When documenting an ABL facility alongside a separate term loan, borrowers and financial sponsors increasingly request that the ABL credit agreement be drafted to essentially match material terms of the term loan agreement. This understandable desire for conformity often overshadows fundamental differences between ABL and term loan facilities and can create significant issues for ABL lenders. The goal from the ABL lender’s perspective should be to understand the tradeoffs involved and provide a level of functional conformity in principal terms, while maintaining customary availability-based metrics and liquidity protections of ABL loan documentation which are often absent or inadequately covered in term loan documentation.

For a number of years now, borrowers and financial sponsors have regularly requested that revolving ABL credit agreements be drafted in general conformity with the borrower's term loan credit agreement, particularly when the ABL facility is of a relatively small size in comparison with the term loan facility (or entered into alongside an existing term loan facility).[1]  Historically, this type of request meant the ABL documentation would be drafted to generally conform with common financial definitions (particularly EBITDA), representations and warranties, affirmative and negative covenants and events of default, subject to additions and modifications to such provisions as were customary in the ABL market.   The intent was to align the terminology and covenant structure with the term loan provisions so as to avoid renegotiating commonly shared terms and permit consistent financial and covenant compliance reporting as a matter of convenience and efficiency. This "conforming approach" typically meant that ABL documentation terms would generally align with the term loan facility, but would have some additional or different ABL-specific terms due to the fundamental differences between a revolving ABL facility and a term loan facility.  In particular, the ABL covenant structure would commonly omit certain specific term loan baskets due to the ABL convention of providing "payment conditions" baskets that gave the borrower the ability to make unlimited dividends, investments and debt prepayments so long as certain availability and pro forma fixed charge coverage requirements were met. Term loan baskets based on leverage, "available amounts" or net asset/EBITDA tests were not viewed as appropriate for ABL facilities nor necessary given the unlimited baskets the ABL facility provided (so long as a payment-conditions test was met). 

More recently, however, it has become common for borrowers and sponsors to request that asset-based lenders essentially match various term loan provisions (particularly covenant baskets) when these two types of credit facilities are prepared for a borrower.  Notwithstanding the many fundamental differences between revolving ABL and term loan facilities, borrowers and financial sponsors often require that ABL lenders align the terms of these two types of facilities almost verbatim to ensure that the operational flexibility built into one facility (the term loan facility) is not lost due to the restrictions contained in the other (the ABL facility).[2]  No longer are borrowers always willing to rely on the unlimited "payment conditions" baskets in the ABL facility to permit transactions that are allowed under "available amount", leverage or net asset/EBITDA baskets typical to term loans.[3]

This desire for conformity is understandable, but can create significant issues for ABL lenders who rely on traditional availability-based metrics and liquidity protections of ABL loan documentation which are often absent or inadequately covered in term loan documentation.  The goal from the ABL lender's perspective is to provide a level of functional conformity in principal terms, while maintaining the availability-based metrics and liquidity protections customarily provided in the ABL credit agreement.

This article discusses the four key issues that regularly arise in negotiating and drafting ABL credit facilities when borrowers push for functionally identical documentation:

• How the inclusion of Available Amount baskets and Grower Baskets can undercut the effectiveness of payment conditions baskets (and other availability requirements) in the negative covenants.

   

• How limiting debt prepayment restrictions to only "Junior Debt" conflicts with long-standing ABL prohibitions on voluntary prepayment of any debt, senior or junior.

   

• How term loan concepts of "Limited Condition Acquisitions" and "Limited Condition Transactions" have eroded ABL protections based on requiring minimum pro forma availability.

   

• How term loan interpretive provisions (originated in the high-yield debt markets) have crept into term loan and ABL facilities and can dramatically weaken ABL negative covenant baskets.

The goal is to acknowledge and understand key elements of the changing market regarding these terms and enable ABL lenders to adapt to and accommodate these changes while retaining essential liquidity protections fundamental to ABL lending.

Available Amount Baskets and Grower Baskets Payment Conditions Baskets

The "Available Amount" is a basket composed of a fixed-dollar amount or percentage of EBITDA that increases for each test period (typically rolling four quarters) based on certain cash and non-cash amounts that are deemed "available" for restricted uses such as acquisitions, investments, equity distributions (restricted payments) and debt prepayments ("Restricted Uses").[4]  The Available Amount forms a general pool of "funds" that can be "used" for Restricted Uses without any availability or pro forma fixed charge test.  Given these amounts can be cash and non-cash and, even if cash, are not required to be physically segregated in specific accounts (or otherwise remain identifiable), the liquidity they represent is more conceptual than actual from the perspective of a working capital lender. In addition, there is no time correlation between realizing the amounts included in the Available Amount calculation and when those amounts can be "used" in a transaction. Finally, any calculation based on EBITDA almost certainly includes non-cash add-backs negotiated in the context of financial covenants and further limits the utility of this basket when evaluated on a liquidity basis.^[5]

"Grower Baskets" are similar to Available Amount baskets, but are based on a dollar amount plus a percentage of EBITDA or Total Assets (therefore the basket can increase as those metrics grow over time).^[6]   Like Available Amount baskets, Grower Baskets flow through negative covenants, permitting Restricted Uses up to an amount that grows as EBITDA/Total Assets increase.

