Over the past decade and a half in particular, the growth in importance of the private credit markets for completing middle market business acquisitions and for providing post-acquisition working capital lines of credit has been a huge driver of middle market business growth and expansion. Acquisition funding and working capital facilities provided by the nonbank lender is frequently an irreplaceable staple in the business plans of independent sponsors and committed capital funds. For legacy owner operators as well, nonbank lenders step up to provide working capital to grow operations, or to keep operations afloat when the going gets tough.
While non-bank debt can provide flexibility, speed, and access to capital in situations where traditional banks are unwilling to lend, it also comes with its own set of challenges, some of which may not be fully appreciated until after the financing has closed. In this article, we highlight a series of issues that can arise when using non-bank debt financing, with the goal of helping borrowers avoid pitfalls and understand possible optimal approaches.
The Commitment Letter That . . . Isn’t? (And Other Commitment Letter Issues)
You’ve heard this attorney’s lament before: I wish you had involved me before you signed the letter of intent. The dynamics at play that lead to that scenario frequently are understandable. However, the dynamics at play with a loan or credit facility commitment letter with a nonbank lender may be quite different.
The lender may earn a commitment fee or other substantial fee when the letter is signed, notwithstanding that the “commitment” is entirely conditional at that time. If the ultimate loan amount that the lender is willing to underwrite is reduced, is that loan commitment fee then reduced? What if the conditions ultimately cannot be satisfied? If the initial payments upon signing are tied to projected costs, are costs realistic? Are the costs open-ended? Are the terms related to the loan underwriting generic, and if so, does this indicate a risk that the lender will not understand the credit well enough to sign off on the underwriting? We have seen all of these issues in signed commitment letters that we received only after signing, and we have seen would-be borrowers get burned by a subsequent disconnect between borrower and lender after the commitment letter has been signed.
We have occasionally seen lenders that cannot deliver the funding and we have occasionally seen lenders that seem more interested in the fees they earned by signing the commitment letter than actually completing the transaction. Less disappointing, but possibly equally troublesome, borrowers may not fully understand the negative covenants, the borrowing base maintenance requirements, the security requirements and/or the other deliverables summarized in a commitment letter until after (post-signing) review with their legal counsel. Broadly speaking, commitment letters should be reviewed and negotiated in a similar fashion as the actual credit agreements, and the focus should include ensuring that conditions precedent are realistically achievable and potentially narrowing any material adverse change or other type of lender discretionary outs.
Borrower Covenants That Are Overly Restrictive
How restrictive are the financial covenants, operational restrictions, and reporting requirements in the loan documentation? How much room is there for hiccups or worse in the business plan? Do any of the following actually conflict with the business plan, or will they be overly onerous to fulfill:
Total leverage/debt service coverage/fixed-charge coverage ratios;
Borrowing base coverage (and exclusions);
CapEx limitations;
Asset sales requiring lender consent;
Onerous reporting obligations such as weekly borrowing base certificates or rolling 13-week cash flow forecasts
Etc.
What will happen when the covenant package that seems workable when agreed to turns out to be prove too restrictive in practice, or upon some small level of underperformance relative to the business plan? This is where understanding the lender’s reputation is key. It is not simply a matter of “are they loan to own?”—probably not, although that is a question to consider. It is more a combination of two key factors:
Does the lender understand your business, and how committed are they to seeing you succeed?
What is the lender’s approach to waiving defaults and restructuring covenants—does the lender approach this as an opportunity to extract exorbitant fees and juice its returns to borrower’s detriment and possibly such that the default cycle is designed to continue, or do they take a more reasonable approach designed to bring the loan back on track based on reasonable requirements?
What can borrowers do to address these possibilities? Running performance models against all maintenance requirements and deliverables using realistic downside scenarios is one important step. Frank discussions with the prospective lender and due diligence on the lender’s track record are perhaps more important.
Receivables Financing Complications
Receivables-based financing, such as factoring arrangements or asset-based loans (ABL) frequently are utilized for working capital liquidity. The same as with other types of credit facilities, these arrangements should be closely scrutinized to assure they deliver the result that the borrower expects.
Watch out for overly restrictive conditions for receivables to be eligible or conditions that might better fit another business, and seek to negotiate terms that fit your business. Make no assumptions regarding eligibility. For example, with a customer concentration limit of 20% work for your business? Will the aged receivables limit trip you up?
A perhaps more unexpected hazard that we see with surprising regularity is a grant of security that is not limited to the contracts and/or receivables in question (and the related proceeds). Buried in the language of the grant of security, we often see text that extends the grant past the appropriate collateral, sometimes to all assets. We also have seen situations where the grant of security is appropriately limited, but the description of the collateral in the UCC-1 financing statement is misleading as to the breadth of the grant of security. Our experience indicates that careful attention must always be paid in this area to prevent surprises.
