Portability in Sponsor-Backed Acquisition Finance
Is Portability Coming to the Middle Market?
Capital structure “portability” provisions, which allow a borrower’s loans to remain outstanding despite a change of control event, may be coming to the middle market in 2021. The acquisition finance landscape post-COVID has been marked by intense competition – perhaps more intense than pre-COVID. As negotiating leverage has tipped in favor of private equity sponsors, more lenders are giving up their rights to have loans automatically repaid if the borrower is acquired. While this trend has thus far been primarily limited to larger, upper-middle market transactions, a portable capital structure can make companies more attractive to prospective buyers, potentially driving up valuations and providing an easier exit for sponsors. The prevalence of sponsor-to-sponsor trades in the core middle market increases the attractiveness of portable capital structures.
While portability has been around for the last ten years or so, the concept has only recently gained traction in the US loan market. It was initially introduced in the high-yield bond market to protect exiting and incoming owners from paying out expensive call protection on existing bonds, but portability has gradually migrated into leveraged loans as well.
Lenders are historically accustomed to enjoying the protection of a change of control provision. Typically, in the event a borrower is acquired, it must pay back the debt in full or refinance it under new terms. This allows lenders to reassess the new owner’s credit quality, evaluate any changes in operating or management structures, and adjust covenant levels, provisions, and interest rates to the now-prevailing market. Risk management aside, lenders also enjoy the fees that would normally accompany a new origination or refinancing.
Why would lenders give up these protections? The short answer is: only because they have to, in order to win the deal. COVID-19 has created an interesting combination of highly competitive lending markets, deferred sponsor exits, and increased uncertainty in the future. The level of lender competition has shifted negotiating power away from lenders in favor of private equity sponsors. Many of these sponsors have deferred portfolio company exits of businesses that were slated to be sold in 2020 or 2021, as the valuations are likely to be negatively impacted by COVID-19. Instead, sponsors are opting to return capital through a dividend recap or, if that is not achievable, extend the maturity of their portfolio companies to allow for a later exit. In both instances, a portable capital structure would be a significant benefit – capture the borrower-friendly terms of today’s market and set up for an exit in two to three years.
Portability, however, is less likely to benefit sponsors at the time of an initial investment because the typical hold period approximates the typical capital structure maturity date as well – both are around five years. A portable capital structure may be particularly coveted by private equity sponsors looking for short-term investment opportunities or a short-term extension of an existing investment, as it can facilitate a quick exit from the business. By avoiding the typical change of control provision, execution risk associated with refinancing at an exit is eliminated and potential acquirers are less at the mercy of the financing markets and the associated credit approval process and negotiation of a new credit agreement (including covenants, etc.).
Implications for Negotiations
Given the delicate balance between lenders’ concerns and benefits to private equity sponsors, there are several points of contention we expect to be front-and-center if portability migrates into the core middle market in a real way.
Calculation Flexibility
Portability is often based on a leverage test, most commonly Net Leverage. Both lenders and sponsors pay close attention to add-backs, proforma adjustments, and synergies allowed in the calculation of EBITDA. The definition may allow sufficient flexibility to manipulate the calculation figure to trigger portability.
In more aggressive deals, the leverage ratio may be based on Senior Secured Leverage rather than Total Net Leverage. This may allow the new owner to layer in unsecured debt to complete the transaction but keep senior secured debt in place.
The Cash Injection Roundabout
If the portability clause is contingent on a Net Leverage test, without adequate protections, there may be sufficient flexibility for sponsors to inject cash into the business to trigger portability, then pull it out after the transaction closes. The additional equity injection may build restricted payments capacity, which can subsequently be pulled out once the transaction closes. To protect against this, lenders often reset the builder basket to zero in the restricted payments covenant and designate capital injected as Excluded Amounts to carve out new funds introduced by the new owner.
Cherry-picking the Acquisition Date
The Limited Condition Acquisition provision was originally engineered to protect against the risk of earnings movements between entering and closing an acquisition transaction. Value accretive acquisitions would otherwise be abandoned if covenant tests were no longer met due to shifts in earnings. This provision means companies can calculate ratios and compliance tests when the definitive agreement is entered into and do not have to retest when the transaction closes. As it applies to portability, this term provides significant flexibility to choose when to enter into an agreement. Sponsors can essentially wait until earnings are at a peak to trigger portability.
Same Day Debt Exclusion
There have been instances where same-day debt exclusion language has allowed the company to exclude debt incurred on the day that ratio calculations are completed, including the calculation of the portability ratio.
Portability vis-à-vis Opening Leverage
In order to protect against any deterioration in the credit risk profile, lenders have historically required that the company delever between a half to a full turn of EBITDA before the portability provision is made available. However, this is being seen less and less often, particularly in the high-yield space. Now it is more common for portability to be set at or slightly below opening leverage or even available immediately.
Use and Term
Typically lenders will want the portability provision to be limited to a single use, in contrast to high-yield bonds, which can often be used more than once.
Some portability provisions have an 18-36-month sunset clause or have step-down leverage ratios tied to expiring time periods.
Risk Profile Protections
Rather than offer unrestricted portability, lenders may pre-approve a list of permitted acquiring entities or define minimum characteristics the new owner must meet, such as minimum capital or AUM. The impetus is to ensure that the new owner’s credit profile is similar to the current owner. On more aggressive deals, the buyer list may allow strategic or non-sponsor buyers.
Lenders may also require a ratings condition, blocking the portability provision from being triggered if there is a ratings downgrade resulting from the transaction.
Too Early to Call It a Trend
Portability is not common in the US middle market, but current market conditions are certainly supportive of an increased prevalence. If it develops, the “trend-setters” are likely to be strong borrowers who were only moderately impacted by COVID-19 who are also backed by sponsors with established reputations amongst lenders. Other borrowers and sponsors would then follow suit. That said, it is too early to call it a trend, and time will tell how common these provisions become.