Debt Knowledge Series
An Introduction to Debt Agreements for Leveraged Loans
A section-by-section breakdown of the sometimes confounding debt agreements that govern leveraged loans.
Feb 1, 2023
The Credit Facility
Representations and Warranties
The Administrative Agent
Other Generic Clauses
Couched in dense legalese spanning more than two hundred pages, leveraged loan agreements can be difficult to parse, even for experienced professionals. By summarizing the sections of a typical loan agreement in simple terms, this paper aims to provide finance professionals with greater insight into the debt raise process. For CFOs contemplating new debt issuance, acquaintance with the legal fundamentals can equip them to engage more constructively with lenders and to communicate more authoritatively with their corporate board and internal finance teams.
The Definitions section plays a pivotal role in the debt document, belied in part by its pedestrian name. The section now accounts for over a third of the pages in a typical document.
At a basic level, the section describes terms and clarifies references used throughout the document. For example, the section:
Spells out the long forms of acronyms like GAAP;
Ties generic language to specific referents (e.g., states that “the bankruptcy code” relates to Title 11 of the United States Code; sets forth that all timings denote US Eastern Standard Time);
Defines accounting formulas, such as net income. Irons out semantic fine points (e.g., “The word ‘will’ shall be construed to have the same effect as the word ‘shall’.)
Establishes that when specified people, documents, institutions, or statutory codes are replaced by a successor, the new version or replacement assumes the role of the original entity.
In all of the above, there is much standardization with limited variance exhibited across different loan agreements. Two critical exceptions to this general uniformity relate to a) interest rates, and b) procedures for measuring debt, assets, and collateral. The terms here are unique to each agreement and therefore entail more vigorous negotiation between loan counterparties. A short discussion of these two areas follows.
Loans are typically issued at a base interest rate that adjusts upwards in response to variables that reflect the financial health of the borrower. Two commonly measured variables look at the borrower’s debt ratio and credit rating agency score. Borrowers with stronger debt ratios (total debt to gross asset value) and credit rating agency scores enjoy lower interest rates.
The formulas for all these variables are usually expressed in a table format. Figure 1 shows one example using the borrower's debt ratio. Here, the sum of an exogenous benchmark rate (SOFR) and a margin fixed by the borrower's debt ratio determine the interest rate. A borrower with a low debt ratio at Pricing Level 1 would secure an interest rate of SOFR + 1.20%. As the borrower's debt ratio increases, so does the interest rate.
Table 1: Sample Interest Rate Schedule for a Term A Loan, Based on Borrower Debt Ratio
PRICING LEVELRATIOTERM A SOFR RATE LOANPricing Level 1Less than or equal to 35%1.20%Pricing Level 2Greater than 35% but less than or equal to 40%1.30%Pricing Level 3Greater than 40% but less than or equal to 45%1.45%Pricing Level 4Greater than 45% but less than or equal to 50%1.60%Pricing Level 5Greater than 50%1.80%
Measuring Assets, Debt, and Collateral
Since the debt to asset ratio can affect the interest rate, it becomes necessary to specify a) the non-cash items that should be included when tabulating asset totals, and b) a method for determining their cash value.
The Definitions section performs these functions, with details that depend on the borrower’s line of business. A loan agreement involving a clothing retailer may cover the valuation of gift card receivables. For a borrower with substantial real estate holdings, the focus may instead be on its portfolio of property assets.
The Credit Facility
This section covers the fundamental loan-related obligations of the parties and prescribes methods for fulfilling those obligations.
More specifically, the section describes:
The different facilities extended to the borrower (e.g., revolver, term, swing line, bid)
How the borrower can initiate draws and how lenders make funds available in response
Allowable uses of loan proceeds
Procedures for modifying debt terms and establishing new credit facilities
Terms associated with repayment, including pre-payments; minimum payment amounts; and mandatory pre-payments
The process for converting debt from one tranche to another
Loan fees for which the borrower is responsible, including the agent’s fee and the facility fee that applies to the unused portion of certain tranches
The process for requesting and issuing letters of credit
The process for terminating the loan
This short section summarizes the fees that need to be paid and the certificates and documents that need to be completed for the loan agreement to take effect. It may also list conditions that need to be fulfilled before future credit extensions are granted. A sample clause: The Administrative Agent shall receive certified resolutions of the Board of Directors approving the execution of the Loan Documents.
Representations and Warranties
In the Representations and Warranties section, the borrower certifies that the financial statements it has submitted are accurate and that there are no hidden problems concerning itself, its subsidiaries, or the loan guarantors. The section delves into litigation and labor risks. In several separate clauses, the borrower affirms that it has notified the lender of all lawsuits, investigations, regulatory fines, and labor disputes to which it might be subject.
