Primer on Priming: A guide to identifying flexibility in high yield bond covenants

During last Friday’s FLT Office Hours, we discussed how to analyze covenants for priming capacity in typical high yield bond documents. This question has become increasingly prevalent, particularly given the increase in creditor-on-creditor violence in Europe and more frequent liability management transactions.

In this guide, we describe the different ways priming can arise and where to look in your documents to identify potential vulnerabilities – or opportunities, depending on which side of the table you’re sitting.

Understanding Priming: The Four Key Aspects

When assessing priming capacity, lenders should consider four main areas:

1. Structural Subordination
2. Dropdowns
3. Contractual Subordination
4. Effective Subordination

Let's explore each of these in detail.

1. Structural Subordination

Structural subordination occurs due to the fact that debt ranks ahead of equity in claims on a subsidiary’s assets. This can happen when:

• You lack a guarantee from a subsidiary (as a guarantee is a debt obligation, being a promise to pay if the primary obligor does not), and
• Another lender secures either a primary obligation or a guarantee from that subsidiary

2. Dropdowns

A dropdown involves:

• Moving assets to an Unrestricted Subsidiary
• Using these assets to raise capital outside the restricted group
• Re-injecting the capital back into the group for liquidity purposes or to repay other debt, or using it for other purposes

3. Contractual Subordination

This type of priming is established when a contract, like an intercreditor agreement, stipulates:

• Certain debt gets repaid ahead of other debt from proceeds from collateral enforcement (e.g., a super senior RCF) or
• Guarantees rank junior to other senior guarantees in the structure

4. Effective Subordination

Effective subordination occurs when another lender has a better claim to an asset than you do. This happens when:

• Another lender has a lien over an asset that is not part of your collateral
• In a restructuring, their debt would be repaid from the proceeds of that asset before any residual value reaches you

Steps to Identify Priming Capacity

Here is a handy checklist of steps for identifying priming capacity.

Step 1: Determine Ratio & Grower Capacity

1. Check for ratio debt capacity, even if unlikely instressed scenarios
2. Review fixed amounts in permitted debt baskets – theseare likely to be higher than growers in a stressed scenario, unless…
3. …There is a super grower provision present

Step 2: Analyze the Debt Covenant

When reviewing the Debt covenant, collect three key pieces of information for each carveout:

1. Clause number (this will come in handy later…)
2. Amount of the carveout
3. Whether the basket is available to non-guarantors (more on this below)

Step 3: Examine Guarantor vs. Non-Guarantor Debt Incurrence

1. Understand the difference between guarantors and non-guarantors in the structure – how much non-guarantor value is in the structure?
2. Check for sub-clauses limiting non-guarantor debt incurrence
3. Review each Permitted Debt basket's lead-in language to determine availability to non-guarantors

Step 4: Assess Effective & Contractual Priming Capacity

1. Determine your position in the capital structure and analyze your collateral
2. Put the borrower’s assets into three buckets – your collateral, assets secured in favor of other lenders, and unencumbered assets
3. Analyze whether each debt carveout can be secured and on what basis

Types of Lien Analysis:

• Permitted Collateral Liens (your collateral could be attractive to junior or unsecured lenders)
• Super senior positions (to lure in for new money lenders)
• Permitted Liens (for security over unencumbered assets)

Step 5: Evaluate Unrestricted Subsidiaries & Dropdowns

1. Assess capacity to invest in Unrestricted Subsidiaries
2. Consider practical aspects of asset transfers:
   •   What assets could realistically be stripped from the group?
   •   How easy is the valuation?
   •   Are there complications with transferring specific assets?
3. Check rules for designating Unrestricted Subsidiaries
4. Remember that YOUR collateral may be released automatically if transfers comply with applicable provisions

Conclusion

Understanding priming capacity in your debt documents is crucial for protecting your position as a lender. By systematically analyzing the four types of priming and following the steps outlined above, you can identify potential vulnerabilities and take appropriate action.

Remember, this guide covers scenarios that can occur without lender engagement. If amendments to the documents are being considered, all bets may be off...