A leveraged buyout (LBO) is the acquisition of a company, division, business, or collection of assets (“target”) using debt to finance a large portion of the purchase price. The remaining portion of the purchase price is funded with an equity contribution by a financial sponsor (“sponsor”). LBOs are used by sponsors to acquire a broad range of businesses, including both public and private companies, as well as their divisions and subsidiaries. The sponsor’s ultimate goal is to realize an acceptable return on its equity investment upon exit, typically through a sale or IPO of the target. Sponsors have historically sought a 20%+ annualized return and an investment exit within five years.¹¹¹

EXHIBIT 4.1 LBO Fundamentals

This section provides an overview of the key participants in an LBO (see Exhibit 4.2).

EXHIBIT 4.2 Key Participants

The term “financial sponsor” refers to traditional private equity (PE) firms, merchant banking divisions of investment banks, hedge funds, venture capital funds, and special purpose acquisition companies (SPACs), among other investment vehicles. PE firms, hedge funds, and venture capital funds raise the vast majority of their investment capital from third-party investors, which include public and corporate pension funds, insurance companies, endowments and foundations, sovereign wealth funds, and wealthy families/individuals. Sponsor partners and investment professionals may also invest their own money in particular investment opportunities.

Investment banks play a key role in LBOs, both as a provider of financing and as a strategic M&A advisor. Sponsors rely heavily on investment banks to help develop and market an optimal financing structure. They may also engage investment banks as buy-side M&A advisors in return for sourcing deals and/or for their expertise, relationships, and in-house resources. On the sell-side, sponsors typically engage bankers as M&A advisors (and potentially as stapled financing providers ¹¹⁷) to market their portfolio companies to prospective buyers through an organized sale process.

Bank and institutional lenders are the capital providers for the bank debt in an LBO financing structure. Although there is often overlap between them, traditional bank lenders provide capital for revolvers and amortizing term loans, while institutional lenders provide capital for longer tenored, limited amortization term loans. Bank lenders typically consist of commercial banks, savings and loan institutions, finance companies, and the investment banks serving as arrangers. The institutional lender base is largely comprised of hedge funds, pension funds, prime funds, insurance companies, and structured vehicles such as collateralized debt obligation funds (CDOs).¹²⁴

Bond investors are the purchasers of the high yield bonds issued as part of the LBO financing structure. They generally include high yield mutual funds, hedge funds, pension funds, insurance companies, distressed debt funds, and CDOs.

Management plays a crucial role in the marketing of the target to potential buyers (see Chapter 6) and lenders alike, working closely with the bankers on the preparation of marketing materials and financial information. Management also serves as the primary face of the company and must articulate the investment merits of the transaction to these constituents. Consequently, in an LBO, a strong management team can create tangible value by driving favorable financing terms and pricing, as well as providing sponsors with comfort to stretch on valuation.

Management Buyout An LBO originated and led by a target’s existing management team is referred to as a management buyout (MBO). Often, an MBO is effected with the help of an equity partner, such as a financial sponsor, who provides capital support and access to debt financing through established investment banking relationships. The basic premise behind an MBO is that the management team believes it can create more value running the company on its own than under current ownership. The MBO structure also serves to eliminate the conflict between management and the board of directors/shareholders as owner-managers are able to run the company as they see fit.

Financial sponsors as a group are highly flexible investors that seek attractive investment opportunities across a broad range of sectors, geographies, and situations. While there are few steadfast rules, certain common traits emerge among traditional LBO candidates, as outlined in Exhibit 4.3.

EXHIBIT 4.3 Characteristics of a Strong LBO Candidate

The ability to generate strong, predictable cash flow is critical for LBO candidates given the highly leveraged capital structure. Debt investors require a business model that demonstrates the ability to support periodic interest payments and debt repayment over the life of the loans and securities. Business characteristics that support the predictability of robust cash flow increase a company’s attractiveness as an LBO candidate. For example, many strong LBO candidates operate in a mature or niche business with stable customer demand and end markets. They often feature a strong brand name, established customer base, and/or long-term sales contracts, all of which serve to increase the predictability of cash flow. Prospective buyers and financing providers seek to confirm a given LBO candidate’s cash flow generation during due diligence to gain the requisite level of comfort with the target management’s projections. Cash flow projections are usually stress-tested (sensitized) based on historical volatility and potential future business and economic conditions to ensure the ability to support the LBO financing structure under challenging circumstances.

