Looking at all the angles: incremental debt incurrence flexibility in detail

From large cap syndicated deals to mid-market private credit, whether in loans or in bonds, the ability for borrowers to incur material incremental debt is commonplace. However, when you look beyond the headline ratios and baskets, it becomes clear that the devil – and the true amount of debt capacity – is in the details. In this bulletin, we will look at how these provisions work together and what they mean in practice.

The permission to incur incremental debt (whether as incremental commitments under an existing document or “side car” debt under a separate document) will typically consist of a ratio-based permission (permitting an unlimited amount of debt to be incurred subject to pro forma compliance with the relevant ratio test) plus a fixed amount freebie basket (commonly with an EBITDA-based grower). Depending on the transaction and the parties, these permissions can permit senior secured, second lien and/or unsecured or non-collateral debt to be incurred. 

These are the headline terms that appear in a commercial grid, but exceptions and adjustments can have a material impact on the total amount of debt capacity available to borrowers, and greatly increase their flexibility to incur additional debt. Here are some of the common points to keep in mind:

• Take (Fixed Charge) Cover! – the ability of a borrower to incur unsecured / non-collateral debt (or assume acquired debt) based only on compliance with a fixed charge coverage ratio has become common in the large cap syndicated market, and will even appear in some private credit deals. A minority of documents also allow junior secured / second lien debt to be incurred based only on compliance with the fixed charge coverage ratio, potentially giving borrowers wide flexibility to incur junior secured debt within the capital structure and shared on the transaction security.
  • In the past decade, low interest rates have meant that compliance with the Fixed Charge Coverage Ratio test was rarely in question. Although rates are much higher in 2024, incurrence tests based on a Fixed Charge Coverage Ratio still give borrowers significant capacity to incur additional debt.
• For better or worse – debt incurrence ratios may include a “no worse than” condition. This will allow a borrower to incur an unlimited amount of debt no matter what the leverage ratio is provided that, after taking account of the debt being raised and completion of the relevant transactions (e.g. an acquisition), leverage is equal to or lower than it was immediately prior. This is most common in large cap syndicated deals but is increasingly appearing in private credit deals.
  • “No worse than” conditions sometimes appear in the incurrence tests for delayed draw facilities. This is ultimately a negotiated point, but the two are not necessarily analogous – the flexibility to incur further debt which is uncommitted is not the same as the ability to draw debt which has already been committed (at least from a creditor perspective), even though they can both lead to the same amount of debt being incurred.
• (Sort of) unsecured – where finance documents refer to “unsecured” debt, it will usually include “non-collateral” debt – this is any indebtedness that doesn’t share in the transaction security but is nonetheless secured on other assets of the group. This concept originated in the US market, where comprehensive all asset security is common and so the scope for “non-collateral” debt is limited. In European financings where security packages are typically much more limited, there can be a large pool of valuable assets that could be secured for the benefit of other creditors (including intellectual property or real estate assets). 
  • This allows borrowers to raise non-collateral debt that would have super senior priority in respect of certain assets as compared to the senior creditors – which is a form of priming.
  • In this context, it is especially important to be clear on what flexibility there is and what restrictions apply for borrowers to grant security over material assets.
  • Even where there is “all asset” style security (such as an English law floating charge), some borrowers will try to exclude assets secured only by a floating charge / non-fixed security from being considered part of the “transaction security” for determining what constitutes the non-collateral assets.
• To accede or not to accede, that is the (intercreditor) question – although any senior or junior secured creditors will need to accede to an intercreditor agreement in order to share in the transaction security, many (but not all) credit agreements will also require certain unsecured creditors to accede to the intercreditor agreement. 
  • Unsecured creditors being party to the intercreditor agreement helps to ensure (for the benefit of the borrower group and other creditors) that material unsecured creditors are not able to take acceleration or enforcement action ahead of other (secured) creditors. If those unsecured creditors are not subject to the intercreditor agreement, their enforcement action could destabilise a capital structure and risk destroying value in a downside scenario.
  • The intercreditor accession requirement may only apply to debt incurred under certain ratio permissions, often above a given threshold, and would not typically apply to creditors of any acquired debt.
• Give or take an RCF – revolving and/or delayed draw term facilities may be treated in different ways for the purpose of incurrence. Some documents will treat undrawn debt as fully drawn, but give no pro forma credit for the use of proceeds (being the worst treatment for borrowers), while others will treat all undrawn debt as undrawn, allowing facilities to be established on a ‘leverage neutral’ basis (being the best treatment for borrowers). 
  • Some documents go further and will also allow borrowers to disregard some or all revolving or working capital debt for the purpose of ratio testing, with the effect of increasing the actual amount of headroom under a ratio permission.
• Ratios first – ratio debt capacity will customarily always be used before any fixed basket capacity. Put another way, borrowers will be able to incur debt under the freebie basket even if they are above the ratio, and so the total debt capacity will be able to exceed that headline ratio.
• Assumptions can be dangerous – flexibility to allow borrower groups to “assume” debt existing in any acquired company is relatively customary, although this will usually be subject to conditions, including: 
  • requiring acquired debt to be refinanced a certain period after the acquisition completes – often six months – although it may be allowed to remain outstanding if the debt could have been incurred under other permissions (which can include the unsecured ratio debt permissions);
  • there may be a “freebie” basket applicable to the acquired debt permission (in addition to the main incremental freebie basket);
  • where the general incurrence ratio permissions benefit from a “no worse than” permission, this will also apply to the acquired debt ratios; and
  • although acquired debt may be secured, it will be secured on the assets of the target group, rather than sharing in the transaction security and so, for ratio testing purposes, will constitute unsecured / non-collateral indebtedness. However, unlike other unsecured debt, creditors are unlikely to be required to accede to the intercreditor agreement (irrespective of the quantum of the debt). 
• Prime numbers – priming, in all its forms, is one of the hot topics of 2024 and a clear focus area for creditors. This includes ensuring that junior debt is incurred structurally junior to the senior debt. In practice, this means that the borrower of junior secured or unsecured debt should be at the same level as (or higher than) the senior borrower in the corporate group. However, this is not always the case, and some documents will allow junior secured or unsecured indebtedness to be incurred in a structurally senior position in the operating group.
  • This can be mitigated if all creditors are party to the intercreditor agreement, but creditor accession thresholds mean this will not always be the case!
• No one expects the general basket! – typically incremental debt to be incurred under any applicable permissions or, at the least, borrowers will be permitted to reclassify which permission is being used. This means that the general debt basket (and potentially the “local lines” basket) can be added to the other debt incurrence permissions to increase the total amount of incremental debt capacity. Just like the freebie, this capacity could be used irrespective of the leverage ratio.

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