Why the Advanced LBO Covenant Analysis Must Assess LMEs

Following a recent webinar on LBO covenant analysis, it's clear the market needs to recalibrate its analytical framework. As I discussed on Bloomberg's Credit Edge podcast, we're experiencing an unprecedented moment: witnessing the consequences of covenant flexibility in existing deals while new transactions incorporate similar structural features.

The Integrated Analysis Imperative

I now integrate liability management exercise (LME) analysis into every LBO review because modern covenant packages require this broader perspective. When evaluating any LBO financing, we must consider not only the immediate transaction but potential future restructuring scenarios.

Key questions that should frame our analysis:

• What circumstances might necessitate a future liability management exercise?
• How could another private equity sponsor acquire this company within existing covenant frameworks?
• What are the implications for current lenders?

These questions have become necessary because covenant flexibility provides sponsors with significant optionality during their structuring decisions throughout the life of the debt in question.

Critical Covenant Areas

Change of Control Evolution

Portability provisions have fundamentally altered change of control protection. In the Boots transaction, the "specified change of control event" creates exceptions when leverage remains below 3.65x, the acquirer maintains $5+ billion AUM, and new equity represents at least 35% of consideration.

While it can be used only once, it demonstrates the value of these provisions to private equity sponsors – which is why we are increasingly seeing them in not only European deals, but also U.S. deals and leveraged loans as well.

Restricted Payments Complexity

There are currently multiple interacting capacity sources for Restricted Payments: builder baskets, fixed baskets, and capacity from asset sales.

During the webinar, we discussed one of the most flexible provisions in the context of an LBO, which allows unlimited restricted payments in connection with permitted change of control events, effectively eliminating the constraints of the RP covenant when portability leverage thresholds are met.

Unrestricted Subsidiary Risk

Post-J. Crew, unrestricted subsidiaries are now used to facilitate complex liability management exercises by allowing the movement of valuable assets outside the restricted group.

The analysis must combine unrestricted subsidiary investment capacity with traditional restricted payments capacity, as aggregate exposure often exceeds initial assessments.

The Modern Redemption Reality

Covenant packages today reflect years of legal innovation. Straightforward provisions often contain multiple exceptions and interaction mechanisms.

For example, we discussed in the webinar how blended make-whole provisions substantially reduce redemption costs by combining equity claw and make-whole pricing, specifically targeting LBO scenarios.

Essential Risk Assessment

To ensure a comprehensive risk assessment is made, it is essential to cover:

• Guarantor Coverage: Focus on non-guaranteed asset values and whether they could support third-party financing, creating structural subordination.
• Collateral Segmentation: Divide borrower assets into three categories: your collateral, other lenders' collateral, and unencumbered assets. The third category represents primary effective subordination risk.
• Super Senior Capacity: These provisions appear in different places throughout the documentation and can fundamentally alter recovery scenarios.

Systematic Analytical Framework

The framework for analyzing LBOs should cover these categories:

• Transaction Structure: Comprehensive change of control analysis, including portability provisions and carve-outs.
• Financing Capacity: Calculate restricted payments capacity from all sources, assess debt incurrence under multiple scenarios, evaluate secured debt limitations and their interactions.
• Strategic Alternatives: Consider redemption economics (including blended make-whole provisions), refinancing alternatives, and other sponsor options.

The New Professional Approach

Effective modern LBO analysis requires:

• Comprehensive Documentation Review: Understanding detailed covenant interactions beyond summary terms
• Scenario-Based Analysis: Evaluating multiple potential future circumstances
• Dynamic Capacity Calculations: Understanding how capacity sources accumulate and interact over time

Credit professionals must think systematically about sponsor flexibility utilization across multiple scenarios and timeframes, stress-testing transactions against potential LME structures, secondary buyouts, and refinancing alternatives.

The Bottom Line

The embedded covenant flexibility in the leverage finance market demands evolved analytical frameworks. While complexity creates challenges, it offers opportunities for credit professionals developing sophisticated analytical capabilities.

Success requires understanding not only what covenant packages permit today, but how they might be utilized across future scenarios. This forward-looking approach enables better risk assessment, more accurate pricing, and effective covenant structuring in an increasingly complex environment.

Clients can access the replay of this week's Knowledge Series webinar here. If you are not a client and would like to purchase access to our Primary Market Education Series, visit our website here. To find out more about our comprehensive legal enablement series, schedule a demo call here.

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