Leading and defensible market positions generally reflect entrenched customer relationships, brand name recognition, superior products and services, a favorable cost structure, and scale advantages, among other attributes. These qualities create barriers to entry and increase the stability and predictability of a company’s cash flow. Accordingly, the sponsor spends a great deal of time during due diligence seeking assurance that the target’s market positions are secure (and can potentially be expanded). Depending on the sponsor’s familiarity with the sector, consultants may be hired to perform independent studies analyzing market share and barriers to entry.

Sponsors seek companies with growth potential, both organically and through potential future bolt-on acquisitions. Profitable top line growth at above-market rates helps drive outsized returns, generating greater cash available for debt repayment while also increasing EBITDA and enterprise value. Growth also enhances the speed and optionality for exit opportunities. For example, a strong growth profile is particularly important if the target is designated for an eventual IPO exit.

While an ideal LBO candidate should have a strong fundamental business model, sponsors seek opportunities to improve operational efficiencies and generate cost savings. Traditional cost-saving measures include lowering corporate overhead, streamlining operations, reducing headcount, rationalizing the supply chain, and implementing new management information systems. The sponsor may also seek to source new (or negotiate better) terms with existing suppliers and customers. These initiatives are a primary focus for the consultants and industry experts hired by the sponsor to assist with due diligence and assess the opportunity represented by establishing “best practices” at the target. Their successful implementation often represents substantial value creation that accrues to equity value at a multiple of each dollar saved (given an eventual exit).

All else being equal, low capex requirements enhance a company’s cash flow generation capabilities. As a result, the best LBO candidates tend to have limited capital investment needs. However, a company with substantial capex requirements may still represent an attractive investment opportunity if it has a strong growth profile, high profit margins, and the business strategy is validated during due diligence.

A strong asset base pledged as collateral against a loan benefits lenders by increasing the likelihood of principal recovery in the event of bankruptcy (and liquidation). This, in turn, increases their willingness to provide debt to the target. The target’s asset base is particularly important in the leveraged loan market, where the value of the assets helps dictate the amount of bank debt available (see “LBO Financing” sections for additional information). A strong asset base also tends to signify high barriers to entry because of the substantial capital investment required, which serves to deter new entrants in the target’s markets. At the same time, a company with little or no assets can still be an attractive LBO candidate provided it generates sufficient cash flow.

A proven management team serves to increase the attractiveness (and value) of an LBO candidate. Talented management is critical in an LBO scenario given the need to operate under a highly leveraged capital structure with ambitious performance targets. Prior experience operating under such conditions, as well as success in integrating acquisitions or implementing restructuring initiatives, is highly regarded by sponsors.

Internal rate of return (IRR) is the primary metric by which sponsors gauge the attractiveness of a potential LBO, as well as the performance of their existing investments. IRR measures the total return on a sponsor’s equity investment, including any additional equity contributions made, or dividends received, during the investment horizon. It is defined as the discount rate that must be applied to the sponsor’s cash outflows and inflows during the investment horizon in order to produce a net present value (NPV) of zero. Although the IRR calculation can be performed with a financial calculator or by using the IRR function in Microsoft Excel, it is important to understand the supporting math. Exhibit 4.4 displays the equation for calculating IRR, assuming a five-year investment horizon.

EXHIBIT 4.4 IRR Timeline

EXHIBIT 4.5 IRR Timeline Example

In addition to IRR, sponsors also examine returns on the basis of a multiple of their cash investment (“cash return”). For example, assuming a sponsor contributes $250 million of equity and receives equity proceeds of $750 million at the end of the investment horizon, the cash return is 3.0x (assuming no additional investments or dividends during the period). However, unlike IRR, the cash return approach does not factor in the time value of money.

LBOs generate returns through a combination of debt repayment and growth in enterprise value. Exhibit 4.6 depicts how each of these scenarios independently increases equity value, assuming a sponsor purchases a company for $1,000 million, using $750 million of debt financing (75% of the purchase price) and an equity contribution of $250 million (25% of the purchase price). In each scenario, the returns are equivalent on both an IRR and cash return basis.

EXHIBIT 4.6 How LBOs Generate Returns

Scenario I In Scenario I, we assume that the target generates cumulative free cash flow of $500 million, which is used to repay debt during the investment horizon. Debt repayment increases equity value on a dollar-for-dollar basis. Assuming the sponsor sells the target for $1,000 million at exit, the value of the sponsor’s equity investment increases from $250 million at purchase to $750 million even though there is no growth in the company’s enterprise value. This scenario produces an IRR of 24.6% (assuming a five-year investment horizon) with a cash return of 3.0x.