The borrower also confirms that it has been fulfilling customary business obligations; standards that any business in good standing would aspire to, even if it weren’t seeking a loan. Here, the borrower attests that it is:
Properly registered to do business
Current on all tax obligations
In compliance with environmental codes and employee benefit regulations, and
In possession of clear titles to its intellectual property.
Covenants dictate further conditions a borrower must follow after the agreement is signed.
Through covenants, lenders monitor the financial health of the borrower and limit downside risk by ensuring that borrowers do not engage in actions that could compromise their ability to repay.
It is important to note that many loans today are issued on a borrower-friendly, “cov-lite” basis. Cov-lite loans involve the reduction or loosening of requirements once considered standard. Borrowers, especially those with strong balance sheets that raise debt during favorable economic times, may be able to negotiate for the removal of certain covenants or for casting them in more lenient forms, especially by inserting numerous exceptions (“carve outs”) to otherwise broadly conceived rules.
The table below summarizes the three varieties of covenant. A typical loan agreement will have a separate section devoted to each.
TYPE OF CONVENANTTHUMBNAIL DESCRIPTIONEXAMPLEAffirmative CovenantAction a borrower must performMust pay federal, state and local taxes on timeNegative Covenant"Taboo" a borrower must not doCannot issue new debtFinancial CovenantFinancial soundness test a borrower must passMust pass quarterly test showing debt to earnings ratio less than 3:1
Affirmative covenants specify actions a borrower is obligated to perform. Examples of affirmative covenants include requirements that the borrower pay taxes in applicable jurisdictions, maintain insurance, and apply standard accounting frameworks like GAAP. In addition to these standard practices that should be followed in the normal course of business, borrowers are also required to submit periodic financial reports to lenders.
Negative covenants constrain the borrower from carrying out certain actions without explicit lender consent. These restricted actions typically involve a change to the company s corporate structure, a revision to the cap table, or the transfer of collateral or productive assets.
More specifically, common negative covenants prevent the borrower from:
Channeling cash, including dividends, to parties with less seniority in the cap structure (the “restricted payments” clause)
Selling capital assets used in productive, revenue-generating activities that help service the debt
Buying capital assets that could take a long time to operationalize and generate cash
Taking on additional debt, which reduces the cash available to service the existing debt
Financial covenants consist of balance sheet tests that assess a borrower’s ability to honor its debt. Each test is expressed as a ratio that measures a company’s cash flow against its obligations. For a fuller treatment of covenants, please refer to our paper on the topic Introduction to Covenants in Leveraged Loans.
All possible causes of default are assembled in the Default Events section. Causes typically listed include:
Failure to pay principal, interest, or loan fees
Failure to comply with covenants
Making false representation on any report, financial statement, or document
Loss in a lawsuit that results in major financial damages
Significant uninsured loss to collateral
A change of corporate status (e.g., dissolution, liquidation, merger) not permitted by the agreement
An event that substantially affects a borrower’s pension plan liabilities
After listing the possible causes of default, the section covers cure periods, which allow the borrower to resolve issues before lenders may begin to take action. The section then outlines the specific remedies available to lenders, such as making a demand for immediate repayment, and describes the waterfall of distributions to creditors if proceeds are secured through the remedy process.
The Administrative Agent
This section first describes the administrative agent’s duties with regards to handling transactional activities, such as collecting and distributing loan payments. If circumstances sour, the agent also manages enforcement of liens on loan collateral and obtains consent from lenders before acting on their behalf. The section may also prescribe how the agent should handle cases of defaulting lenders that fail to honor their funding commitments.
The section is careful to frame the agent’s role as administrative in nature, rather than fiduciary. A host of exculpatory clauses serve to limit the agent’s liability and specify the duties that lie outside the agent’s purview, such as verifying the accuracy of representations the borrower makes.
The administrative agent position was created to streamline transactions and communication in situations with multiple lenders. In loans with only one or two lenders, deals may proceed without a designated agent.
Other Generic Clauses
Different loan agreements take varying approaches to categorizing other generic clauses. Some place the below items in stand-alone segments while others include them in more broadly-conceived sections.
Part of the agreement will clarify the treatment of taxes on loan payments. Depending on the jurisdiction, for tax purposes, borrowers may be required to withhold part of any payments. The lender may also be obligated to pay income taxes on payments it receives.
