The Coronavirus (COVID-19) pandemic has not been in play long enough for market participants to properly assess its long-term impact. In the short term, however, the pandemic continues to affect the markets, with many loans being priced at a significant discount. As a consequence, sponsors and borrowers are evaluating opportunities to buy back their outstanding loans at significantly reduced prices to allow them to build up equity at a discount, reduce leverage or generate capacity under ratio-based incurrence baskets, for example. Growing attention to transfer restrictions coupled with a slow market on the buy-side has led to a particular interest in buy-backs, although they have historically been subject to certain limitations. Below we set out a general overview of buy-backs together with some key considerations for borrowers, sponsors and lenders.
IN DEPTH
Structuring
Loan buy-backs came into particular focus during the 2008 financial crisis. Lenders have traditionally been concerned about potential abuse of the equal treatment doctrine (i.e., where loan buy-back offers must be made to all lenders in the relevant tranche at the same time) and asserted that any debt reduction should take place via voluntary prepayment provisions only. Sponsors successfully challenged these concerns, and the majority of credit agreements now contain express provisions governing the structure of loan buy-backs, which can typically be undertaken as follows:
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By the borrower by way of a solicitation (where the borrower asks the lenders to offer their loans for sale) or open order process (where the borrower sets the price and amount of loans it wishes to acquire and notifies the lenders) directly with the lenders or via a purchase agent/broker. The loans purchased are typically required to be treated as intra-group liabilities and then extinguished (under English law, it is not generally possible for a legal person to lend to itself.)
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By the sponsor/affiliates through open market purchases with individual lenders or via a purchase agent/broker. The loans purchased will continue in the same form, but the sponsor/affiliate that holds the loan should be disenfranchised for voting and information purposes under the credit agreement.
Borrower-Led Considerations
The key present concerns for borrowers will be whether their group has enough available liquidity to withstand a prolonged economic downturn, and whether that liquidity is best served being kept in the business or being used to reduce debt burden. Some borrowers are approaching sponsors to seek additional support or engaging with lenders to discuss options and flexibility. It may be too early at this point for some businesses to decide which option to undertake, and so the market may experience a “wait-and-see” period. Below is a list of considerations that borrowers may wish to contemplate in this context.
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Source of funds: Cash sources readily available to a borrower, such as other debt or operational cash flows, may be a (contractually) restricted source of funding loan buy-backs. Note that some credit agreements allow loan buy-backs on the open market if particular funding sources are used.
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Blockers: Conditions such as the absence of defaults may prevent loan buy-back transactions.
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Financial covenants: Credit agreements may or may not allow borrowers to benefit from gains realised on loan buy-backs when calculating EBITDA and financial ratios. Borrowers could potentially draw on their revolvers to fund a term loan buy-back. This is particularly pertinent if revolving drawings are excluded from debt for the purposes of calculating leverage covenants.
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Cap: There is normally no cap on the amount of loans that can be bought back by a borrower group.
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Tax: A borrower buying back its loans at a discount may recognise a profit which is taxable. Anti-avoidance rules may prohibit the use of structures which can avoid that tax arising, but there are growing platforms designed to help reduce or eliminate tax inefficiencies in this regard. Tax advice should be sought prior to undertaking the buy-back.
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Confidentiality: Loan buy-back transactions must typically be notified to the lenders at the point they are commenced or upon completion. Note that this could affect pricing, and so irrevocable commitments to sell at an agreed price should be sought, where possible.
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Unrestricted subsidiaries: Borrowers should carefully consider any unrestricted subsidiary flexibility and whether loan buy-back restrictions apply.
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Holding companies: Borrowers should check whether the underlying credit agreement contains any restrictive covenants relating to holding companies.
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Intercreditor principles: Intercreditor principles may re-characterise the loans as intra-group or investor liabilities resulting in equitable subordination.
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Voluntary prepayments: In the absence of definitive documentary buy-back provisions, borrowers should ensure that no call protection or equivalent economic penalties are incurred.
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Local law issues: Where co-borrowers exist, local law advice should be sought.
Sponsor-Led Considerations
Sponsors are generally subject to fewer loan buy-back conditions than borrowers, but additional considerations do apply. In particular, sponsors should have regard to their ongoing relationships with lenders and investors alike, and to whether they should take advantage of loans trading at a discount or support portfolio companies trying to de-lever throughout the COVID-19 pandemic. Sponsors should also doublecheck any portability conditions in credit agreements if they plan on selling portfolio companies in the future.
