Overview
In large cap syndicated leveraged loans, there are often changes made to the credit agreement after the initial draft is posted for lender review purportedly based on lender feedback. These changes are referred to as “flex” and such changes are nominally intended to be lender friendly. 1 It is customary for the lead arrangers to circulate one–page transaction updates (a “One Pager”) to the lenders that are participating in the syndication describing the changes that have been agreed to between the borrower and the lending syndicate (usually prior to, or even in lieu of, updated loan documentation). However, many times the brief descriptions of the revisions to the credit agreement included in the One Pager are incomplete or misleading. In this Report, we provide some examples of credit agreement terms that are commonly included in the One Pager but that often end up looking quite different in the final credit agreement.
Serta Protection
A very common flex term during syndication is the inclusion of what is colloquially referred to as “Serta” protection (named after the company that utilized the particular weaknesses in loan documentation that are supposed to be addressed in the One Pager). For additional information on these provisions see our prior report here. Frequently the One Pager will include a short statement such as “Serta protection to be included” or words of similar effect. Lenders are led to believe that they have successfully negotiated an affected lender consent for amendments to subordinate the payment and lien priority of the obligations under the credit agreement.
However, lenders are frequently surprised when they read Covenant Review’s analysis of the language that was included in the revised credit agreement. There are often a number of exceptions or limitations on the protections that lenders did not agree to in the negotiations. For example, the Serta protection added will often include an exception for priming debt if the existing lenders are given a bona fide opportunity to participate in such debt on a pro rata basis. This appears on its face to be acceptable to lenders because this exception would at the very least prevent the exact facts of Serta, where the lenders that were outside the restructuring group woke up one morning to discover that they now held deeply subordinated obligations. However, there is often an exception to the pro rata offer requirement for certain fees, such as structuring fees. This allows the company to cut a deal with the majority lenders, compensate them with structuring fees, and then conduct a coercive exchange offer with the remaining lenders, who will not receive the structuring fees. 2 Another common exception to Serta protection is for priming debt permitted by the credit agreement. The flaw here is that it often isn’t limited to the credit agreement as in effect on the closing date. This potentially allows the company to amend the negative covenants to permit additional priming debt with just a majority lender vote to circumvent the Serta protection. In some very aggressive deals, there may even be a blanket exception for any priming revolver or asset-based facility. This exception swallows the rule, and it almost never includes restrictions on revolvers that term out over time, so the company could potentially incur a priming revolver and in very short order convert it into a priming term loan.
J. Crew Blockers
Another common flex term during syndication is addition of a J. Crew blocker (which are provisions meant to block the transfer of certain material assets—usually limited to IP—to unrestricted subsidiaries). As with Serta protection, it will often be a simple statement in the One Pager such as “J. Crew blocker to be included.” Lenders believe that they have successfully negotiated to keep at least material intellectual property (if not all material assets) from being transferred to unrestricted subsidiaries.
The scope of coverage of J. Crew blockers can vary greatly. For some examples of common methods that companies use to weaken J. Crew blockers, see our prior report here and for some of the inherent weaknesses of J. Crew blockers, see our prior report here. All of the methods described in those reports have shown up in various forms in revised credit agreements after flex during syndication. And there are even more aggressive examples floating in the market. In one recent transaction, the J. Crew blocker was limited to three specific trademarks. The credit agreement did not even include a representation that these trademarks represented all material intellectual property, and, to the extent any intellectual property subsequently became material, it would not be covered.
A particularly egregious example of flawed blocker language came in another recent transaction. The One Pager that was circulated included “Incorporation of J. Crew & Chewy protections.” However, the language that was included in the credit agreement with respect to the J. Crew blocker had two significant limitations. The first was that transfers of material intellectual property to unrestricted subsidiaries were permitted as long as they didn’t cause a “Material Adverse Effect.” Given how broadly the term “Material Adverse Effect” is defined in most BSL credit agreements, it would take an absolutely catastrophic event to be triggered, rendering the J. Crew blocker essentially meaningless. To add insult to injury, transfers of material intellectual property to unrestricted subsidiaries would be permitted if the loan parties continued to “have use of such Material Intellectual Property.” So, a transfer of material intellectual property to an unrestricted subsidiary with a relicense back to the loan parties would be permitted. The reason that is so galling is that it is exactly what was done in the J. Crew transaction itself. The One Pager said that J. Crew protection would be incorporated, but the provision that showed up in the revised credit agreement would not have protected from J. Crew! That’s the level of craziness we have reached in the broadly syndicated leveraged loan market.
