Europe’s private equity sponsors want private credit lenders to give them greater flexibility to increase leverage once an M&A deal has closed and are asking for provisions that typically appear in high-yield deals to be included in their legal contracts.
Specifically, tough negotiations over the implementation of the so-called “freebie basket” in new core and upper mid-market private credit deals are rife, say market sources, and a number of lenders have already agreed to the new terms.
“In some instances, on very good credits with strong sponsors, we are seeing unitranche and private debt deals done with high-yield style covenant packages,” said Megan Lawrence, leveraged finance partner at Proskauer.
In the large-cap private credit space, she says legal document terms, in some instances, are converging with the syndicated loan markets.
Providing headroom for additional debt under a Credit Facilities basket has long been a staple in the high-yield market and has become a cornerstone of additional debt flexibility for borrowers needing an extra turn of leverage. Its prevalence (under the “freebie basket” moniker) has also been on the increase in mid-cap leveraged loan documents.
Now, sponsors are pushing for these more flexible terms in private credit deals thanks to the fierce competition for new business between the broadly syndicated loan and direct lending markets.
Alexander Griffith, private credit partner at Proskauer, confirms that there have been an increasing number of deals over the past 18 months that have added freebie flexibility to certain provisions.
“In most mid-market deals leverage is moderate,” said Henri Lusa, managing director private debt Europe at Partners Group. “However, there are many occasions in which borrowers request the ability to increase leverage post-closing of the deal.”
Ready to roll
The amount of additional leverage requested by sponsors varies from deal to deal, say market sources, though sponsors are typically seeking flexibility through the freebie basket to add 0.5-1x of leverage.
Activating the freebie basket will be dependent on positive EBITDA performance of the company in question.
Having this flexibility in the documents can cut out further rounds of negotiations between parties if new capital is needed for an acquisition, because the documents are already in place, says Partners Group’s Lusa.
And, assuming an uptick in M&A activity in the coming months, the capacity to add new debt means both lenders and sponsors are ready to move quickly, when the time comes.
Negotiating flexibility
But despite the increasing number of requests, freebie baskets are currently restricted to the strongest, best-known credits in the private credit space, backed by the biggest sponsors, say market sources. And for the most part, the majority of direct lenders are reticent to offer the provision to would-be-borrowers.
Those that are willing to include the provision may suggest a compromise.
“We are very focused on the ability of borrowers to incur additional debt,” said Mark Bickerstaffe, co-head of direct lending at Hayfin, adding that “we sometimes see sponsors preferring a lower opening leverage with the ability to increase post-closing, for example to fund an acquisition. Subject to the right controls, we are open to providing that flexibility in the docs.”
The maths must work too. Despite the highly competitive financing environment, neither banks nor debt funds can accept the prospect of higher debt in documents if the opening leverage has already reached a critical level at closing of the deal, say market sources.
For now, activity is restricted to all but the private credit market behemoths, but the door is ajar for smaller borrowers who may want to get in on the freebie action in the months ahead.
Sponsors will remember which private credit fund managers have accepted the freebie basket provisions on larger deals, says Griffith, and they’ll ask that same lender to accept the provisions on a smaller deal, too.
Be careful what you wish for
Lenders must be confident that borrowers can handle the load and trust the sponsor to jump in to help in times of stress. High leverage can quickly turn into curse, even for promising borrowers.
In one recent example, Arcmont is taking the keys to German computer gaming equipment provider Pro Gamers Group (Caseking), according to public filings, in part because of the high leverage multiples.
There was fierce competition to fund this HAL Investments portfolio company in 2021 when the sponsor acquired it from Rivean, given that it benefited from a strong demand for gaming equipment from consumers during the pandemic.
But despite reporting improved revenues and operating income in 2023, it missed HAL’s targets, and the sponsor reduced its expectation of the future profitability of the company.
“In view of the high leverage of the company and the associated interest expense, the book value of the investment in Pro Gamers was fully impaired during 2023 (effect for HAL of €131mn),” the 2023 financial report for HAL stated.
Kerstin Kubanek
kerstin.kubanek@levfininsights.com
+44 (0)7442 014 521