Available Amount Baskets and Grower Baskets are problematic for ABL lenders due to the illiquid nature of many of their components and the fact that time of usage of such amounts are not tied to the time of receipt of those funds. Consequently, once established, the Available Amount or the Grower Basket could conceptually permit accumulation of amounts over time sufficient to permit Restricted Uses greater than cash flow (or even a multiple thereof) for a given accounting period with no availability or liquidity test to ensure the cash being utilized derives from the transactions producing them (and not revolving loan proceeds).  There are usually no practical means for working capital lenders to confirm that cash or other amounts, when "used", are actually "available" from the sources indicated (despite the name).

State of the Market: Historically, ABL lenders have successfully argued that borrowers did not need and should not expect Available Amount Baskets or Grower Baskets due to the unlimited nature and flexibility of the "Payment Conditions" baskets.^[7]  Borrowers and sponsors have argued that some level of non-availability-based baskets are needed in cases where the underlying transaction makes sense and availability is not sufficient to comply with the Payment Condition test.  This position has largely been accepted, particularly with respect to investments (which are, in theory, accretive to the assets of the borrower) and, to some extent, debt prepayments (which reduce debt and corresponding fixed charges). As a result, many ABL facilities include some level of additional non-Payment Condition baskets, usually (i) a Grower Basket at a reduced amount (often only so long as included as "fixed charges" in the financial covenant) and/or (ii) a modified Available Amount Basket calculated based only on cash items received contemporaneously with the permitted payment or investments.^[8]  Similarly, additional baskets for equity-based proceeds are typically acceptable for permitting Restricted Uses, so long as they are tied in time to the particular use they fund. 

Recently, however, given the competitive nature of the credit markets, some ABL lenders have agreed to incorporate Available Amount and Grower Baskets essentially identical to the term loan facility in certain larger sponsor-driven transactions. These situations should be carefully evaluated and understood in the context of the following:

1. How stringent is the total covenant package applicable to a borrower (can cash leakage be generally managed through the totality of restrictions in the credit agreement)?
2. How comfortable are the ABL lenders with the particular management team or sponsor backing the borrower (can the borrower be relied upon to manage liquidity responsibly and undertake conservative utilization of baskets)?
3. How confident is the ABL lender in its borrowing base collateral, advance rate cushions, liquidation values and exit strategies (how much liquidity will be required to "run out" the receivables or sell the inventory)?
4. What are the particular circumstances of the borrower as well as the broader context of the borrower’s business and related risk factors?

Finally, given the highly negotiated nature of these facilities, "market precedent" arguments offering up documentation "giving" on these baskets should not be accepted at face value without close analysis of the contextual factors at work and the mitigating terms that may have been negotiated in other parts of the loan documentation. 

Prepayment Restrictions Only on "Junior Debt"

Term loan facilities typically restrict prepayments of indebtedness only to the extent the debt is subordinated in right of payment, junior in lien priority or in some (but not all) cases, unsecured (sometimes referred to as "Restricted Debt" or "Junior Debt"),^[9]  leaving prepayments of pari passu debt outside the scope of the applicable negative covenant and therefore unlimited (often not even subject to an event of default test).  Term lenders typically do not have significant concerns if the borrower chooses to prepay other pari passu debt, so long as the prepayment terms of the term loan facility are complied with. Since the term loan facility is typically funded at closing, the prepayments necessarily come from sources other than the term loan facility, reduce leverage and, if pari secured debt is prepaid, increase the collateral coverage of the term loan, so it is typically not a material concern for term lenders. Borrowers and financial sponsors want the flexibility the term loan facility provides to prepay more expensive or earlier maturing debt without hinderance by the ABL lenders. 

ABL lenders, on the other hand, care very much about debt prepayments, particularly voluntary payments that can be financed through or otherwise drain the working capital the ABL lenders provide.  As a rule, ABL lenders do not typically permit voluntary prepayments of any debt (pari passu, subordinated, secured or otherwise) unless the payment conditions can be met, thus ensuring minimum availability after giving effect to the payment.^[10] 

Consequently, adopting the term loan definition of "Junior Debt" with respect to voluntary prepayments is a problem for ABL lenders as it removes any limitation on the borrower using the ABL facility or the last dollars of working capital to prepay other debt (leaving the ABL lenders without sufficient liquidity or operating horizon to realize on its borrowing base collateral).  Additionally, even if the covenant is not limited to junior debt, incorporating broad baskets based on leverage, Available Amounts or Grower Amounts also undercuts this fundamental protection.

