‘High water marking’ provisions on the rise in UK mid-market leveraged financings

Lenders in the mid-market space will need to prepare for both an uptick in M&A activity as well as the continued push by bullish sponsors to incorporate US style, large-cap market terms into mid-market financings.

The most recent large-cap market construct which we have seen make its way into more opportunistic sponsors’ mid-market term sheets is the inclusion of so called ‘high water marking’ provisions. These provisions can be seen as a further evolution of the ‘grower baskets’ construct which itself historically developed out of larger financings. 

This borrower-friendly ‘grower basket’ construct allows ‘baskets’ (i.e. allowances granted to borrowers for certain activities which would customarily be restricted by Loan Market Association style documentation) to grow beyond their originally agreed fixed limits by reference to growth in a specified performance metric, invariably earnings before interest, taxes, depreciation and amortisation (EBITDA). So, for instance, one might see basket sizes expressed to be determined by reference to the greater of the (traditional) fixed amount and an additional limb tied to EBITDA as at the date of determination, thereby allowing the amounts permitted under the relevant basket to scale beyond the day one fixed amount in line with the borrower’s EBITDA growth.

Grower baskets in their simplest form have long been accepted by the large and mid sponsor-backed markets alike. It is hard to argue that baskets sized on the basis of a borrower’s size at the time of origination will remain appropriate for the business over what may be a facility term of seven years or more facility term – not least given the agreed business plan, on the basis of which financial covenants are set, will have assumed growth. From a lender perspective, this approach is preferable to agreeing larger baskets at the outset which may not transpire to be justified over the life of the facilities.

Further, once the grower basket concept is accepted in principle, it is also then hard to argue that a default should occur in circumstances where a borrower has made proper use of the enlarged basket – for instance, to incur debt - but performance subsequently declines. While some mid-market documents do require the borrower to reduce maintenance-based baskets – such as an amount of debt outstanding at any time – back to a lower permitted level within a specified period where the relevant performance metric declines, in the main lenders accept that no default will occur in such a scenario. As such, anything properly incurred at a time when a higher basket level applied will be permitted to subsist, but not further increase, without a default occurring. Absent any ‘grandfathering’ provisions, in time the basket usage would often be expected to drop back in any event.

High water marking, however, is an even more aggressive addendum. This construct allows the performance metric limb of the grower basket to effectively be re-interpreted as a fixed basket amount which is tied to the highest performance achieved by the borrower during the life of the facility, as the performance metric limb of the basket is precluded from fluctuating down again when the borrower experiences a decrease in performance. In other words, the performance metric limb of the basket remains fixed to the highest level of performance that the borrower achieves at any point during the life of the facility - hence “high water” marking.

Where not expressly called out in a term sheet, we have typically seen high water marking provisions incorporated through the underlying facilities’ construction clause. However, given the novelty of the construct, the market has not developed any standardised approach or wording in order to document these provisions and so currently they can be less easy to spot relative to the more customarily acceptable formulations discussed above.

For example, in a recent deal that came to market, the provision simply read: “… the borrower may deem EBITDA to be the highest amount of EBITDA achieved for any test period after the closing date … regardless of any subsequent decrease in EBITDA after the date of such highest amount.”

Owing to its aggressive nature, lenders – in both the large-cap and mid-market spaces – have historically pushed back on the inclusion of such mechanics on the basis of concerns around leakage and wider value protection and which, in a worst-case scenario, could provide the borrower with a de facto ability to pre-emptively asset strip the group as it heads toward an insolvency scenario. The effect of the provision is also more significant where it relates to periodic incurrence baskets, such as annual, where the permission will continue to refresh after the high water mark.

That being said, in an era of cheaper debt and continuing pressure from sponsors to incorporate large-cap market terms, it remains to be seen how the market will react to more frequent proposals to include high water marking provisions in mid-market documentation.