Scenario II In Scenario II, we assume that the target does not repay any debt during the investment horizon. Rather, all cash generated by the target (after the payment of interest expense) is reinvested into the business and the sponsor realizes 50% growth in enterprise value by selling the target for $1,500 million after five years. This enterprise value growth can be achieved through EBITDA growth (e.g., organic growth, acquisitions, or streamlining operations) and/or achieving EBITDA multiple expansion.

The concept of using leverage to enhance returns is fundamental to understanding LBOs. Assuming a fixed enterprise value at exit, using a higher percentage of debt in the financing structure (and a correspondingly smaller equity contribution) generates higher returns. Exhibit 4.7 illustrates this principle by analyzing comparative returns of an LBO financed with 25% debt versus an LBO financed with 75% debt. A higher level of debt provides the additional benefit of greater tax savings realized due to the tax deductibility of a higher amount of interest expense.

EXHIBIT 4.7 How Leverage is Used to Enhance Returns

Scenario III In Scenario III, we assume a sponsor purchases the target for $1,000 million using $250 million of debt (25% of the purchase price) and contributing $750 million of equity (75% of the purchase price). After five years, the target is sold for $1,500 million, thereby resulting in a $500 million increase in enterprise value ($1,500 million sale price - $1,000 million purchase price).

EXHIBIT 4.8 Scenario III Debt Repayment Timeline

Scenario IV In Scenario IV, we assume that a sponsor buys the same target for $1,000 million, but uses $750 million of debt (75% of the purchase price) and contributes $250 million of equity (25% of the purchase price). As in Scenario III, we assume the target is sold for $1,500 million at the end of Year 5. However, annual free cash flow is reduced due to the incremental annual interest expense on the $500 million of additional debt.

EXHIBIT 4.9 Scenario IV Debt Repayment Timeline^(a)

Most sponsors aim to exit or monetize their investments within a five-year holding period in order to provide timely returns to their LPs. These returns are typically realized via a sale to another company (commonly referred to as a “strategic sale”), a sale to another sponsor, or an IPO. Sponsors may also extract a return prior to exit through a dividend recapitalization. The ultimate decision regarding when to monetize an investment, however, depends on the performance of the target as well as prevailing market conditions. In some cases, such as when the target has performed particularly well or market conditions are favorable, the exit or monetization may occur within a year or two. Alternatively, the sponsor may be forced to hold an investment longer than desired as dictated by company performance or the market.

Traditionally, sponsors have sought to sell portfolio companies to strategic buyers, who typically represent the strongest potential bidder due to their ability to realize synergies from the target and, therefore, pay a higher price. Strategic buyers may also benefit from a lower cost of capital and a lower return threshold. The proliferation of private equity funds, however, made exits via a sale to another sponsor increasingly commonplace during the mid-2000s. Moreover, during the strong debt financing markets of this time period, sponsors were able to use high leverage levels and generous debt terms to support purchase prices competitive with (or even in excess of) those offered by strategic buyers.

In an IPO exit, the sponsor sells a portion of its shares in the target to the public. Post-IPO, the sponsor typically retains the largest single equity stake in the target with the understanding that a full exit will come through future follow-on equity offerings or an eventual sale of the company. Therefore, as opposed to an outright sale, an IPO generally does not afford the sponsor full upfront monetization. At the same time, the IPO provides the sponsor with a liquid market for its remaining equity investment while also preserving the opportunity to share in any future upside potential. Furthermore, depending on equity capital market conditions, an IPO may offer a compelling valuation premium to an outright sale.

While not a true “exit strategy,” a dividend recapitalization (“dividend recap”) provides the sponsor with a viable option for monetizing a sizeable portion of its investment prior to exit. In a dividend recap, the target raises proceeds through the issuance of additional debt to pay shareholders a dividend. The incremental indebtedness may be issued in the form of an “add-on” to the target’s existing credit facilities and/or bonds, a new security at the HoldCo level,¹³⁷ or as part of a complete refinancing of the existing capital structure. A dividend recap provides the sponsor with the added benefit of retaining 100% of its existing ownership position in the target, thus preserving the ability to share in any future upside potential and the option to pursue a sale or IPO at a future date. Depending on the size of the dividend, the sponsor may be able to recoup all of (or more than) its initial equity investment.

