When a private equity shop acquires a new business, it rarely stops there. Instead, the firm builds momentum around its new portfolio company like a snowball rolling downhill, expanding and growing the business through add-on acquisitions of complementary enterprises. Doing so, however, requires capital. Fortunately, credit facilities typically contain incremental (or “accordion”) provisions that allow borrowers to finance add-on acquisitions under existing financing agreements. While many borrowers take advantage of this opportunity, there are numerous factors to consider before doing so – particularly regarding the so-called Most Favored Nation (“MFN”) provisions applicable to incremental credit facilities.
Incremental Debt Capacity and MFN Provisions
When financing an add-on acquisition through an incremental credit facility, the additional indebtedness may take the form of additional term debt or increased revolving commitments. While there are several nuances to incremental debt capacity and variations in market practice, many modern credit facilities contain three primary incremental baskets:
- A cash-capped basket that permits the borrower to incur incremental indebtedness of up to the greater of either (i) a set dollar-threshold or (ii) a percentage of trailing twelve months (“TTM”) EBITDA;
- A ratio-based basket that permits the borrower to incur unlimited indebtedness, so long as the borrower is in pro forma compliance with a pre-determined leverage ratio; and
- A voluntary-prepayment basket that recaptures borrowing capacity by permitting the borrower to incur incremental indebtedness in an amount equal to the amount of voluntary prepayments made on or prior to the date of such incurrence (in the case of voluntary prepayments of revolving loans, such prepayments must be accompanied by a corresponding permanent reduction in the revolving commitments).
Modern credit facilities for syndicated loans give borrowers the option to document the terms of any indebtedness incurred under the incremental provisions as either (i) an increase in the size of an existing tranche of indebtedness, (ii) a new stand-alone tranche of indebtedness under the existing credit facility or (iii) a new tranche of indebtedness documented under a separate credit facility. If incremental indebtedness will be documented under a separate credit facility, many credit facilities provide borrowers with additional flexibility and may permit such debt in the form of notes or loans.
In exchange for the increased flexibility to incur additional indebtedness, borrowers are commonly asked to provide lenders with MFN pricing protection. This gives lenders the comfort that if the all-in yield of the incremental indebtedness exceeds the all-in yield of the existing loans by a pre-determined spread, the interest rate margin of the existing loans will be increased to ensure that the all-in yield of the existing loans remains within that spread. The all-in yield often includes margin, interest rate floors, upfront or similar fees or original issue discount shared with all financing providers, but excludes the effect of any arrangement, commitment, underwriting, structuring, syndication or other fees payable in connection with the incremental financing that are not shared with all such providers.
The application of MFN provisions vary from agreement to agreement in terms of scope, duration and types of indebtedness to which they apply. A savvy borrower will fully understand the circumstances in which the financing of an add-on acquisition could trigger the MFN protections of its credit facility and potentially result in a repricing of the existing indebtedness. Indeed, the specter of such a repricing should give pause to any borrower considering this financing approach.
The cost associated with a repricing could even alter the expected return on investment from the add-on acquisition to the point that the investment is no longer justified. Further, the additional burden of determining in real time the implications of MFN provisions can put a potential acquirer at a disadvantage in a fast-moving acquisition scenario. Borrowers should therefore ensure that they have carefully thought through the potential impact that MFN provisions may have on the cost of capital associated with the financing of add-on acquisitions.
In exchange for the increased flexibility to incur additional indebtedness, borrowers are now commonly asked to provide lenders with MFN pricing protection that keeps the all-in yield of the original indebtedness in line with that of subsequent financing.
Possible Variations in MFN Provisions
Perhaps not surprisingly, the terms of the MFN provisions are often one of the most heavily negotiated components of a credit facility, with lenders seeking to have the MFN apply to all incremental indebtedness and borrowers seeking to limit its application as much as possible. While it is generally the case that the MFN provisions will be triggered if the all-in yield of the newly issued tranche of pani passu indebtedness exceeds the all-in yield of the existing indebtedness, there can be exceptions and limitations. Some of the most common include:
- MFN Cushion Size: Typically, MFN provisions are only triggered if the all-in yield of the newly issued tranche of indebtedness exceeds the all-in yield of the existing indebtedness by more than 50 basis points. In recent deals, some sponsors have increased the cushion from 50 basis points to 75 basis points.
