European leveraged loan restructurings: why the next downturn will be different

Although the IMF recently announced at Davos that it would upgrade its global economic forecasts, with an improvement predicted in the later part of 2023 and into 2024, times remain difficult for many companies and their lenders – and are likely to remain so for a while yet.  In this article, we look at how current trends in the UK and European leveraged loan markets may affect the way in which future restructurings may play out, new UK legislative hurdles that may need to be factored in to any potential restructuring and (on a more positive note!) the new UK tools such as the restructuring plan that may assist a company in achieving a successful restructuring despite creditor or shareholder objection.

More Flexible Terms

When evaluating leveraged loan terms, lenders have three key questions:

  • How much more senior secured debt could be added to the deal going forward without their consent?
  • How easily could they get to the negotiating table should things go wrong?
  • How easily could they trade out of that loan if necessary?

For loan documents signed in the European leveraged loans market in the run up to the economic financial crisis of 2008 (the “GFC”), the answers to these three questions were usually:

  • Not very much;
  • Pretty easily due to a suite of quarterly maintenance financial covenant tests, which included interest and cash cover tests in addition to leverage; and
  • Without much difficulty, particularly after the occurrence of an Event of Default.

In the intervening years, and partly as a reaction to restructuring experiences gained during the GFC, market forces have moved documentation terms to deliver far greater flexibility and autonomy for private equity sponsors and their portfolio businesses.

More senior secured debt can be incurred

Let’s start with the secured debt pile. Prior to 2008, accordion/incremental facilities were rarely seen. Fast forward a decade and virtually no deal is signed without one, and they are usually uncapped in amount, albeit indirectly controlled by leverage restrictions. Other debt incurrence flexibilities have been incorporated. Some of these, like structural adjustment clauses, have become standard precisely because of the restructuring experiences of both lenders and sponsors trying to restructure businesses during the GFC, where to facilitate the injection of emergency funding “hollow tranche “structures were resorted to. Of course, additional secured debt, of itself, is not a bad thing: it can be a lifeline for distressed businesses; but where lenders get twitchy is when they are unable to monitor or control how that debt is raised.  For instance, on large cap deals there will be permissions for the borrower to transfer assets to Unrestricted Subsidiaries, and to raise more debt against those assets.

According to Reorg1, borrowers on H1 2022 facility agreement terms are, on average, able to incur additional senior secured debt of 3.8x EBITDA and additional structurally senior debt of 2.51x EBITDA. There are also now fewer asset protection controls. Previously rigid controls over asset disposals have been relaxed and much wider permissions given, including sizeable grower baskets. Lenders generally also have much less control over the application of disposal proceeds than would have been the case pre-GFC.

Financial covenant tests do not provide the same level of protection

For many years now, European leveraged loans have followed the high yield bond market in relying  on an incurrence leverage test, sometimes alongside a springing maintenance leverage test operational if the RCF is sufficiently drawn at the time. Unlike quarterly tested maintenance covenants, incurrence tests are easier for the business to work with to ensure that they are in compliance.

Mid–market transactions normally only have one maintenance test now, usually a leverage test of Net Debt to Adjusted EBITDA. A maintenance test does ensure the need for more rigorous adherence by the business compared to a debt incurrence test. But compared to pre-GFC terms, the additional cushion to the base case model with which these tests are now set, the well-documented wide EBITDA add-backs (including synergies and cost savings which apply following a wide range of trigger events, not just permitted acquisitions), the frequent exclusion of RCF outstandings from the debt side of the ratio, as well as expanded equity cure rights, do collectively enable portfolio businesses to manage the maintenance test more easily.

It is also worth mentioning that the various permission baskets applying to negative covenants are also generally run off Adjusted EBITDA and are grower baskets. This can result in greater dissipation of assets out of the banking group than was the case pre-GFC.

Less warning of distress and a later ability to intervene

The combination of these factors means that:

  • any Event of Default is likely to occur at a much later stage in any decline of a portfolio business than in previous downturns.  It may well be that the first default to occur will be a payment default or insolvency event; and

  • lenders are likely to have less warning of impending financial distress.  They may find it more difficult to force a negotiation meeting when the business is distressed but before the occurrence of an event of default should the sponsor not be ready to involve them in discussions at that time. 

The flipside is that financial sponsors generally will have more ‘skin in the game’ in terms of a larger percentage equity cheque than was the case pre-GFC. Clearly they will be keen to protect this by keeping the business afloat and so, to that extent, will have a common purpose with the secured creditors. Most will also be keen to protect their reputations as investment partners.

Transfer restrictions

In post-GFC documentation, how easy is it for lenders to trade out of the loan should that become necessary? Well, considerably harder than it is for noteholders to dispose of high yield bonds.

