I generally view claims of the latest market horror (“unprecedented”; “fatal for investors”; “the end of the end” etc. etc.) with the wry smile which comes from over 30 years in the market and a considerable number of peaks and troughs – let alone odd terms.
But yesterday I heard about something which both shocked and worried me and I wanted to share it with you.
I cannot name the deal in question as it is a private loan – but all participants (sponsor, law firms and lead banks) would be considered top-tier market participants. And I have to be careful not to go into too much detail as I am mindful of confidentiality constraints.
As is usual, the first step in the deal coming to market was a marketing term sheet (“TS”). Not surprisingly the terms disclosed there were what are commonly called “aggressive” (market speak for highly favourable for the borrower/sponsor). As such, they incorporated provisions from both the high-yield market and leveraged loan market to give the borrower maximum flexibility. So far so normal.
In what might be termed “non LMA” deals (which today means most deals) the concept of “Permitted Acquisitions” which principally governed the making of investments by the borrower group subject to certain conditions has disappeared and been replaced by the generally very loose concept of “Permitted Investment” (drawn from high-yield bond market terms).
There was no detail in this TS about Permitted Investments – which in itself might have made me raise an eyebrow but no more.
In stark contrast to the majority of the covenant package, the TS did contain information relating to the main baskets for payments (“RPs”) to be made to the owners of the business – and rightly so, as few would argue this is an essential component of the leverage lending matrix. This is an area where there has been much market debate and investors would only be acting rationally if they read these RP provisions and, having understood them, decided they knew (for better or worse) the circumstances under which value could pass from the borrowing group to the owners.
So far so good (or, at least, so normal).
The SFA is then released for investor review (subject of course to the usual super-tight deadline) and contains lengthy Permitted Investment provisions. One of these allows investments to be made by the group companies which provide lenders with security and guarantees into group companies which do not so provide (non-guarantor restricted subsidiaries, “NGRS”); i.e. value can pass outside the lender “security/guarantee net” without any cap.
This is bad – I would always expect, and English law SFAs traditionally provide, some restriction on value leakage from borrowers and guarantors to NGRS. A red flag in itself, but, you might think to yourself, not fatal given that the NGRS are part of the restricted group and are subject to the covenant package.
However (and this is the horror) a separate Permitted Investment allows the NGRS’s to use the amounts received to make any investments they wish without restriction – including into entities outside the restricted group.
Thus to circumvent the detailed provisions relating to the RPs (which we all agree are essential and which were detailed in the TS) all that is necessary is an investment into an NGRS, followed by a corresponding investment by the NGRS into an unrestricted third-party entity owned by the sponsor – which can pay the proceeds to the sponsor.
And it was not mentioned in the TS, but buried without reference in one of over 30 Permitted Investments in the SFA.
Why bother having all the complex RP provisions while providing a side-step route?
Is it an error, obfuscation, misleading or misrepresentation? I have no idea.
Did the lead banks which negotiated the terms point out this “flaw” to investors? Do lead banks (and their law firms) owe any duty to investors (I know the answer to that one).
Personally I think to provide terms purporting to inform investors about the groups’ ability to make RPs under one set of provisions, while allowing payments having the same effect to be made under other unmentioned provisions, renders the TS at best misleading and quite probably something worse.
Lack of transparency is bad for markets. At a time when regulators on both sides of the pond are looking very closely at our market it beholds all market participants to be transparent. Do we want to kill the golden goose?
I should add that all investors should get the documents reviewed by independent experts and should demand more time for this review to make it meaningful. I hope this goes without saying.
Stephen Mostyn-Williams is chairman of deal documentation specialist Debt Explained. He had a 25-year career in leveraged finance at Cadwalader, Wickersham & Taft; Shearman & Sterling and Ashurst. He co-founded the European High Yield Association and served as its chair for the first three years of its existence.