- Interest Margin Only: Here, the MFN is based on interest rate spread alone rather than the all-in yield. This approach allows issuers to structure financings so that the interest rate spread will not trigger the MFN, even if the all-in yield of the newly issued indebtedness greatly exceeds the all-in yield of the existing indebtedness (e.g., when issuing debt with high levels of original-issue discount).
- MFN Sunsets: With this provision, MFN only applies to indebtedness issued within a certain time period – often from 6 to 24 months – following the issuance of the existing indebtedness.
- Maturity Date Limitations: This clause limits the MFN only to incremental that matures within a specific period outside of the existing indebtedness.
- Currency Limitations: Here, the MFN applies only to indebtedness denominated in the same currency.
- Interest Rate Limitations: Many MFN provisions include exceptions for indebtedness that accrues interest at a fixed rate.
- Incurrence Limitations: This clause restricts MFN provisions only to indebtedness that is incurred under certain baskets. For example, a common formulation is for indebtedness incurred under a ratio-based incremental basket to be subject to the MFN, while indebtedness incurred under the cash-capped incremental basket is not.
- Use of Proceeds Limitation: Some credit agreements do not apply the MFN if the use of proceeds is to finance a “Permitted Acquisition.”
- Basket Exceptions: Recently, we have seen credit agreements include an exception that permits the borrower to incur an agreed amount of additional indebtedness without triggering the MFN, regardless of the all-in yield of that indebtedness. These baskets can be sized at up to 100% of TTM EBTIDA.
- Syndication Limitation: Many MFN provisions apply only to indebtedness that is syndicated, thus creating an exception for indebtedness that is privately placed or provided by “buy and hold” investors.
- Security Limitation: A near-universal exception provides that the MFN applies only to indebtedness that is secured on a pani passu basis with the existing indebtedness.
- Documentation Limitations: Some MFN provisions include exceptions for indebtedness documented either under a separate credit agreement or as a note or security.
In most cases, a given credit agreement will only include some of these exceptions. For committed financings, the MFN exceptions are often subject to “market flex,” which allows the arrangers to modify or remove the exceptions to the MFN in order to help facilitate syndication of the underlying indebtedness.
How Borrowers Can Manage MFN Provisions
A borrower faced with the possibility that the financing of an add-on acquisition may result in a repricing of existing debt may be able to avoid that outcome by structuring the transaction to fall under an exception or limitation to the MFN provisions.
For example, some borrowers with a security limitation in their MFN have issued 1.5 lien debt. In this debt structure, the add-on lenders’ position is senior to any junior lien or unsecured indebtedness, but junior to the pre¬existing indebtedness. While this strategy carries an economic cost, as 1.5 lien debt is more expensive than first lien debt, the cost savings associated with avoiding triggering the MFN may make the greater expense of the debt acceptable.
We have also seen borrowers structure loans so that a portion of the fees payable in connection with the debt issuance takes the form of structuring or arranging fees – thus excluding the fees from the calculation of all-in yield. This structure is primarily available if the financing is provided by “buy-and-hold” investors, but is unlikely to be successful in the case of a syndicated debt issuance.
A more common method of sidestepping MFN provisions is to either structure the indebtedness as a security or have the indebtedness incur interest at a fixed rate. By issuing a secured bond, the borrower will be able to issue indebtedness that is secured on a pani passu basis with the existing indebtedness but may be able to avoid the MFN if the MFN then applies only to indebtedness issued in the form of term loans. The same logic applies to the issuance of indebtedness that accrues interest at a fixed rate of interest. However, prior to pursuing a bond issuance as part of one’s acquisition financing, the issuer should ensure that both it and the target company have prepared any necessary historical financial data. Without ready access to this information, it may not be feasible to launch a bond offering in the 144A market.
The MFN provisions contained in a borrower’s existing credit documentation can significantly affect the viability of accessing an incremental credit facility to finance add-on acquisitions. As outlined above, savvy borrowers may be able to structure a financing to avoid an MFN provision, if proper forethought is given in the initial drafting and negotiation of the MFN provision. However, many lenders have come to view MFN protection as a sacred right and, therefore, borrowers should consider the impact that any transaction structured around an MFN provision might have on its ongoing relationship with its debt investors, including in connection with future refinancings or incremental financings. In addition to the strictly contractual considerations, a sophisticated borrower should also consider how the borrower’s existing creditors would view such a structure and how that might impact execution of the current or future syndication.
The Private Equity Report Fall, 2019, Vol 19, No 2