In the race to secure business amidst paltry merger and acquisition (M&A) activity over the past few years lenders have eased up on some of the protective measures, they previously relied on, to make deals more attractive for borrowers. Though relatively restrictive covenants remain a staple in middle market private equity deals, that could change if the surge in M&A activity that the industry has long awaited finally comes to fruition this year –a likelihood that many industry experts are counting on.
Following multiple false starts, industry experts are optimistic that 2025 will finally be the point when M&A activity picks up momentum and the floodgates predicted for the past few years truly open.
“There are some real reasons why people expect 2025 to have the increased M&A activity that they have been saying is just around the corner for a while now. In private equity there is a backlog of deals and a lot of pent-up demand which, combined with a shift in valuation and factors such as a potential change in the political climate and interest rates coming down, makes it more likely that activity will pick up in the coming years,” says Caroline Sandberg, a partner at law firm Fried Frank.
“With more deal activity, if we assume that both the private credit and the syndicated markets are going to be available, that’s going to lead to more competition.”
And if that happens, she believes the result could ultimately be a further erosion of covenant protections.
For now, restrictive covenants and provision protections remain a staple part of deals. And despite all the concern surrounding headlines for last summer’s preferred equity financing for Pluralsight Inc., many industry experts believe the deal was merely an example of a blurring of the difference between covenants in larger syndicated deals and private credit deals.
In that deal, Pluralsight’s backer, Vista Equity Partners, used a drop-down transaction to secure additional financing for the educational platform for technology developers. What raised a red flag for existing lenders that had previously financed the company in 2021, a group that included Ares Management, Goldman Sachs, Blue Owl Capital and Golub, among others, was that Vista initially placed the company’s intellectual property (IP) within a restricted subsidiary.
Pluralsight’s original lenders ultimately prevented the company’s IP from being separated, but the deal’s structure resonated across the private equity lending community. In fact, industry experts say that the attention to Pluralsight has caused lenders to look more closely at incurrence covenants.
“The lesson of Pluralsight was such a concern that the Loan Syndications and Trading Association also addressed and introduced ‘best practices’ with respect to such transactions at the industry level with boilerplate language and a guide,” says Elina Yuabov, a managing partner at Yuabov Law Group. “Pluralsight raised preferred equity rather than ‘debt’.”
Lenders are cautious now. Depending on their credit risk appetite, they employ broader language to restrict their borrower — and their subsidiaries, now or in the future — from incurring debt, raising equity and other such ‘funding’ infusions, as well as restrictions in releasing funds in the form of dividends or expenditures. We’ll be reasonable, but also include a monetary threshold that, if crossed, requires the prior written consent of the majority lenders,” says Yuabov.
Fried Frank’s Sandberg, however, believes the Pluralsight deal structure was nothing more than an inevitable evolution where sponsors took advantage of flexibility that already existed in covenant packages both in broadly syndicated deals and private credit deals.
“People are thinking about what this technology provides, in terms of the outlook post-Pluralsight, but also in conjunction with what we are expecting to be a more active M&A market. I think we’re going to see a continued convergence between what covenants look like in syndicated deals and private credit deals,” says Sandberg.
As a result, she expects lenders across the board will be hypervigilant about deal terms moving forward, particularly as deal activity picks up and private credit deals face heightened competition from syndicated deals.
Her sentiment is shared by colleague Eliza Riffe Hollander, a partner at Fried Frank. “I don’t see people zeroed in only on Pluralsight. It is more that it is part of a full package of LMT (liability management transaction) protective provisions that they’re focused on,” says Riffe Hollander.
“LMT protective provisions are the one place where there has been a significant push by the lenders in both markets, and the place where we often see them holding the line is the J. Crew, Chewy and Serta [provisions]… I think that’s the one place where, even in really competitive situations, they can usually maintain protections,” she says, referring to previous deals whose lending terms were so controversial that they have become standard within the industry.
J. Crew blockers —stemming from a 2016 deal where the popular clothing retailer moved IP, including the company’s trademark, into an unrestricted subsidiary— limit the transfer of IP and other assets to unrestricted subsidiaries.
Chewy blockers, which come from PetSmart’s 2018 acquisition of Chewy.com, where a significant percentage of Chewy’s equity shares were transferred to an unrestricted subsidiary, prevent existing guarantees of a subsidiary from being eliminated if it ceases to be fully owned.
And Serta protection, based on Serta Simmons’ 2020 effort to reduce its debt load and provide itself an equity injection by altering existing credit agreements, is a provision that prevents lenders’ debt or liens from being subordinated with their unanimous consent.
Restrictive covenants are not the only protective measure lenders are leaning on. “Equally important is the schedule of existing debt and liens that borrowers have to disclose with respect to themselves and their subsidiaries, and financial covenants that require a certain debt to equity ratio, an operating reserve, a collateral reserve and so on,” says Yuabov.
As people get back into the swing of things following holiday breaks and the new year gets into gear, the private equity industry will be keeping a particularly close watch on M&A activity within the first quarter. “It feels real this time. We are certainly seeing a big increase in grid activity and sponsors looking at assets in a way that I haven’t seen in recent memory,” says Riffe Hollander.
One major factor she predicts will spur deal activity is the industry’s overall optimism that the impending changing of the guard in the White House will yield a more friendly environment on the regulatory front.