Covenants 101: Change-of-Control Portability Provisions in European Leveraged Loans Explained

Legal Analysts: Aaron Spence , Ian Chin

The language in high-yield bond indentures, offering memoranda and leveraged loan documents is not always straightforward. In this Covenants 101 series, we demystify key concepts and provisions of high-yield and leveraged loan documents, explaining them in plain English. We hope this series will be a valuable resource for market participants’ forays into high-yield and leveraged loan covenants.

In this installment of our Covenant 101 series we explain portability provisions in European leveraged loan documentation. This 101 focuses solely on express portability provisions seen in English law governed senior facilities agreements, or SFAs, for broadly syndicated European leveraged loans. It does not focus on what is called ‘‘disguised portability’’ (for example, exceptions to change-of-control triggers that arise through widely drafted ‘‘Permitted Holder’’ definitions).

What is the Consequence of a Change of Control in a Syndicated Loan?
One of the key components in an investment decision for lenders is evaluating the current shareholders’ or sponsors’ track record of running the business or their future strategy. If the current shareholders or sponsor were to exit or lose control of the company, the new controlling shareholder may have different priorities and objectives for the business. This may fundamentally impact the business plan and the investment hypothesis. As a result, when there is a change in the controlling shareholders, lenders want the right to consider their continued participation in the loans and to exit the debt if the new shareholder acquiring control does not fit comfortably with the relevant lender’s investment thesis.

This is where a change-of-control provision comes in.

The Loan Market Association’s form of senior facilities agreement requires the loans to be mandatorily prepaid upon occurrence of a change of control. However, as high-yield bond-style terms started being imported into European leveraged loans, it became more common to include a ‘‘Change of Control Put Offer,” i.e. when a change of control occurs, each lender is given the individual right to continue to hold its loans or to cancel its commitments and require that its loans be prepaid. We discuss change-of-control provisions in high-yield bonds in more detail HERE. In recent years, some sponsor-backed deals give the borrower the option to choose between the two, i.e. either a mandatory prepayment of all lenders, or to offer each lender the right to require prepayment of its loans..

Whichever formula is adopted, the price at which the company is required to prepay the outstanding amounts under European leveraged loans is typically par (or 100% of the principal value), lower than 101 typically offered in high-yield bonds.

What is Portability?
Portability is a feature in debt documents that allows a company to keep its existing debt in place when it is sold. It is drafted as an exception to the “Change of Control” provisions, which typically require payment of the existing debt when the company is sold.

Portability provisions are valuable tools for private equity sponsors in both acquisition and divestiture activities.

For private equity sponsors, including portability provisions in debt documents of a portfolio company, can deliver compelling advantages when it seeks to exit its investment in that company.

If exercised, portability eliminates the need for costly and time-intensive refinancing processes that would otherwise be required in connection with a change of ownership. This is particularly advantageous when access to financing is limited due to volatile market conditions.

Portability provisions can also make the portfolio company more attractive to the prospective buyer, by offering pre-arranged financing solutions, which streamlines the acquisition process and may improve valuation outcomes.

Portability provisions are typically found in the “Definitions” section of a debt document, at the end of the the definition of ‘‘Change of Control’’ as an exception, which is typically defined as a ‘‘Specified Change of Control of Event’’, ‘‘Permitted Change of Control,’’ ‘‘Change of Control Triggering Event’’ or a similar variation. In some cases, portability provisions may appear as a standalone section within the change-of-control covenant.

Portability Provisions in European Leveraged Loans
Portability provisions in European broadly syndicated loans continue to be rare. They are much more common in European high-yield bonds.

When included, portability in European leveraged loans shares some common features with portability provisions typically seen in high-yield bonds (which we discuss HERE). However, European leveraged loans typically include a greater number of conditions for portability to be accessed.

We explore the range of conditions seen in portability provisions in European leveraged loans below.

What are the Conditions to Portability in European Syndicated Loans?

Leverage Test
Portability provisions in European leveraged loans require the company to meet a specified leverage test pro forma for the change of control. A total net leverage ratio test is most protective for lenders as it accounts for all the debt outstanding in the company’s capital structure.

The level at which the leverage test is set can vary from deal to deal – with sponsors preferring immediate accessibility. If the portability provision is being added as part of a refinancing or amend-and-extend, sponsors, looking to exit the investment, could make the case for the test to be set with headroom relative to leverage as at the time of refinancing or amend-and-extend (assuming they have achieved some deleveraging since the original investment).

Documentary flexibilities could make calculating pro forma compliance with the specified leverage test easier for the borrower. Such flexibilities include EBITDA adjustments from cost-savings and synergies expected from the acquisition which may or may not be subject to a cap, the flexibility to choose the testing date and the ability to exclude certain outstanding debt from the ratio such as revolving debt or certain lease liabilities. We discuss some of these in our Change- of- Control Covenants 101 for high-yield bonds (see HERE), which apply equally for European leveraged loans.

Time-Based Limitation for Use of Portability
Portability provisions often provide that portability can only be exercised within a specified timeframe, typically between 18 to 36 months, from closing of the original syndicated loan or the date of the amendment pursuant to which portability was introduced.

Single-Use or Multi-Use?
Portability can typically be used only once. Therefore once the loan is ported over to the new owner of the borrower, a second sale during the lifetime of the facilities to a third owner would trigger the lenders’ right to prepayment. For the initial sponsors, such accommodation is more than sufficient to enable their exit.

Minimum Equity Requirement
The minimum equity test is critical to any leveraged lending. A hypothetical exercise of change-of-control portability can be conceptualized as lenders providing “new” financing to the new shareholder / sponsor. Seen that way, a critical element for lenders is the requirement that the new shareholder / sponsor maintains an acceptable level of equity cushion in the business to support the loans.

It is therefore unsurprising that one of the conditions of portability is that the new controlling shareholders maintain a minimum equity in the business, typically set at 35% to 40% of the company’s overall enterprise value or capital structure.

Buyer Requirements / Equity White List
Portability provisions may require that the buyer meets certain minimum requirements.

The cleanest way to achieve this is to have a white list of approved transferees. Such an “equity white list” could specify the names of sponsors or industry buyers that would be acceptable to the lender(s).

On top of that or as an alternative, the conditions could include the requirement that the new buyer be active within the same industry. Or, if it is a sponsor or investment fund, there may be a requirement that such sponsor or fund be of sufficient size, i.e. it has to have a minimum volume of assets under management. Where present, the typical minimum assets under management test is set at €5 billion if the buyer is a private equity firm. This minimum assets under management threshold can fall, to around €1 billion, if the buyer is instead a business that is active in the same industry as the company.

Default Conditions
Portability may be blocked if a default has occurred. The rationale is that the controlling shareholder should not be able to walk away easily, if the borrower is in default. The exact scope and nature of the default blocker can vary from deal to deal.

KYC Requirements, Sanctions
As one might expect where there is a change in identity of the counterparties, know-your-customer, or KYC, and sanctions risks are addressed in the conditions for portability in European leveraged loans. While lenders are given the opportunity to conduct KYC on the new sponsor / shareholder, the timeframe for running KYC is typically set at around 15 business days.

Comparison with European High-Yield Bonds
There are more conditions that a borrower needs to meet before being able to access change-of-control portability in European leveraged loans, compared with those seen in European high-yield bonds. In European high-yield bonds, the only conditions present are typically the leverage and single-use conditions described above.

The more extensive scope of conditions required to be met compared with European high-yield bonds is an indicator of the importance lenders in the European leveraged loan market attach to the identity of the owners of the portfolio company borrower they are lending to.