The standard LMA transfer provision requires borrower consent (not to be unreasonably withheld or delayed, and deemed to be given if the borrower does not respond within a specified short timescale) unless the transfer is to an entity on the pre-approved lender list or to another lender/affiliate or related fund of the transferring lender, or if the transfer is made whilst an event of default is outstanding. Pre-GFC loan documents did not stray far from this LMA construct.

This position has been heavily negotiated by sponsors over the last few years. Loan documents now give the borrower much more control over the transfer process. Those controls are usually extended to voting sub-participations too and may even apply to all sub-participations. Modern transfer requirements are quite burdensome, including pre-notification requirements of up to 10 business days prior to the proposed transfer, even sometimes for transfers to parties on the pre-approved list. In addition, many deals contain no requirement for the borrower’s consent right to be reasonably (or even promptly) exercised.

In many deals the deemed consent provision has been removed altogether, or the period after which consent is deemed given significantly lengthened.

The event of default gateway on the ability to freely transfer debt is significantly curtailed now in the vast majority of deals and limited to a sub-set of events of default, being insolvency and non-payment default only and potentially financial covenant breach and failure to deliver key financial information. What’s more, there is frequently a complete ban (whether or not an Event of Default has occurred and whether or not the transferee is on the pre-approved list) of transfers to entities whose interests may not be aligned to the borrower’s interests, including loan to own/distressed investors, industrial competitors, and sometimes to sponsor competitors and net short lenders. The definitions used for these categories require close scrutiny. They can be very widely drawn.

To police these provisions, it has become normal for the agreement to state that any transferee will be disenfranchised if they have taken a participation in breach of the transfer clause and may even have no entitlement to interest payments.

New hurdles

Pre-packs to connected parties

More flexible covenant packages are not the only new hurdles that restructuring professionals will face in the next downturn.  

During the downturn that followed the GFC, pre-pack administrations (where the terms of a business or asset sale are agreed pre-appointment and the sale completed immediately following the appointment of the administrator) were a device commonly used to effect a restructuring.  Although subjected to intense criticism at times, particularly around the issue of perceived lack of transparency for unsecured creditors not involved in the transaction, pre-pack administrations can have significant benefits when compared to a sale following a trading administration, including greater preservation of jobs and reduced disruption to a trading business.

Pre-packs involving sales to parties connected with the company in administration, such as the management team or the shareholders, attracted the most sustained criticism.  So in 2021 the Administration (Restrictions on Disposal etc to Connected Persons) Regulations 2021 were made (the “Regulations”).  In short, where the administrator wants to dispose of a substantial part of the company’s business to a connected party within the first eight weeks of the administration:

  • it either has to obtain creditor consent at the same time as the administrator’s proposals are approved; or
  • the proposed purchaser must obtain a report from an evaluator which either:

    • confirms that the evaluator is satisfied that the consideration to be provided for the relevant property and the grounds for the substantial disposal are reasonable in the circumstances; or

    • that it is not so satisfied (although the administrator is still able to dispose of the assets even with this negative report).

The Regulations set out the matters that the evaluator’s report has to cover.

While the Regulations don’t prevent an administrator making a disposal to a connected party, the requirement for an evaluator’s report does have to be built into the timetable when preparing for a pre-pack.  Failure to get the report pre-appointment is likely to delay completion of the sale which, depending on the type of business being sold, may cause value to drop significantly. Another issue to keep in mind is that where lenders control one third or more of the voting rights of the company in administration and the proposed sale is to a company in which the lenders will also have an interest, it is likely that the lenders will be connected parties and the Regulations will have to be followed. You can read more about the Regulations in our Engage article here.  

Distressed disposals

Where a company or an asset is being sold in a distressed situation, it is likely that any purchaser will want to be sure that it is taking that company / asset free from debt liabilities or security.  And it’s here that the distressed disposals clause in the LMA Intercreditor Agreement comes into its own. 

The distressed disposals clause is intended to allow the Security Agent to dispose of assets free from security and to effect a release of certain borrowing or guarantee liabilities entered into by the company being sold. Following the GFC, many junior creditors were taken by surprise when senior creditors were able to effect a pre-pack which saw the junior debt left behind in the old, insolvent company and guarantees and security granted by companies who were transferred into a newco structure released without the active involvement of the junior creditors (in other words, the junior debt was ‘burnt off’ in restructuring parlance).

Two well-publicised cases in this area are the restructurings of IMO Car Wash (where, following an unsuccessful challenge to a scheme of arrangement involving the senior creditors and a subsequent pre-pack administration, the junior creditors’ claims were burnt off) and Stabilus (where again the junior creditors’ claims were burnt off, this time by the Security Agent enforcing the security, transferring the trading subsidiaries into a new structure free from the junior debt, and releasing the security and guarantees held by the junior creditors).