Security Interests Granted to Noteholders and the Role of a Collateral Agent
The focus here is on private debt, so how might a secured noteholder workout scenario arise? We have seen this scenario in recent workout situations involving secured noteholders in a lower middle market distressed asset sale and also in a similarly sized venture capital “down round” financing.
The issues that arise when dealing with a collateral agent and multiple noteholders will be familiar to most, falling broadly into two categories: the “herding cats” issue and the “my collateral agent won’t act” issue. In workouts / distressed scenarios, the negotiations need to move quickly and frequently will run through numerous twists and turns. Corralling a majority interest of the noteholders to approve terms involving less than payment in full, and then needing to repeatedly update the approval, can be a tremendous impediment. On top of that, the collateral agent may require additional protections and/or fees, or may simply not act, or seek to resign, in a given scenario. Sometimes, these issues will result in the optimal outcome not being achieved.
We saw a recent venture capital “down round” scenario create related issues when the lead investor required that an all assets grant of security be added to the new bridge-round convertible notes in order to assure that the bridge-round (distressed) financing would prime, at least temporarily, not only the company’s existing convertible preferred stock and common stock, but also the company’s unsecured lenders. The security would be released and the bridge round notes would convert if the company subsequently completes a full financing round that places the company back on track. In this situation, the grant of security sounds simple, but the point that the parties then need to grapple with is who will serve as collateral agent for the noteholders at a time when the company and the investors do not wish to use the bridge round proceeds to pay the fees of a regular institutional agent? Will the lead investor “step up” and play this role, and if so, how fully can it be protected? The scenario is more complicated than the parties may first consider, and requires that each party be realistic to accommodate the other party’s requirements.
Impact of Debt Financing on Management Equity Incentives
The typical potential negative impact of debt financing on management equity incentives arises when underperformance vs the business plan leads to resources being directed primarily to repayment of debt, and this impedes growth, and then creates a negative spiral, in which the growth required to achieve vesting goals and increase equity value is no longer the focus of the business, and the business may in fact contract. At this point, what was designed as a management incentive plan serves to achieve just the opposite—a disincentivizing reminder of what could have been.
However, before ever reaching that downside scenario, there is this question: Was this unhappy end foreseeable in light of the financial covenants built into the loan structure? This question serves to reinforce the importance of modeling the impact of loan facility covenants into the business plan.
Downside scenarios frequently arise despite excellent planning. Where possible, borrowers can seek to negotiate carve-outs that preserve flexibility for management compensation and equity incentives. Once the unhappy downside scenario arises, re-incentivizing the management team is important, and since the lender won’t wish to use cash, recasting the management equity incentives is the most likely step. That, or other forms of incentives and bonus plans that are subordinated to the lenders, or which are subject to lender carveouts, may be renegotiated with the lenders. The lenders also have an incentive to prevent management departures.
Intercreditor Issues
The senior secured and the junior secured (mezzanine) or separate collateral asset-based lender will enter into an intercreditor agreement that covers terms such as lien priorities, enforcement rights, and the priority and allocation of recoveries. In the typical scenario, where one lender is senior, the senior lender will require the junior lender to agree to a stay of enforcement of default remedies while the senior loan obligations remain outstanding. The intercreditor agreement is necessary, and the typical terms, such as the subordinated lender stay, are unavoidable, and may not seem to be the borrower’s issue, but they generally complicate resolution of creditor issues in a workout.
The financial strength, or weakness, of the mezzanine lender can be a positive or negative factor when addressing intercreditor issues, because it will affect the lender’s ability to possibly perform cure rights, buy out or pay off the senior debt, or otherwise manage a distressed situation in a manner that, by benefiting the mezzanine lender, may benefit the equity owners. A workout in which only one part of the capital stack needs to be replaced likely has a better chance of success—measured as avoiding bankruptcy while preserving some equity value—as compared to a full replacement of the existing debt structure.
When it comes to negotiating the intercreditor agreement, a mezzanine lender with lesser credibility regarding its potential capacity to step in and cure senior debt defaults or otherwise stabilize a troubled loan scenario will have less traction in negotiating these rights with the senior lender. From this perspective, in addition to considering a potential mezzanine lender’s initial execution capacity and other reputational factors referred to above, a borrower should consider the mezzanine firm’s overall strength of funding capacity and relevant industry experience as additional positive or potentially negative factors.
Conclusion
As noted at the outset, non-bank debt financing is an indispensable staple for middle market acquisitions and for working capital to fuel growth. We hope you will take the foregoing mini survey of typical issues that borrowers face with these financings as a motivator to dig in and plan to use these financing tools to achieve your business plans.
