The Battle of the Grid
Tutorial of a niche Lord of the Rings video I made
Dropped a heater of a video this morning. A lot of it is niche/complex/IYKYK so I wanted to walk through it on here. Watch it here first and then I’ll explain it.
To set the stage (for the super noobs): when sponsors buy companies, they need to line up financing alongside their final bid to prove they have the money to close it. So they solicit a bunch of lenders to get the most debt, cheapest pricing, and most aggressive terms. The final legal document is called a credit agreement - credit agreements are born as little baby term sheets (non binding overview of terms), which eventually turn into commitment letters (binding overview of terms, but in less detail than a credit agreement), which hopefully turn into credit agreements if the sponsor wins the deal and it closes. You know when sea turtles hatch, they have to run to the ocean and away from predators? Lenders with commitment letters are the turtles, who not only need to avoid death by predators (in this case, sponsors pissed off that the terms aren’t aggressive enough), but also need their sponsor to win the deal. Simply put, credit agreements (which are very similar to bond indentures) are the king governing document in leveraged finance. They control literally everything the borrower can and cannot do, from pricing of the loan to how many days they have to deliver financials. Commitment letter negotiations are often done through “grids”, which is a document with a literal grid that lists all the terms, with the sponsor desired term on the left, and the lender’s response (in each box either “OK with this request” or a revised proposal. Lenders and sponsors have their respective counsels duke out the nitty gritty legal terms, and bubble up certain issues to the “ business side”. K&E is the predominate sponsor counsel, I imagine them in an evil lair throwing together garbage credit agreement terms. They often push the envelope unprompted, just to “provide value” to the sponsor (their client) and show they’re whipping on lenders without being asked. Think of K&E as Darth Vader reporting to the sponsor Emperor Palpatine (people forget that the Galactic Empire’s demise was partially driven by an overleveraged capital structure after a series of note issuances to finance a failed Death Star expansion). Ok, lets get into the niche references (NOTE: if I have explained these terms before, I copy and pasted from previous blogs so some of it may sound familiar)
“Fuck Cov-Lite”: Covenant lite is a term that means there is no financial covenant. The sponsor can fuck around, ruin the company, and the lender’s get basically no chance to attack back. These are crucial because they brings lenders back to the table if the company’s performance declines, at which point the lenders have the sponsor over the barrel and can tighten up the terms and direct as much cash flow back to paying off their loans. With a good sponsor and great credit, lenders will oftentimes remove this covenant for an additional ~50bps. In this tough market, cov lite is basically unheard of.
“The analysts and junior associates who have no fucking clue what’s going on”: Negotiations on these deals on the lender side are usually led by grizzled vets. Juniors are more focused on the memo/modeling side, and start to learn about this stuff at the senior associate level.
“Why don’t you take the pen on the first proposal?”: K&E will sometimes have lenders take a crack at the grid first in hopes of them starting off aggressive, so K&E can get even more aggressive on the response.
“First draft shows incurrence test 0.50x below closing leverage / WTF we got approved for 0.25x”: The incurrence test is the max point of leverage the company take their debt up to (excluding a bunch of carveouts but let’s ignore that for now). So if leverage is 4.5x and the incurrence test is 5.5x, the Company can lever up to 5.5x with zero questions asked. So a deal could be at 2.0x leverage today with 4.5x leverage pricing and you’d be like “wow great deal sign me up”. BUT when you read the fine print, you see incurrence test leverage is 6.0x. Oof. This is a huge “butt”. I’m talking huge. Like the kind of butt that’d be the result of some sort of cheap frankenstein BBL surgery gone wrong (the sub 10k follower IG model risked going to a cheap doctor she found on groupon and is now paralyzed from the ass down). The joke in the clip is that the lawyers went too lender friendly with an incurrence test much lower than closing leverage (so the company closed at 6.0x leverage, but going forward can only raise debt up to 5.5x. So they would have to grow EBITDA organically and delever before they could borrow again). This really pissed off the sponsor (“off-market” is what people say when they don’t get a term they think they should easily get). The lender MD says “WTF we got approved for 0.25x under closing”, saying that counsel went too conservative and they are about to get an ear full from the sponsor and K&E.
“The precedent doc is lender friendly on restricted payments and liens”: Credit agreements are all based on precedent deals. One poor law firm made the first ~300 page credit agreement from scratch in like 1950, and since then they just basically just tweak relevant terms. As a lender, if you agree to one term with a sponsor on one deal, you agree to that term in perpetuity regardless of credit quality. That is unless, the market has severely changed from the last time the precedent was used - aka right now!! This is when the bloodbath really ensues, because lenders are going to want to tweak precedent terms that the sponsor would sacrifice their first born for. Restricted payments/liens comment is the lender looking for conservatives terms related to dividends and making sure the company can’t put too many other liens on their assets.
“Prevent investments in unrestricted subsidiaries”: On a couple deals, sponsors engaged in some real fuckery where they snuck valuable IP into legal entities that don’t support the existing debt, then immediately borrowing new debt off of it. Lenders are scared shitless of this happening again, so have been putting in lots of language to prevent it.
“*Aggregate 25% cap on EBITDA adjustments calculated BEFORE giving effect*”: We’re all familiar with an EBITDA adjustment cap, but wanted to cover “before giving effect” concept. So let’s say you have $100MM of Adjusted EBITDA, which consists of $24MM of adjustments. That can be considered both 24% of EBITDA ($24MM / $100MM) or 31% ($24MM / $76MM) depending on whether you are including the addbacks in your denominator. Lenders always argue “before” effect and sponsors argue “after”.
“No grower on free and clear basket”: Let’s start with what a free and clear basket is. let’s say the Company levers up to their max incurrence ratio as described above. But the sponsor’s insatiable taste for leverage has not been quenched. That’s where the freebie bucket / Free & Clear (“F&C”) incremental basket comes in. It allows for the incurrence of debt ABOVE the max amount allowed under the incurrence test. So if your F&C basket is 100% of EBITDA, you could take your 6.0x incurrence test deal listed above and lever it to 7.0x. Even worse for creditors, borrowers can usually raise this debt outside of their credit agreement. So the sponsor can say “oh, the bank group won’t agree to give me an extra turn of leverage because it will completely fuck the credit profile up? That’s chill, I’ll just go down the street and raise it from a homeless day trader who is thirsty for yield”. The “no grower” concept would mean that its a hard number (usually 100% of closing EBITDA), but does not grow as EBITDA grows.
“No MFN carveouts”: MFN is meant to keep existing lenders from getting screwed on economics if a borrower issues a new piece of debt that is higher priced than the current deal. So if MFN is 50bps and the current deal is S+600, any new incremental piece of debt that is S+750 or higher would “trigger” MFN. As a result, the existing debt would increase to be within 50 bps of the new piece of debt. There are usually tons of carveouts with this (related mainly to size and seniority of the new debt) that nefarious lawyers can sometimes use to avoid increasing existing pricing, so lenders will try to remove them when negotiating. Also some of the more borrower friendly deals have an MFN sunset, which eliminates the MFN provision after a certain amount of times (6 months - 18 months). A new more expensive tranche can send the existing debt’s open market treading price to the shadow realm (especially if MFN has expired), because there’s no reason to buy the cheaper debt now.
“Limited unfunded facilities”: Lenders don’t love unfunded facilities (revolver and delayed draw term loan aka “DDTL”), mainly because they have to have the lending capacity to fund the loans, even though they are unfunded for an indefinite amount of time. This is a use of committed capital that isn’t racking up cash interest (aka profit) for the lender.