Perhaps because of that experience, for many years now junior creditors have sought more protection in the intercreditor agreement to try to ensure that any distressed disposal is for a fair value. In short, junior creditors resist drafting which assumes that a disposal by an insolvency practitioner or by a court-appointed or supervised process is deemed to be fair. This is because of concerns that a pre-pack administration or a scheme of arrangement does not necessarily deliver guaranteed fair value. Instead the fair value requirement will often only be presumed to be satisfied if sale has been made by a ‘competitive sales process’ or if a ‘financial adviser’ has delivered a ‘fairness opinion’. Detailed provisions will be included to define what these conditions require. While these protections will not prevent a restructuring from taking place, they may well limit the restructuring options open to senior creditors. 

More new legislation…

The Regulations are not the only new piece of legislation that may impact the way in which a restructuring in the next downturn is carried out.  Of particular note are the National Security and Investment Act 2021 (“NSIA”) and the Pension Schemes Act 2021 (the “PA”).

The NSIA

Under the NSIA, prior notification of an acquisition of control of a company must be made if the company is in one of 17 specified sectors.  Failure to make the notification and to obtain clearance before the acquisition of control is a criminal offence and may lead to significant civil penalties too.  The transaction will also be void unless retrospectively validated. 

NSIA can affect restructuring transactions in unexpected ways. In particular, where shares in an entity which is subject to the NSIA mandatory notification regime are charged, it is possible that an acquisition of control will take place once the lenders (or the Security Agent in a syndicated transaction) gain the ability to vote charged shares – regardless of whether they actually vote the shares or not.  Often this transfer of control will happen automatically on the occurrence of an event of default, or (depending on the drafting of the security document) possibly on a declared default.  So care needs to be taken (and advice sought) if it is likely that control of the voting rights will pass to the lenders as part of the restructuring. While there is an exemption in the legislation for lenders holding security over shares, the scope and effectiveness of that exemption is still somewhat unclear. 

Administrators are exempt from the mandatory notification requirement, but any purchaser buying a company which is in scope from the administrator will have to obtain clearance and that will have to be factored into the timing of any sales process.  Unfortunately, that exemption does not extend to liquidators or receivers. It would appear that a receiver who takes control of charged shares and the attached voting rights in an in-scope entity would have to obtain clearance first, which again may impact the timing and implementation of any enforcement strategy.

The PA

Creditors have been aware for a while of the risks that can accompany the restructuring of a group with a defined benefit pension scheme, particularly if that scheme has a deficit.  One of those risks is that if the creditor is “connected” to the employer, the Pensions Regulator may exercise its moral hazard powers and impose a financial support direction or contribution notice, potentially requiring the creditor to make a financial contribution to the pension scheme.  Another is that steps taken as part of the restructuring may require notification to, and clearance from, the Pensions Regulator.

The landscape became more complicated with the arrival of the Pension Schemes Act 2021.  Through an amendment to the Pension Act 2004, two new criminal offences were introduced with effect from October 2021 which are broad enough potentially to be triggered by a restructuring impacting the employer.  You can read more about these new offences here.  The notifiable events regime under the 2004 Act will also be amended with effect from a date yet to be announced, however, the changes will considerably broaden the reporting regime. 

New tools

One positive change for restructuring professionals and lenders who see restructurings on the horizon is the new restructuring plan.  Schemes of arrangement (“Scheme”) have been used for years to implement restructurings but the restructuring plan has been referred to by some as a “super scheme” and others as “schemes on speed”.

So why is the restructuring plan seen as a real addition to the restructuring professional’s toolbox?  The answer is because, while under a Scheme it is possible to horizontally cram creditors within a class (a decision by 75% by value and more than 50% in number of creditors voting in a class will bind 100% of the creditors in that class), under a restructuring plan the court can cram down entire dissenting classes.  

One of the permanent changes introduced under the Corporate Insolvency and Governance Act 2020, restructuring plans can be found in Part 26A of the Companies Act 2006, with schemes of arrangement in Part 26.  This isn’t a coincidence – the restructuring plan process is heavily based on the scheme of arrangement, which allows the courts and restructuring professionals to draw on scheme law and practice, but with added bells and whistles. 

A company (including an overseas company provided it has “sufficient connection” to this jurisdiction, on which more later) can propose a restructuring plan (a “plan”) provided:

  • the company has encountered, or is likely to encounter, financial difficulties that are affecting, or will or may affect, its ability to carry on business as a going concern; and
  • the plan is a compromise or arrangement between the company and its creditors, members or classes of either, the purpose of which is to eliminate, reduce or prevent, or mitigate the effect of, those financial difficulties.

