Episode 30 | Understanding Debt Portability in Loan Agreements

Piccirillo, Chris Hello and welcome to the Lending Lowdown. I’m Chris Piccirillo, senior managing analyst at LSEG LPC. Today's topic of discussion is debt portability or portable capital structures. Before we go there, I would like to introduce you to our guest, Arek Maczka, who is a partner at Ropes & Gray. Arek, thank you for joining us. Maczka, Arek M. Thank you, Chris. So just to introduce myself. My name is Arek Maczka and I'm a partner at Ropes & Gray based out of the firm’s New York office. I'm homegrown. I joined Ropes as a first-year associate. I have been here a little over 15 years. My practice is primarily comprised of representing PE sponsors and their portfolio companies and their leveraged financings, both in the syndicated and private credit markets. And I also regularly work with public companies with leverage credit facilities as well. In terms of sector, I'm fairly agnostic. I've worked with borrowers in tech, healthcare, business services, industrials, and digital infrastructure, to name a few. And in terms of size, I would say my practice is fairly broad. I represented borrowers with over a billion dollars of EBITDA all the way down to those with zero or less EBITDA including in the context of recurring revenue facilities and obviously everything in between. Piccirillo, Chris Great intro. Next would be a quick overview just to kind of brief our listeners on the topic. What is debt portability? Maybe a basic overview of the provision, its purpose, and its mechanics. Maczka, Arek M. Sure. So, starting from first principles, traditionally change of control triggers an event of default under a credit facility, and the definition of change of control can vary. But customarily it is when the original sponsor loses the ability to control the borrower. And any sale, you know, or disposition of the company, which is what we are going to be talking about here would fall within that category. And the rationale for that change of control, it’s pretty simple, I think and obvious probably to most listeners, lenders want to know whom they are partnering with. They are probably underwriting a particular sponsor’s investment thesis. They want to know that if the sponsor gets out, they can get out as well. Portability is a carve out from that change of control trigger, and the idea is subject to certain conditions and parameters being satisfied. A company can be sold, meaning the original sponsor or sponsors can exit without the change of control being triggered, so without lenders having any recourse. And the rationale is that, notwithstanding the points I mentioned earlier, lenders, to some extent, are also underwriting a debt facility to a particular borrower based on certain financial metrics or equity value as much as they are underwriting the identity or the investment thesis of a particular sponsor. And the benefits of the sponsors or borrowers’ perspective of having a portability feature in their credit facilities is nowadays, I think it's twofold, what people would say, the first one and probably the original rationale for getting for the creation of portability was fees. So, if a credit facility can be ported over and a new one doesn't need to be put in place in connection with an acquisition that obviously saves origination costs; fees to the lenders, you know, legal fees, etc. So, so there's an economic angle to it. And the second reason, and this one has kind of been learned over time just in, in the practice of doing deals, is that a portable capital structure is also useful as a backstop in the context of a sale process. So, if a sponsor is looking to sell a company and there's portable feature already in the credit agreement, incoming buyers or bidders in the context of an auction don't need to go out and find their own financing, necessarily. They can if they want to, but they don't need to because the, the facility that's already in place is portable and what that means is a sale process can move faster. There's no waiting on lenders. There's no, you know, lender diligence process. It's really just can become a two bilateral negotiation between the buyer and the seller and also confidentiality of a of a sale process, because there's much less concerned about leakage with information kind of being, you know, spread out among various parties. And I think two final kind of quick notes, high level in portability customarily it's added not in the context of the original origination of a facility, meaning when a sponsor acquires a company, more typically it's added after a few years in the context for refinancing or a dividend recap, and I think we'll talk a little bit about that rationale or why that is when we get some of the parameters of the facility, but that's historically been the practice. And the final point which is I think a simple and obvious one maybe to some people, but it bears repeating, is that portability is optional from the borrower's perspective. So there's not a requirement for a facility to port over it. The borrower can always prepay a facility in connection with an acquisition with if it's acquired if it, if the sponsor wants to or the incoming buyer wants to wants to prepay that facility so the lenders can be taken out. They don't have to remain in place. Piccirillo, Chris Makes sense. Yeah, the benefits are obviously clear to the borrower and the sponsor, which leads to our next question, what are some customary terms and conditions for portability sort of to get investors comfortable with that exception to the change of control provision. Maczka, Arek M. So there is market practice on this. I would say there's a handful of provisions that I think you'll find in every portable debt facility. So the first and probably most important one is that there's a max leverage, maximum leverage condition. Usually that's set at around closing date leverage. It doesn't necessarily have to be. Sometimes if a company is, you know, performing well and it's under lever that can be set at a little bit above closing date leverage. Sometimes if it's already has high leverage going in that can be set a little bit below. So it has to levered, but something in that in that vicinity is typically the case. In a small minority of deals, we have seen the concept of no worse than leverage. So as long as in the context of the sale of the company's leverage neutral, leverage isn't increasing, so maybe there's no incremental facility that's being done. Sometimes you'll see that in the concept of CL, incremental is done in addition to the portability. So, sponsor can pay cash out that the selling sponsor can pay cash out. So, in this context, you can't do that, but that means that leverage can be even above closing date leverage as long as it's not getting worse. And in many facilities as well syndicated particularly there's a minimum ratings condition, so B3B minus is I think the typical the typical set of ratings conditions. The next one I think probably second on the list would be the limitation on the identity of the sponsor and in certain cases strategics as well. So, the sponsor that will be acquiring the company typically cannot have AUM less than, Assets Under Management, less than a certain threshold. Typically around a billion dollars or so can be a little bit more, can be a little bit less, but usually It's around there, so the idea kind of being if a sponsor has a billion dollar fund or funds, you know, it's kind of a top tier, at least middle tier sponsor. Then for strategics, sometimes we'll see something