Borrowers and sponsors, however, often argue that (i) prepayment restrictions amount to payment subordination, (ii) the ABL facility should not impair the ability of the borrower to repay higher priced debt, and (iii) the ABL lenders should rely on the borrower to manage its liquidity so long as the borrower is "in formula" on collateral coverage under the borrowing base.

From the perspective of ABL lenders, these arguments can fall flat.  A term lender should not expect voluntary prepayment of its loan under all circumstances and restricting (but not prohibiting) those payments does not equate to subordination. The desire to prepay higher-priced debt is understandable, but should not be the priority if liquidity is tight. And finally, the argument that the ABL lender should simply "rely on the borrowing base" ignores the long-standing reason liquidity thresholds are included in ABL facilities in the first place: to address the practical difficulty of realizing on collateral without sufficient liquidity to run the business while that process takes place.  The Payment Conditions test protects the ABL lenders from precisely this risk and is why voluntary payments should not be solely at the borrower's discretion.  Even well-intentioned borrowers acting in good faith can find themselves in trouble and decide to risk repaying term debt notwithstanding insufficient remaining liquidity.  The ABL lenders should not be required to shoulder this risk.

State of the Market: Although exceptions exist, most ABL lenders will not agree to entirely omitting the restriction on voluntary prepayments of the term loan and other pari passu debt.  However, it has become more common in middle market sponsor transactions for ABL lenders to agree to include an Available Amount Basket and/or Grower Basket amounts in the prepayment negative covenant, preferably limited to actual cash items and with some minimum availability threshold (as opposed to a full payment conditions test). 

Limited Condition Acquisitions and Limited Condition Transactions

A "Limited Condition Acquisition" (or "LCA") is essentially any permitted acquisition identified by the borrower as to which the conditions to funding (including no default, representations and warranties and financial covenant tests) are only required to be met on the date of execution of the purchase agreement, and not on the consummation date (so long as completed within a certain time period).

This concept originated in the term loan market in connection with post-closing material acquisitions funded with incremental term loans.  The intent was to apply the same "SunGard" and limited condition closing terms applicable to initial acquisition financings in the context of a future material acquisition (which would benefit from the same certainty of execution protections provided).

State of the Market: The Limited Condition Acquisition concept has been widely accepted in the ABL market, however, typically only so long as some level of availability is required upon consummation.  This is consistent with the conceptual basis of the provision, as any "closing date" acquisition financing would requiring minimum opening availability, even if closed on a limited-condition basis.

Limited Condition Transactions: A "Limited Condition Transaction" (or "LCT") provision takes the Limited Condition Acquisition concept and expands it to include not only material acquisitions, but also (i) other non-controlling investments, (ii) debt prepayments and (iii) dividends.  Similar to Limited Condition Acquisition provisions, this concept provides that if the conditions to the investment, debt prepayment or dividend are met on the date of execution of the applicable agreement, those tests do not have to be met on the consummation (payment) date.  For borrowers whose equity is publicly traded or who have issued high-yield debt, the practical demands to complete announced dividends and tenders may warrant inclusion of LCT provisions in the ABL facility, but otherwise, for most private companies, the certainty of execution demands in acquisition financing (and often the accretive nature of the transaction) are not present and weigh against expanding the concept of limited conditionality to include non-acquisition transactions.   

The Limited Condition Transaction concept has not been widely accepted in the ABL market, although exceptions do exist.[12]  Expansion of the LCA concept to include equity distributions and debt prepayments can materially undermine the fundamental protection of the Payment Conditions test given it is only tested when the contractual commitment is created, not when paid.   Borrowers have argued that in order to comply with binding agreements and investor expectations, they should be permitted to apply the LCA concept to an expanded range of Limited Condition Transactions.  As with other issues, this makes much more sense in the context of a term loan than it does a working capital ABL facility.  ABL lenders predicate and underwrite their exposure based on minimum-availability thresholds and provide considerable flexibility if those thresholds are met. Creating additional carve outs that strip this minimum criteria shifts the risk of inadequate liquidity to the ABL lenders simply because the borrower has "written a check it can’t cash."

State of the Market: Generally, ABL lenders have been able to hold the line on not agreeing to full Limited Condition Transaction provisions in ABL credit agreements.  In instances where LCTs are agreed to, an availability test at some level on the date of consummation should always apply. 