As with a Scheme, those to be affected by the plan must be split into classes and each class has to be asked to vote on the plan.  However, unlike a Scheme, an order can be sought from the court, under which any class which has no “genuine economic interest” in the company can be excluded from the voting process.  If the plan is sanctioned, the excluded class will be bound by the plan without ever having had an opportunity to vote on it. This ability to exclude out-of-the-money classes from even having a vote on the plan has only been used once to date (in In the matter of Smile Telecoms Holdings Limited [2022] EWHC 387 (Ch)), but is a very powerful option for the company, and one which removes the need for the court later to exercise its cram-down power. 

A class will be taken to have voted in favour of the plan if 75% by value of class members who voted, vote in favour. There is no numerosity requirement which may mean classes are less open to manipulation in a plan than in a Scheme.  However, provided two conditions are met, the court has the ability to sanction a plan even if one or more classes don’t approve the plan by the requisite majority – in other words, the court can effect a cross-class cram down.

To do so, the court must be satisfied that two conditions are satisfied:

  • Condition A is that no member of the dissenting class would be any worse off if the plan were sanctioned than under the “relevant alternative”;
  • Condition B is that the plan has been approved by a class which would receive a payment, or have a genuine economic interest in the company, in the event of the “relevant alternative”.

The “relevant alternative” is whatever the court considers would be most likely to occur in relation to the company if the plan were not sanctioned – that could be liquidation, or it could be something else such as an accelerated M&A process. 

Of the thirteen plans sanctioned to date, seven have required the use of the cross-class cram down.  However, those cases show just how powerful the tool can be.  The plan proposed by Virgin Active (In the matter of Virgin Active Holdings Limited and others [2021] EWHC 1246 (Ch)) was the first to cram down five classes of dissenting landlords and remains one of the leading cases on the use of the cram-down.  Houst (Re Houst Limited [2022] EWHC 1941 (Ch)) saw the cram down of HMRC, a preferential creditor – something that would not have been achievable under a company voluntary arrangement.  And in DeepOcean (Re DeepOcean 1 UK Limited [2021] EWHC 138 (Ch)),  the plan was used to effect a solvent wind-down, showing that there is no need for the plan to be intended to restore the company as a going concern.

So you can see why the restructuring plan has been greeted with enthusiasm by restructuring professionals.  However, it is not a process to be undertaken lightly.  The process can be expensive, with detailed valuation evidence being required particularly where a challenge is expected.  As with any new tool, there are still areas of uncertainty – for example, is it possible to effect a cram-up of senior debt?  It is generally accepted that it is possible in theory, but can the two conditions be satisfied where a junior creditor is seeking to cram up a senior one? One to watch. 

The other new tool available to distressed borrowers is the freestanding moratorium, found in Part A1 of the Insolvency Act 1986.  In brief, the directors of a company which is or is likely to become unable to pay its debts can file for a moratorium on creditor action, provided the company is “eligible” and certain conditions are satisfied, including confirmation from the proposed monitor that the moratorium is likely to lead to the rescue of the company as a going concern.  A number of companies are excluded from eligibility, including companies party to a capital markets arrangement of over £10m.  The initial moratorium is for 20 business days but can be extended by the directors for another 20 business days, and further extended with creditor consent for up to a year in total, or indefinitely by the court.

However, the moratorium has not seen much use since its introduction in June 2020.  The recent report published by the Insolvency Service, looking at how the new permanent changes introduced under the Corporate Insolvency and Governance Act 2020 (including the plan and the moratorium) have worked in practice, flagged a number of concerns raised by interviewees, so we may yet see changes made to the moratorium process and eligibility. 

Riding the wave

While the immediate future may look stormy, with the right advice, restructuring transactions can still be structured in a way which identifies and navigates both the documentary challenges embedded in current European leveraged loan documentation and new legislative challenges to lead to a successful outcome.  Riding the wave will be challenging but is in no way impossible.

 

 

Authored by Tom Astle, Francis Booth, James Maltby, Margaret Kemp, and Sue Whitehead.

References
1 Reorg Covenants Primary Trends H1 2022 European Leveraged Loans in Review; Economic Headwinds Sow Uncertainty in Markets; Successful Investor Pushback Increases But Covenants Remain Weak And Borrowers Deepen Erosions of Lender Protections Fri 07/29/2022
Contacts
Tom Astle
Partner
London
Francis Booth
Partner
London
James Maltby
Partner
London
Jo Robinson
Partner
London
Susan Whitehead
Senior Consultant
London

 

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