” rather than a historical lookback. From an underwriting perspective, this may be simple to address, but the speakers reminded lenders that “EBITDA” must also work with respect to the financial covenants in the credit agreement. Speakers cautioned lenders to look at restructuring costs and EBITDA synergies which are uncapped, lengthy “look forward” periods, e.g. 12-24 months, and actions which may not need to be taken but rather can only “initiated” during that period. With respect to investment baskets, the speakers warned lenders to look at the size of the basket permitting investment in unrestricted subsidiaries. In some cases, there may be an outright restriction on the transfer of material IP or material assets to unrestricted subsidiaries. Increased lender attention here is an outgrowth of J Crew/Neiman Marcus, but is an area that merits particular attention in middle market transactions where borrowers often have “crown jewel” assets. Moreover, attention should be paid to the ability to reclassify transitions to move from the fixed basket to the unlimited basket and “stacking” where additive investments baskets may be used for unrestricted subsidiaries absent an express overall cap on unrestricted subsidiaries. The use of restricted and unrestricted subsidiaries, an import from the high yield bond market, is not new in credit agreements, but it can lead to collateral leakage if not structured appropriately. Lenders should pay attention to the ability of borrowers to designate unrestricted subsidiaries, which are non-guarantors and not subject to the covenants in the credit agreements, and the ability to release non-wholly owned subsidiaries/guarantors that become non-wholly owned. Like investments baskets, the additional debt baskets and restricted payments basket can be prone to “stacking” and lenders should be aware of any latent additive flexibility in the credit agreement. Finally, there have traditionally not been step downs for asset sales because assets are collateral for senior, secured lenders. However, there have been successful borrower requests for longer reinvestment periods with respect to asset sales and borrowers have negotiated for asset sale prepayment step downs albeit with flex to remove such step downs during syndication. As 2018 draws to a close, an important point flagged by the speakers is that the tide may be turning on terms. Amid a sell-off across the capital markets, 4Q18 saw $10 billion in loan fund outflows with more than 50% of that seen in December alone. This change in market technicals puts pressure on some of the more aggressive borrower-friendly terms. Going forward, it remains to be seen whether the market conditions continue to evolve in this way as we begin 2019. For an in-depth look at the terms discussed here and more, please review the webcast replay.
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