Basket Case - The use of baskets in European mid-market leveraged finance transactions
"Baskets" are leveraged finance jargon for certain permissions a Sponsor's borrower group has to undertake certain transactions that, because of they are viewed by lenders as "leakage" items of a more risky nature to the business, require to be capped at an agreed amount. These differ from the more generic (and uncapped) business specific or market standard accepted operational types of permissions that we often see in the bulk of the so-called "Permitted" in a loan agreement.
US vs Europe
While the use of baskets in mid-market European transactions has its origins in the US market, they have often differed from those in the US. One point of difference is the "builder basket" which is a staple of US deals. A builder basket "builds" following closing (often with a starter amount soft-capped by reference to EBITDA) based on the borrower group's performance either through excess cash flow or 50% of consolidated net income. It is often also referred to as an "Available Amount" basket. This Available Amount can often be used to make restrictive payments , investments and payments of certain types of indebtedness that would otherwise be restricted by the negative covenants, but often only where leverage is in compliance with an agreed leverage ratio or the borrowers meets a fixed charge cover test.
Typical European mid-market deal, by contrast, do not include express builder baskets. That said, the use of excess cash and retained excess cash is a familiar concept in European mid-market deals, and amounts under these headings do "build" over the life of the facilities similar to a US-style builder basket. However, the uses are much more restricted in a European mid-market deals e.g. while they can be used to make certain permitted payments (dividends) you would not necessarily see a permission to use these items for junior debt repayment outside of the facilities.
European style mid-market baskets
There are two main types of baskets in mid-market European leveraged finance transactions:
"At any time" baskets. These baskets are revolving in nature and apply to items that typically fluctuate over the life of the facilities e.g. Loans between obligor/non-obligors (which can be made, repaid and then made again) or financial indebtedness items (which can be incurred, repaid and re-incurred).
"Financial Year" baskets. These typically relate to items that are either costs or expenses (holding company expenses, Sponsor monitoring fees) or do not fluctuate e.g. different types of permitted disposals.
These can be fixed amount, scaleable or grower baskets.
Fixed Amount baskets
For those who remember the pre-GFC days of mid-market leveraged finance transactions, baskets in those days were often simply expressed as being a fixed amount. The only way the amount of the basket could change was with consent of the lender – in those days the mid-market was dominated by bank syndicate/clubs with 66 2/3rd % consent levels, making any consent an infuriating process for the Sponsor. This was clearly a very inflexible approach and did not give the Sponsor any leeway on usage where the business grew either organically or through acquisitions.
Scaleable baskets
The first foray away from fixed amount baskets which we saw many years ago now (but post-GFC) was the move to use "scaleable" baskets. Scaleable baskets were originally designed only to increase following acquisitions which led to an overall increase in closing EBITDA (or projected EBITDA as set out in the base case model) by a minimum percentage. They did not typically take into account organic EBITDA growth per se, although often once the threshold to upscale the baskets had been met, the total increase percentage in EBITDA was taken into account, not just the percentage increase as a result of the acquisition. These baskets came into being largely in response to the more "buy and build" approach that we saw evolve within private equity post GFC where acquisitions were key to growth of the business.
That said, scaleable baskets evolved beyond acquisition-related resets to reflect overall increases in EBITDA growth, albeit still linked to achieving a threshold before they would be upscaled. Scaleable baskets would also reduce where EBITDA reduced beyond a threshold (although the basket size would not usually be reduced below the opening fixed amount). While this could potentially pose problems for the Sponsor where it has utilised the basket at the higher level, especially if scaleable baskets were not expressed to be incurrence based, agreements often contained a proviso that no default would arise if a basket was breached solely as a result of a decrease in EBITDA.
It is also worth noting that EBITDA in the context of scaleable baskets often meant an un-adjusted EBITDA (i.e. no pro forma adjustments, including for cost/savings synergies), which made it harder for the Sponsor to achieve the required threshold.
Grower Baskets
By far the most typical type of baskets we have found in mid-market leveraged finance transactions in the last few years are "grower" baskets. These baskets are usually expressed as the greater of a fixed amount and a percentage of an "Adjusted" EBITDA (EBITDA adjusted for the pro forma impact of acquisitions, disposals and group initiatives - synergies/cost savings in particular) – commonly referred to as Consolidated Pro Forma EBITDA (Pro Forma EBITDA). This move away from the unadjusted "actual" EBITDA approach that we saw under scaleable baskets was reflective of the move generally towards testing covenants and other incurrence type tests on a Pro Forma EBITDA basis.
While the fixed amount element of the basket is negotiated between the parties, more often than not it is set at the amount which is the equivalent to the percentage component of the basket at closing by reference to structuring/closing EBITDA. So if structuring/closing EBITDA were £10m and the basket was expressed as being the greater of x and 15% of Pro Forma EBITDA, the fixed amount of the basket would be £1.5m.
The advantage of a grower basket from the Sponsor's perspective is that the basket can grow with the business. Meaning the baskets remain proportionate to growth in Pro Forma EBITDA and avoid the Sponsor having to seek lender consent to increase basket sizes or having to wait until a threshold has been reached before feeling the benefit in basket sizes. Of course Pro Forma EBITDA can move both ways and so under the grower concept baskets will normally shrink in line with Pro Forma EBITDA as well as grow - meaning that they reflect the size of the business at any point in time. This in itself does not usually pose an issue for the Sponsor as grower baskets are tested at the point of incurrence, and so any subsequent shrinkage in the size of the basket will not in itself create a default if the basket was already utilised at the previous higher amount. Some more aggressive mid-market deals have included "high water marking" where the shrinking element of the grower basket does not apply – and Pro Forma EBITDA, for the purpose of the baskets, will always be deemed to be the highest level it has been reported at during the life of the facilities.
Grower baskets testing has also evolved. In the early days of usage the baskets were reset only once per year following delivery of the annual audited accounts. This has evolved, however, to a reset upon delivery of quarterly and sometimes even monthly financial statements.
Carry forward/carry back
Financial Year baskets have also evolved to include an element of carry forward of any unused amount in a particular Financial Year, as well the ability to carry-back basket amounts from future years. The carry forward element will often only allow one year carry forward and one year carry back so as to prevent a continuous rolling of unused or future amounts. Lenders are also keen to ensure that, in the carry forward year, the amount carried forward is spent last to ensure that carry-forward impact does not create further carry forward if only the fixed year amount is spent.
How Borrowers use their baskets
As indicated above, a basket is a permission with parameters. Therefore the Borrower should be free to use the baskets as it sees fit. Where an item can fit within more than one basket, the borrower should be able to choose which basket to put that item within and is free to move that item between available baskets at any time. Moreover, where an item is capable of being utilised in more than one basket, the Borrower should also be able to divide that item between those baskets e.g. where the item is too big to fit within one basket but the excess may be able to be accommodated within another. The so-called "general" baskets are often used for this purpose unless specifically restricted.
Lenders at the lower end of the market often seem to mis-interpret this flexibility as somehow being able to fit items into baskets that were not intended for that item in the first place. So something that were a guarantee could be re-characterised as an item of financial indebtedness. This is not the intention of the provisions, however. They merely reflect how baskets have always been used where an item satisfies the requirements of two different paragraphs within a definition.
Baskets are therefore both an essential element of the Sponsor's flexibility to run its businesses in a way it sees fit, albeit within pre-agreed parameters, while at the same time a control mechanism for lenders to manage risk.