Yield Protection clauses cover two areas that seek to safeguard the lenders’ return on investment. Under Increased Costs, the borrower agrees to compensate the lender for any regulatory changes – such as higher reserve requirements or new taxes - that impose extra costs on the lender in connection with holding the loan. Separately, Compensation for Losses clauses require the borrower to compensate lenders for any loss caused by the borrower's failure to make required payments on time.
This section requires designated entities (typically subsidiaries or a corporate parent) to become guarantors and assume loan obligations when a Guarantee Trigger Condition occurs. Trigger conditions could include a low credit rating agency score or excessive indebtedness.
Loan financing tied to ESG goals has surged in recent years. Through the carrot of more favorable interest rates, these loans incentivize borrowers to meet KPI targets linked to sustainability. For example, a borrower that significantly improves energy efficiency at its factories could be rewarded with an interest rate cut. These loans also typically contain disincentives, with interest rate increases applied for poor performance.
The precise targets and corresponding incentives are codified in tables similar in structure to the debt ratio table shown in Figure 1. For the sustainability-linked portion of a loan, interest rate adjustments typically fall within the range of .05% to .20%.
Although KPIs have traditionally been linked to environmental concerns, goals related to social issues are increasingly popular. Common KPIs measure:
Water and/or electricity consumption
Renewable energy usage
Recycling of production materials
Reviews are typically conducted on an annual basis with an adjustment that applies for the following year until the next review.
As sustainability-linked provisions are a relatively new phenomena, standards on many key facets – Which KPIs should be measured? How are performance levels determined? Who verifies the borrower’s performance? - continue to evolve at a rapid pace.
Depending on the agreement, sustainability-linked clauses may be distributed across different sections rather than integrated in a standalone section.
For more on sustainability-related clauses, please refer to our report, A Primer On Sustainability-Linked Loans.
The following areas might be covered in a stand-alone Miscellaneous section or distributed piecemeal throughout other parts of the debt document.
Issues that can arise among the lender group, including mutual indemnification, the transfer or sale of a loan position, and the case of non-consenting lenders (lenders that do not agree with a decision of the majority of lenders)
Processes for making changes to the agreement, including specification of the consent level required among the lenders (e.g., unanimous or majority consent) to make changes to different parts of the agreement
Confidentiality clauses in which loan parties agree to keep material nonpublic information concerning the loan or other loan parties confidential
Treatment of set-offs, where, in the event of a default, a lender takes possession of any borrower funds deposited with it
Itemization of loan costs for which the borrower is responsible
Description of acceptable communication methods between loan counterparties
Specifying the jurisdiction whose laws govern the agreement. Parties also typically waive their right to a jury trial in the event of disputes.
Anti-net short provisions, which apply to lenders that use credit default swaps to obtain a net short position in a borrower’s debt. Despite their long loan position, these lenders still stand to gain more from a default. Anti-net short provisions disenfranchise these lenders and prevent them from initiating or voting on any amendments or actions, including those related to default or the acceleration of payments. Anti-net short provisions may empower the borrower to transfer the net short lender’s loan position to another party.
Schedules attached after the signature pages typically include lists that itemize:
The borrower and its subsidiaries
Guarantors of the loan
Affiliates of the borrower excluded from serving as guarantors
Owned and leased real estate of the borrower
Capitalization sources of the borrower
Demand deposit accounts and securities accounts of the borrower, including separate lists of blocked and unblocked accounts
Credit card accounts belonging to the borrower
Items to be included in collateral reporting
Existing liens on the borrower’s assets
Existing debt of the borrower
Existing investments of the borrower
Inventory belonging to the borrower
KPIs for sustainability-linked loans
Official methods of communicating with the agent
Lenders, including a table that shows the dollar amount of each individual lender’s commitment and the percentage that it represents of the total commitment
Exhibits typically include three types of document forms.
Forms intended for use at a later date, such as the form that provides notice of pre-payments
Standardized forms that neither side expects to negotiate (e.g., tax compliance forms)
The forms for signing that attach to specific tranches of the loans
Debt agreements in the leveraged loan space have become increasingly complex in recent years. While the complexity can be confounding, it reflects both the borrower-friendly flexibility these agreements have come to embrace and the variety of debt facilities that have emerged. A simpler document would likely be more rigid and less able to accommodate borrowers with unique funding needs. There would then be fewer borrowers able to access the capital markets and fewer lenders willing to make funds available. Legal complexity is concomitant with a robust industry that supports a diverse range of market participants. It is not altogether accidental that document length has grown in lockstep with the rapid growth of leveraged loan volumes in recent decades.
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