In a traditional LBO, debt has typically comprised 60% to 70% of the financing structure, with the remainder of the purchase price funded by an equity contribution from a sponsor (or group of sponsors) and rolled/contributed equity from management. Given the inherently high leverage associated with an LBO, the various debt components of the capital structure are usually deemed non-investment grade, or rated ‘Ba1’ and below by Moody’s Investor Service and ‘BB+’ and below by Standard and Poor’s (see Chapter 1, Exhibit 1.23 for a ratings scale). The debt portion of the LBO financing structure may include a broad array of loans, securities, or other debt instruments with varying terms and conditions that appeal to different classes of investors.

EXHIBIT 4.10 General Ranking of Financing Sources in an LBO Capital Structure

EXHIBIT 4.11 Average LBO Purchase Price Breakdown 1999 - 2008

Note: Prior to 2003, excludes media, telecommunications, energy, and utility transactions. Thereafter, all outliers, regardless of the industry, are excluded. 2008 includes deals committed to in 2007 (during the credit boom) that closed in 2008. Senior debt includes bank debt, 2nd lien debt, senior secured notes, and senior unsecured notes.

Subordinated includes senior and junior subordinated debt.

Equity includes HoldCo debt/seller notes, preferred stock, common stock, and rolled equity.

Other is cash and any other unclassified sources.

EXHIBIT 4.12 Average Sources of LBO Proceeds 1999 - 2008

Note: Contributed equity includes HoldCo debt/seller notes, preferred stock, and common stock.

EXHIBIT 4.13 Global LBO Volume and Number of Closed Deals 1999 - 2008

Excludes deals under $250 million in enterprise value.

EXHIBIT 4.14 Bank Debt

Bank debt is an integral part of the LBO financing structure, consistently serving as a substantial source of capital (as shown in Exhibit 4.12). Also referred to as “senior secured credit facilities,” it is typically comprised of a revolving credit facility (which may be borrowed, repaid, and reborrowed) and one or more term loan tranches (which may not be reborrowed once repaid). The revolving credit facility may take the form of a traditional “cash flow” revolver¹³⁸ or an asset based lending (ABL) facility.¹³⁹ Bank debt is issued in the private market and is therefore not subject to SEC regulations and disclosure requirements.¹⁴⁰ However, it has restrictive covenants that require the borrower to comply with certain provisions and financial tests throughout the life of the facility (see Exhibit 4.22).

Revolving Credit Facility A traditional cash flow revolving credit facility (“revolver”) is a line of credit extended by a bank or group of banks that permits the borrower to draw varying amounts up to a specified aggregate limit for a specified period of time. It is unique in that amounts borrowed can be freely repaid and reborrowed during the term of the facility, subject to agreed-upon conditions set forth in a credit agreement¹⁴² (see Exhibit 4.22). The majority of companies utilize a revolver or equivalent lending arrangement to provide ongoing liquidity for seasonal working capital needs, capital expenditures, letters of credit (LC),¹⁴³ and other general corporate purposes. A revolver may also be used to fund a portion of the purchase price in an LBO, although it is usually undrawn at close.

Asset Based Lending Facility An ABL facility is a type of revolving credit facility that is available to asset intensive companies. ABL facilities are secured by a first priority lien on all current assets (typically accounts receivable and inventory) of the borrower and may include a second priority lien on all other assets (typically PP&E). They are more commonly used by companies with sizeable accounts receivable and inventory and variable working capital needs that operate in seasonal or cyclical businesses. For example, ABL facilities are used by retailers, selected commodity producers and distributors (e.g., chemicals, forest products, and steel), manufacturers, and rental equipment businesses.

EXHIBIT 4.15 ABL Borrowing Base Formula

A term loan (“leveraged loan,” when non-investment grade) is a loan with a specified maturity that requires principal repayment (“amortization”) according to a defined schedule, typically on a quarterly basis. Like a revolver, a traditional term loan for an LBO financing is structured as a first lien debt obligation¹⁴⁸ and requires the borrower to maintain a certain credit profile through compliance with financial maintenance covenants contained in the credit agreement. Unlike a revolver, however, a term loan is fully funded on the date of closing and once principal is repaid, it cannot be reborrowed. Term loans are classified by an identifying letter such as “A,” “B,” “C,” etc. in accordance with their lender base, amortization schedule, and terms.