Chewy Blockers
Lenders often also seek so–called “Chewy” or “PetSmart” blockers during syndication. One Pagers are again often quite vague on this kind of protection, with a statement such as “Chewy blocker to be added.” For background on the genesis of Chewy blockers, see our prior report here. Lenders may think that transfers of minority equity stakes of guarantors to affiliates (which causes release of the guarantee and liens of such subsidiary) are going to be prohibited.
There are a number of ways in which Chewy blockers are watered down. A common example is allowing transfers to affiliates if there is a bona fide business purpose. This allows the company to come up with some reason why it makes business sense to transfer equity of a guarantor to an affiliate and dare the lenders to sue over release of the guarantee. Another method is to permit release unless the primary purpose of the transfer was to cause the release of the guarantor. Under this formulation, even if lenders can prove that the release was one of the reasons why the equity was transferred to an affiliate, as long as there was some other benefit that outweighed the release, the transaction will be permitted.
An egregious example of a weakened Chewy blocker was also seen in the same recent transaction discussed under J. Crew blockers above. To repeat, the One Pager provided for “Incorporation of J. Crew & Chewy protections.” However, the language in the revised credit agreement only required a certification that the company would have been able to make an investment in the amount of the fair market value of the equity of the non-wholly owned subsidiary held by the restricted group on a pro forma basis. It didn’t appear to require utilization of investments capacity, and the credit agreement had the “free flow of value” problem where there is unlimited investments capacity in restricted subsidiaries. The Chewy blocker (if you can call it that) didn’t specify an investment in whom, so because the company had uncapped ability to make investments in restricted subsidiaries, it would always have capacity to make an investment in the amount of the fair market value of the equity of the non-wholly owned subsidiary in another restricted subsidiary. The Chewy blocker was effectively worthless.
Another example of a flawed Chewy blocker from a recent transaction appeared at a quick glance to be a normal (albeit aggressive) Chewy blocker, as it prohibited release of any guarantor that became non-wholly owned as a result of a transfer of equity interests to an affiliate in “a non-bona fide transaction the primary purpose…of which was to cause such entity to become an Excluded Subsidiary.” However, the provision allowed for release with the consent of the administrative agent. So, the administrative agent had the ability to release the guarantor if the transaction violated the Chewy blocker, significantly limiting its usefulness.
Other Examples
Of course, the foregoing are not the only instances where arrangers may “bury the lede.” Other examples include changes to ratio levels during flex. A One Pager may state that the ratio test for unlimited restricted payments will be set 1x inside “the Closing Date Net Total Leverage Ratio.” Lenders assume that this means that one turn of de-levering will be required from marketed levels before the ratio basket for restricted payments becomes available for utilization. The trick is that there the final credit agreement may end up using a defined term for “Closing Date Net Total Leverage Ratio” that sets the level somewhere outside (that is higher than) the marketed level. So instead of requiring one turn of de-levering, the company instead only needs to de-lever by 0.7x to access the carveout.
Lender calls can be another trick. The One Pager will say something like “Quarterly lender calls to be added.” Then the revised credit agreement shows up and the lender call is only required if the majority lenders, or—often—just the agent, request one, putting the onus on the lender group to demand the call. In effect, lender calls are not mandatory.
Conclusion
Lenders should be wary of the terms set forth in One Pagers. The interest of the lead arrangers is getting the deal fully syndicated on the best terms possible for the company—not to provide lenders with the best terms to protect themselves against liability management. An incomplete summary of the flex terms can help them achieve that as the lenders think they have negotiated for a set of revisions. In reality, however, the One Pager hides the truth: that the company has subsequently undermined many of the “negotiated” protections in order to make the deal better for itself.
Covenant Review will continue to assess the terms in One Pagers as we see them.
1 Terms that are changed in the borrower’s favor (most commonly in the context of pricing) are referred to as a “reverse flex.”
2 Indeed, Covenant Review has seen several recent uptiering liability management exercises where non–consenting lenders found themselves between a rock and a hard place (either accept the priming debt terms, regardless of whether they would otherwise have—or face subordination, covenant / collateral strips, or worse).
Kevin Grondahl
Covenant Review
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