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Contractual considerations: Sponsors are not normally restricted to term loan buy-backs only, although it is unlikely that a sponsor would want to buy into a revolver given the return profile. Note that most credit agreements prevent sponsors from buying back loans in a default or event of default scenario.
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Cap: There is normally no cap on the amount of loans that can be bought back by a sponsor.
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Security and guarantees: Some credit agreements treat sponsors as subordinated lenders so they would not be entitled to benefit from the security or guarantees granted under the credit agreement. This issue must be carefully considered in the context of an enforcement scenario.
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Information rights: Assignments and transfers of loans to sponsors do not normally trigger a notification requirement. The majority of credit agreements do not allow sponsors to attend meetings or calls with their lender group or to receive information prepared for that group. Any information received by a sponsor for finance parties should not be passed on to the borrower. This opens up conflict issues as it is practically difficult for a sponsor to ignore any information with which it has been provided.
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Tax: As with borrowers, there are critical considerations for sponsors to make, and tax and structure advice should be sought as early as possible.
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Disenfranchisement and voting restrictions: Sponsors are typically not allowed to vote unless, in some cases, there is a matter that would solely affect the sponsor. A point to note is that whilst sponsors are usually disenfranchised for the purposes of voting under the finance documents, their commitments would currently count towards any creditor vote in a scheme of arrangement or similar process.
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Future investment/equity cures: Lenders may call upon sponsors to support the business in the event of any additional downturn, particularly before greater lending liquidity is offered. Sponsors should consider the cost of capital in doing so and whether warehousing repurchased debt would offer any advantages.
Relationship lenders: In dealing with the equal treatment doctrine, Sponsors should consider any disadvantages of reducing the commitments of any key relationship lenders, as this may weaken their position in a restructuring.
Lender-Led Considerations
Lenders might be supportive of a loan buy-back if the deal is trading at a loss and they are looking to exit. Lenders should carefully review the transfer provisions in credit agreements with particular focus on distressed debt or other transfer restrictions, as a buy-back may be the only credible way of transferring out. If a borrower or sponsor undertakes a loan buy-back, lenders should consider the following items:
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Incurrence covenants: Reducing debt and interest payments through loan buy-backs may generate capacity under leverage or FCCR-based incurrence covenants to incur additional debt.
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Incremental debt capacity: There is often a separate prepayment or buy-back basket included in incremental debt caps. This means that incremental debt capacity is increased by the amount of debt prepaid or bought back.
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CNI/EBITDA: Lenders should pay attention to these definitions and assess the treatment of any profit or loss and any related tax liability.
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Margin: Lenders should analyse margin ratchets, as most are based on leverage and therefore lender returns will decrease as leverage reduces.
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Call protection: This can be avoided if lenders permit borrowers to circumvent voluntary prepayment as par provisions.
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Excess cash flow: Sometimes the amount of loan buy-backs can be deducted from the amount of excess cash flow and thus increase the amount that can be retained by the group.
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Voting dynamics: If a lender retains a rump position where it no longer controls voting or where the remaining lender group comprises one or more activists, lenders should consider their position.
Other Debt
The forgoing focuses predominantly on the institutional TLB market, primarily because revolving credit is not architecturally or economically attractive to buy back, and because private credit does not typically trade with the same frequency or in the same way as the more public loan market. Note that the same flexibility for debt buy-backs exists in many private credit documents, but sponsors may simply approach their lenders to repurchase debt at a discount as a private agreement, depending on how the documentation is set up.
Conversely, high-yield debt is tradeable even more widely than loan debt, but the existence of significant call protection and the search for yield means that other investors (including distressed investors) are more prevalent in the bond market, particularly given the advent of national and supra-national stimulus now extending to the purchase of high-yield debt.
Conclusion
Loan buy-backs are not regularly used in a performing market, but COVID-19 may stimulate unprecedented use. Stakeholders should be strategic around form, timing and anticipated cash need throughout the current economic climate and the coming 12-month period, and may consider repurchasing outstanding loans to benefit from depressed loan pricing—and indeed to facilitate future growth. At the same time, lenders must ensure the proper profile for their returns while minimising any gamesmanship of these provisions to negatively impact creditors in an enforcement scenario.
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