Capsugel’s initial terms demonstrate the fifteen-year shift in lender protections

We keep hearing that covenants have erodedover the past 15 years, but how many of us know what that really means in practical terms?

Apart from the rhetoric about the danger  sof flexible terms, and the very clear and present risk of liability management transactions, we rarely have the opportunity to see precisely how far terms have shifted from the market standard in place a decade and a half ago – until now.

In a recent conversation with a market veteran, I was reminded that Capsugel, which just issued a senior secured bond, actually debuted on the high yield market back in 2011. Though that issuance was unsecured, this is one of the least interesting differences between the covenants in that 2011 bond and the one that was marketed last week.

I chose the word “marketed” carefully – as some will be aware, the covenants were tightened significantly during the road show. The initial suite of contractual provisions were tilted significantly in favor of the borrower, including a two-year non-call on a seven-year maturity.

While several provisions were pared back in the end, the preliminary description of notes reads like a who’s who of sponsor terms and inspired me to describe the precise implications of these additional flexibilities. My intention is to provide context to lenders for when they’re reviewing the next deal – the terms that were changed, and every other term in the preliminary DoN, are always up for negotiation.

Let me tell you why it matters – in two parts. Part 1 will cover Optional Redemption, Debt, and Restricted Payments. Part 2 will cover Asset Sales, Change of Control, and various other individual differences.

Optional Redemption – Investors protect their economics

Let’s start with optional redemption provisions, in part because these economic protections are some of the most important to high yield bond investors. The headline difference was the shortening of the non-call period from 3 years to 2 on a 7-year bond.

One year might not seem like much, but it hits the bottom-line returns for every investor. This is a battle that investors have been holding the line on for years, and despite the continued convergence between loans and bonds, the non-call protection has remained by and large intact – for now.

But that’s not all that shifted over the years – as the Capsugel case study shows, the equity claw increased from 35% to 40% so long as 60% remain outstanding (or 50% in deals with a 10% at 103% provision).

On top of that, language has made its way into many deals that would allow the borrower to combine this provision with the make-whole to achieve a cheaper blended redemption price (look for the words “redeemed substantially concurrently”).

And this story would not be complete without mentioning that bastion of a frothy market, the 10% at 103% redemption provision, which allows the borrower to redeem up to 10% of the bonds (either outstanding or original principal amount, the latter being more borrower friendly) at a price of 103%.

The provision wasn’t present at all in the 2011 deal, and Capsugel’s most recent offering marketed a provision that would also allow the borrower to carry over amounts not used in any given year (though this particular aspect was removed).

Debt Capacity Reaches New Heights – Loan convergence continues

The Debt covenant has certainly evolved compared with its humble beginnings.

In 2011, Capsugel’s Credit Facilities basket contained a simple hard cap – no grower, no ratios. The most recent deal, on the other hand, incorporated several distinct fixed-and-grower baskets in addition to a range of ratio tests stacked on top of each other. It’s a formulation that’s very familiar for high yield bonds these days and mirrors the approach taken in most broadly syndicated loans.

The other loan concept that made its way into bonds is the ability for the borrower to draw in debt capacity from the Restricted Payments covenant. In Capsugel, this aspect of the Debt covenant didn’t exist at all in the 2011 deal, yet in 2026 it was not only present, it was marketed on a 2x basis (that is, for every 1 unit of Restricted Payments capacity, the borrower could incur 2 units of debt).

This 2x aspect was the key difference between the Contribution Debt baskets in the 2011 deal versus the 2026 deal. For each of these two baskets, the final terms reduced capacity to 1x.

The ability to calculate capacity other than at the time of debt incurrence is another notable shift between the 2011 and 2026 bonds – the concept of the Reserved Indebtedness Amount made its way into the typical high yield covenant package and allows the issuer to establish a high water mark for debt incurrence any time it receives a commitment to incur debt.

The result: when it comes time to actually draw down on the commitment, it doesn’t matter whether the calculations would permit it – the capacity has already been grandfathered by this provision.

Restricted Payments – We’re not in Kansas anymore, Dorothy

Of all the provisions in the comparison, the Restricted Payments covenant has shifted the most. Not only has dividend capacity increased and become more easily accessible – even when the borrower is stressed – but the convergence with loans is most readily apparent.

Back in what I lovingly call the “baby lawyer days” when I was learning about high yield covenants, I remember being taught that the builder basket was designed around a bargain struck by the borrower and lenders (largely to benefit sponsors) – half of cash profits could be distributed to junior stakeholders or outside of the restricted group, but half would stay in “the box” for the benefit of lenders.

That’s what the 50% Consolidated Net Income metric is designed to proxy for – if you read the definition, you’ll notice lots of exclusions of non-cash inputs (among other things). This is not your balance sheet net income figure, and it would be reduced by 100% of losses, holding sponsors accountable should cash profits fail to materialize.

As the builder basket would become the most significant source of capacity over time, it would be subject to some conditions, or guardrails as I like to call them: the borrower could not be in default or have an event of default outstanding, and would have to comply with a 2x fixed charge coverage ratio (or whatever ratio the ratio debt basket in the Debt covenant employed).

Capsugel’s terms illustrate clearly how far these provisions have shifted in favor of the borrower and sponsor. First, the builder basket no longer reduces from losses at all – it will build from 50% of CNI plus some other standard components, plus a starter amount and some Asset Sale concepts (also fairly new). If there are losses, these will be counted as a zero on a quarterly basis – meaning that the 50% CNI builder never gets dinged by losses.

Then there’s the guardrails – the 2011 deal contained the two standard ones, while the 2026 deal watered them down to such an extent that the borrower need not comply with any condition at all in order to make investments (including to Unrestricted Subsidiaries).

The 2026 deal also includes additional Permitted Payment baskets and concepts that weren’t even invented in 2011 – the ratio-based Restricted Payments clause, Restricted Payments based on the Available Amount (another loan concept), and more Restricted Payments derived from Asset Sale concepts.

In all, the Restricted Payments covenant is unrecognizable in its current form, and that traditional bargain struck all those years ago has dematerialized, leaving a very sponsor-friendly source of dividend and investments capacity in its place.

Part 1 Conclusion: The additional flexibility is instructive

I am not saying any of this is intrinsically good or bad – contracts are neutral documents on their own. What I am saying is that this borrower, and many others in the leveraged finance and private credit markets, have vastly more flexibility and capacity to take actions under their contracts than they ever have before.

The well-informed lender is well served to understand and absorb these shifts – because you can be sure that the borrowers and their private equity sponsors know this very well.

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