Amortizing Term Loans “A” term loans (“Term Loan A” or “TLA”) are commonly referred to as “amortizing term loans” because they typically require substantial principal repayment throughout the life of the loan.¹⁴⁹ Term loans with significant, annual required amortization are perceived by lenders as less risky than those with de minimus required principal repayments during the life of the loan due to their shorter average life. Consequently, TLAs are often the lowest priced term loans in the capital structure. TLAs are syndicated to commercial banks and finance companies together with the revolver and are often referred to as “pro rata” tranches because lenders typically commit to equal (“ratable”) percentages of the revolver and TLA during syndication. TLAs in LBO financing structures typically have a term that ends simultaneously (“co-terminus”) with the revolver.

Institutional Term Loans “B” term loans (“Term Loan B” or “TLB”), which are commonly referred to as “institutional term loans,” are more prevalent than TLAs in LBO financings. They are typically larger in size than TLAs and sold to institutional investors (often the same investors who buy high yield bonds) rather than banks. The institutional investor class prefers non-amortizing loans with longer maturities and higher coupons. As a result, TLBs generally amortize at a nominal rate (e.g., 1% per annum) with a bullet payment at maturity.¹⁵⁰ TLBs are typically structured to have a longer term than the revolver and any TLA as bank lenders prefer to have their debt mature before the TLB. Hence, a tenor for TLBs of up to seven (or sometimes seven and one-half years) has historically been market standard for LBOs.

Second Lien Term Loans The issuance of second lien term loans¹⁵¹ to finance LBOs became increasingly prevalent during the credit boom of the mid-2000s. A second lien term loan is a floating rate loan that is secured by a second priority security interest in the assets of the borrower. It ranks junior to the first priority security interest in the assets of the borrower benefiting a revolver, TLA, and TLB. In the event of bankruptcy (and liquidation), second lien lenders are entitled to repayment from the proceeds of collateral sales after such proceeds have first been applied to the claims of first lien lenders, but prior to any application to unsecured claims. ¹⁵² Unlike first lien term loans, second lien term loans generally do not amortize.

EXHIBIT 4.16 High Yield Bonds

High yield bonds are non-investment grade debt securities that obligate the issuer to make interest payments to bondholders at regularly defined intervals (typically on a semiannual basis) and repay principal at a stated maturity date, usually seven to ten years after issuance. As opposed to term loans, high yield bonds are non-amortizing with the entire principal due as a bullet payment at maturity. Due to their junior, typically unsecured position in the capital structure, longer maturities, and less restrictive incurrence covenants as set forth in an indenture (see Exhibit 4.23),¹⁵³ high yield bonds feature a higher coupon than bank debt to compensate investors for the greater risk.

Bridge Loans A bridge loan facility (“bridge”) is interim, committed financing provided to the borrower to “bridge” to the issuance of permanent capital, most often high yield bonds (the “take-out” securities). In an LBO, investment banks typically commit to provide funding for the bank debt and a bridge loan facility. The bridge usually takes the form of an unsecured term loan, which is only funded if the take-out securities cannot be issued and sold by the closing of the LBO.

EXHIBIT 4.17 Mezzanine Debt

As its name suggests, mezzanine debt refers to a layer of capital that lies between traditional debt and equity. Mezzanine debt is a highly negotiated instrument between the issuer and investors that is tailored to meet the financing needs of the specific transaction and required investor returns. As such, mezzanine debt allows great flexibility in structuring terms conducive to issuer and investor alike.

The remaining portion of LBO funding comes in the form of an equity contribution by the financial sponsor and rolled/contributed equity by the target’s management. The equity contribution percentage typically ranges from approximately 30% to 40% of the LBO financing structure, although this may vary depending on debt market conditions, the type of company, and the purchase multiple paid.¹⁵⁹ For large LBOs, several sponsors may team up to create a consortium of buyers, thereby reducing the amount of each individual sponsor’s equity contribution (known as a “club deal”).

Both within and across the broad categories of debt instruments used in LBO financings—which we group into bank debt, high yield bonds, and mezzanine debt—there are a number of key terms that affect risk, cost, flexibility, and investor base. As shown in Exhibit 4.18 and discussed in greater detail below, these terms include security, seniority, maturity, coupon, call protection, and covenants.

EXHIBIT 4.18 Summary of Selected Key Terms

Security refers to the pledge of, or lien on, collateral that is granted by the borrower to the holders of a given debt instrument. Collateral represents assets, property, and/or securities pledged by a borrower to secure a loan or other debt obligation, which is subject to seizure and/or liquidation in the event of a default.¹⁶⁰ It can include accounts receivable, inventory, PP&E, intellectual property, and securities such as the common stock of the borrower/issuer and its subsidiaries. Depending upon the volatility of the target’s cash flow, creditors may require higher levels of collateral coverage as protection.