Interpretive Provision - Covenant Basket Aggregation and Reallocation

The "interpretive provisions" of the ABL credit agreement are an often-overlooked category of terms that have migrated from the bond market to the term loan market and into ABL credit agreements.   Although typically appearing as mere boilerplate (usually at the end of the "Definitions" section), these interpretive provisions often do not receive much attention, but can be critically important in gauging the scope and practical protections provided by negative covenants. For example, interpretive provisions often provide the borrower the ability to combine amounts from various baskets (including (i) fixed-dollar baskets ("Fixed Baskets") and (ii) leverage ratio or fixed charge coverage ratio-based baskets, which generally include Payment Conditions baskets ("Ratio Baskets")), to permit Restricted Uses.  Typically, these terms allow the borrower to cobble together amounts permitted under multiple different baskets to achieve the needed dollar amount for a particular Restricted Use (e.g., a $50 million dividend can be made based on $20 million permitted under an Available Amount and/or Builder Basket (each a Fixed Basket) and $30 million permitted under a Payment Conditions basket (a Ratio Basket). 

In addition, these terms often allow recharacterization of such amounts after such Restricted Use is consummated to essentially "re-load" Fixed Baskets.  This occurs by permitting the borrower to shift amounts used under Fixed Baskets into Ratio Baskets once financial metrics or availability improve (e.g., in the above example, if the Ratio Baskets would permit an additional $20 million in the fiscal quarter following the dividend, the Fixed Basket can essentially be credited the $20 million already used and be reloaded to its prior amount).  What this can mean is that, functionally, any time the Payment Conditions Basket is available, the Fixed Baskets would be re-loaded for future use (at a point when the Payment Conditions can no longer be met). 

State of the Market: These provisions have been generally accepted in the ABL market, but as the scope and variety of covenant baskets increases, ABL lenders should be cautious about how much reliance is placed on the practical protection these baskets offer given the "flexibility" provided by the aggregation and recharacterization interpretive provisions. 

In addition, it should be noted that, recently, some term loan facilities have also included an interpretive provision that would allow borrowers to essentially disregard amounts simultaneously "used" in a Fixed Basket when calculating the amount that can be "used" under a Ratio Basket in a given transaction.  If this provision were included in an ABL credit agreement, the impact could be material.  

For example, using the $50-million dividend scenario above, if the dividend were permitted under an Available Amount or Builder Basket, those amounts would be excluded from the concurrent calculation of the Payment Conditions test.  The borrower could arguably incur $20 million more than otherwise available under the Payment Conditions test because the $20- million dividend under the Fixed Basket could be excluded from either or both the Availability prong or the FCCR prong of the Payment Conditions basket. There are other (often nuanced) problems that can arise with this type of provision depending on how it is drafted, so the damage can be greater or lesser depending on specifics. In general, however, this type of provision is very problematic in an ABL credit facility and should be rejected in any form. 

Conclusion

On the whole, there has been a significant shift in the ABL market in the last several years toward accommodating borrower and sponsor requests for conformity in documentation between term loan and ABL credit facilities.  Competitive debt capital markets generally, including crossover from the bond markets, in particular, have put pressure on term lenders to significantly broaden the "flexibility" and permissive nature of the covenant package contained in their facilities.  In response, borrowers and sponsors have tenaciously pushed to press down these gains into the ABL market, and with much success.  It is a "borrower’s market" in many respects as there are abundant sources and providers of debt capital for borrowers to choose from.  The agreement by an ABL lender to hew closely to the term loan document can easily decide who wins the deal.  

Notwithstanding this environment, ABL lenders should understand the potential impact of the changes they are being asked to make and preserve certain minimum protections to liquidity and safeguards against potential depletion of the ABL facility.  As has always been true of sound asset-based lending, reliance upon good collateral, proven advance rates, strong reporting and discretionary borrowing-base calculations can help lessen concerns regarding broad covenant baskets.  Shared interest of term lenders in healthy liquidity can also be of some comfort, as can reliance on borrowers and sponsors to not unreasonably deplete liquid assets.  But, ultimately, term facilities are based on enterprise value considerations of lenders whose money is already committed. Short-term liquidity, cash usage and source of funds for non-accretive transactions are not always their first priority and this is reflected in nature of term loan provisions.  Similarly, borrowers and sponsors may be willing to risk short-term liquidity to pursue strategic opportunities.  In either case, ABL lenders who adopt term-loan provisions wholesale risk finding themselves with insufficient liquidity to successfully realize on their collateral when aggressive acquisitions, dividend recapitalizations and debt prepayments have left the borrower insufficient cash and availability to weather a downturn.  The time-tested approach of maintaining minimum availability-based metrics should not be abandoned without care. [13]