like reasonably that the strategic is in a reasonably related or similar line of business as the borrower. So that one is, that provision is not in too many deals, but it's I think it's starting to grow as, as you know, people come across situations where strategic maybe acquire as opposed to a sponsor. On occasion as well, we sometimes see it more restrictive where there is a whitelist of specified sponsors that the lenders have pre-approved effectively and that whitelist can, if there is a whitelist, it tends to be fairly long like you'll see, you know, 50 to 100 names on there. Right obviously, as the sponsor universe has grown. The next condition is the minimum equity condition. Fairly straightforward. Usually something around 30 to 50%. of LTV minimum equity. Not, not usually a source of much contention. An interesting provision, the next provision is the timing provision. So, this is an interesting provision because it is one that people have been pushing on and that has been changing over the past few years. So originally, portability was viewed as more of a short-term provision - a year to two years. That's been pushed down now to two or three years. So, I would say two years is the floor almost of what people are getting now and three years tends to be the ceiling. Which you know that the rationale here being traditionally that that sponsors wanted some time to sell their asset. Nowadays, selling assets can take longer. So that period has been extended, I would say in, in compared to what it used to be. I think a few kind of, you know, interesting terms as well, not probably the primary terms, but I think people have been focusing on these two, are Basket Usage and Call Pro Refresh. So, Basket Usage, this can cut both ways, and it's a negotiated point from a sponsor's perspective, you would want to have baskets refreshed entirely in the context of a sale, so if there's any basket usage, it goes down to zero. Except you want to retain all the basket build you've had since the original closing date. So builder baskets that have built based on CNI, for example, or equity that's been contributed in the interim, you want to retain that. And that what I would say in many facility, I think that, I want to say it's a settled market but a compromise that tends to be reached fairly commonly is that there is kind of a just a clean slate approach taken where the baskets are refreshed, any basket usage goes away, but also any basket build goes away as well, so it's kinda it's the idea kind of being like it almost is like a brand new credit facility from basket usage or build perspective. Sometimes there's a bit of negotiation around the incremental freebie basket for the show, that capacity there, that's a basket that obviously is probably one of the most important baskets in the credit facility. There's also typically a restriction that any equity that gets contributed as part of the acquisition itself doesn't build equity. It doesn't build basket capacity either. And then finally, lenders have increasingly been pushing for a refresh of any call protection that they've had. Which, particularly in direct credit deals in the private credit market where there might be hard call 102/101. 2% for two years or 2% for the first year, 1% for the second year that that can be meaningful from a lender's perspective and the kind of rationale they're being again, if this was a brand new underwriter of a brand new facility, baskets are being refreshed, etc., then and it's kind of only fair that the call pro be reset. Piccirillo, Chris Good, I guess that's a good segue into our next question. After going through the terms. What is the current market landscape look like for portability? You know, it tends to be, in my view, a hot market provision that tends to ebb and flow with the strength of the markets. And to what extent are you seeing portable capital structures in the private credit market? Maczka, Arek M. So I think portability has become increasingly normalized over the past few years. I agree that it does tend to ebb and flow, especially in the syndicated markets. It also has that ebb and flow feel to it, because as I mentioned earlier, it tends to get put in, in the context of amend-and-extend or refinancings, which tend to be or dividend recaps, which tend to be more opportunistic transactions, right? So those transactions are usually being done in the context of a hot market. And that then tends to align with when it's easier to get portability through. What's interesting to me is with the growth of the private credit market, it used to be the case that seeing portability in private credit deals was pretty rare. Nowadays with the growth of that market and I think lenders increasingly looking to put capital to work and needing to put capital to work, there's been I think more comfort from the private lender perspective with portability where I think we didn't see that in the past. And I think that for companies that are doing well, especially, I would say for jumbo, kind of unit ranches of deals that are, 1 to 2 billion dollars or plus in the private credit side. The companies that are doing well that have that are still held, still owned by the same sponsors that acquired them, maybe 3-4 years ago, portability is becoming, I would say fairly common, but it's not. It's becoming a regular place term. Piccirillo, Chris Interesting. Where we’d go from here? What does the future hold? I mean, it used to be a very situational term. You know, I think sponsors didn't get it unless they asked for it, you know, highly negotiated term. Will we ever get to a point where portability is sort of a standard, you know boiler plate term in the first round of the commitment letter negotiation? Maczka, Arek M. I think there'll always be a place for portability. I don't think I would be as you know from the borrower perspective, I was optimistic to say that it will ever become boilerplate. As much as maybe I would like it to, I think, or my clients would like it to. I think it will, it will depend on things like the state of the overall market and hold times, right? So, as I think private equity sponsors are holding on to assets longer and longer. And exits are becoming either more difficult or there's more negotiation. Let's put it that way around, you know, terms of a deal or price then, and sponsors might look to do, you know, dividend recaps or put their assets in continuation vehicles to, to exit right or to do partial sort of exits. I think in that context, putting portability in place, is attractive, right? And again, as the private credit market grows and I think lenders want to put capital to work as much as they want to get capital back, I think that there's a you know there may be a softening over the next you know few years or continued softening on any kind of resistance to portability in those contexts. So, little I put myself in the cautiously optimistic camp, but I definitely don't think it'll be the place where we'll be seeing portability in any you know, every single deal that we do or anywhere close to that. Piccirillo, Chris Makes sense. Boy, I think that's a wrap, Arek. I just want to thank you for sharing your insights. Thank you for your time and thank you for joining us. I'd like to thank all of our guests for tuning in. Please check out our Loanconnector.com platform for everything related to syndicated loans and direct lending and private credit from news and data to analytics. I'm Chris Piccirillo, subscribe and tune in next time to the Lending Lowdown on your favorite podcast platform.