Seniority refers to the priority status of a creditor’s claims against the borrower/issuer relative to those of other creditors. Generally, seniority is achieved through either contractual or structural subordination.

Contractual Subordination Contractual subordination refers to the priority status of debt instruments at the same legal entity. It is established through subordination provisions, which stipulate that the claims of senior creditors must be satisfied in full before those of junior creditors (generally “senior” status is limited to bank lenders or similar creditors, not trade creditors¹⁶¹). In the case of subordinated bonds, the indenture contains the subordination provisions that are relied upon by the senior creditors as “third-party” beneficiaries.¹⁶² Exhibit 4.19 provides an illustrative diagram showing the contractual seniority of multiple debt instruments.

EXHIBIT 4.19 Contractual Subordination

Structural Subordination Structural subordination refers to the priority status of debt instruments at different legal entities within a company. For example, debt obligations at OpCo, where the company’s assets are located, are structurally senior to debt obligations at HoldCo¹⁶³ so long as such HoldCo obligations do not benefit from a guarantee (credit support)¹⁶⁴ from OpCo. In the event of bankruptcy at OpCo, its obligations must be satisfied in full before a distribution or dividend can be made to its sole shareholder (i.e., HoldCo). Exhibit 4.20 provides an illustrative diagram showing the structural seniority of debt instruments at two legal entities.

EXHIBIT 4.20 Structural Subordination

The maturity (“tenor” or “term”) of a debt obligation refers to the length of time the instrument remains outstanding until the full principal amount must be repaid. Shorter tenor debt is deemed less risky than debt with longer maturities as it is required to be repaid earlier. Therefore, all else being equal, shorter tenor debt carries a lower cost of capital than longer tenor debt of the same credit.

Coupon refers to the annual interest rate (“pricing”) paid on a debt obligation’s principal amount outstanding. It can be based on either a floating rate (typical for bank debt) or a fixed rate (typical for bonds). Bank debt generally pays interest on a quarterly basis, while bonds generally pay interest on a semiannual basis. The bank debt coupon is typically based on a given benchmark rate, usually LIBOR or the Base Rate, plus a spread based on the credit of the borrower. A high yield bond coupon, however, is generally priced at issuance on the basis of a spread to a benchmark Treasury.

Call protection refers to certain restrictions on voluntary prepayments (of bank debt) or redemptions (of bonds) during a defined time period within a given debt instrument’s term. These restrictions may prohibit voluntary prepayments or redemptions outright or require payment of a substantial fee (“call premium”) in connection with any voluntary prepayment or redemption. Call premiums protect investors from having debt with an attractive yield refinanced long before maturity, thereby mitigating reinvestment risk in the event market interest rates decline.

EXHIBIT 4.21 Call Schedules

Covenants are provisions in credit agreements and indentures intended to protect against the deterioration of the borrower/issuer’s credit quality. They govern specific actions that may or may not be taken during the term of the debt obligation. Failure to comply with a covenant may trigger an event of default, which allows investors to accelerate the maturity of their debt unless amended or waived. There are three primary classifications of covenants: affirmative, negative, and financial.

Bank Debt Covenants Exhibit 4.22 displays typical covenants found in a credit agreement. With respect to financial maintenance covenants, the typical credit agreement contains two to three of these covenants.¹⁶⁸ The required maintenance leverage ratios typically decrease (“step down”) throughout the term of the loan. Similarly, the coverage ratios typically increase over time. This requires the borrower to improve its credit profile by repaying debt and/or growing cash flow in accordance with the financial projections it presents to lenders during syndication.

EXHIBIT 4.22 Bank Debt Covenants

High Yield Bond Covenants Many of the covenants found in a high yield bond indenture are similar to those found in a bank debt credit agreement (see Exhibit 4.23). A key difference, however, is that indentures contain incurrence covenants as opposed to maintenance covenants. Incurrence covenants only prevent the issuer from taking specific actions (e.g., incurring additional debt, making certain investments, paying dividends) in the event it is not in pro forma compliance with a “Ratio Test,” or does not have certain “baskets” available to it at the time such action is taken. The Ratio Test is often a coverage test (e.g., a fixed charge coverage ratio), although it may also be structured as a leverage test (e.g., total debt-to-EBITDA) as is common for telecommunications/media companies.

EXHIBIT 4.23 High Yield Bond Covenants