The use of US-style debt documentation in European transactions was once rare, but it has become a common feature of financing deals across the region. As more US investors and M&A dealmakers pursued deals in Europe, particularly in the private equity space, the previously distinct US and European terms have gradually converged.

In Europe, US terms first arose in London and would usually only be used in large-cap financings led by US investment banks in deals involving a US counterparty. Over time, US-style documents became increasingly prevalent in France, Germany, Spain, Italy and the Nordics. In recent years, features of US documentation have filtered into mid-market deals.

Traditional European documents have always included maintenance covenants (such as leverage ratio and interest rate cover covenants) as well as tightly defined incurrence covenants that place limits on acquisitions, additional debt incurrence and dividend payouts. In comparison, US Term Loan B documents often only include incurrence covenants, which are also much more flexible than their European equivalents.

As US documentation has migrated across Europe, these differences have become less distinct.

A hybrid approach

Modern European financing documents do not entirely mirror US documentation. Instead, European lenders combine features from both jurisdictions to provide bespoke financing packages for individual transactions. For instance, lenders today are more familiar with US-style incurrence covenants, which give borrowers more latitude to raise additional financing or make more acquisitions. But lenders will still include European-style maintenance covenants when appropriate.

Capital and financial structuring is now the primary driver of documentation rather than ticket size or whether there is a US party involved in a deal. If a borrower, for example, has a revolving credit facility (RCF) and an institutional Term Loan B facility, the RCF will typically have a European-style springing maintenance covenant (for example, triggered when the RCF is more than 40% drawn), while the Term Loan B debt will follow the US-style incurrence covenant template. In deals where a European borrower has raised a high yield bond and wants to arrange an institutional Term Loan B facility alongside it, the document is more likely to align with a US-style model.

The hybrid approach has become standard in European private equity-backed deals and is now rippling into corporate lending markets. From a documentation perspective, the European market has essentially built a new product.

Room to grow

One example of how European markets have embraced this hybrid approach is the development of “grower baskets,” a documentation feature that automatically increases a borrower’s thresholds for incurring more debt or making restricted payments as their earnings increase.

In a traditional European document, lenders would have put a cap on the amount of extra debt a company could take on or the amount of dividends that can be paid. Today, reflecting the influence of US documents, lenders will allow this cap to be adjusted upward if a company’s earnings increase. As earnings rise, the permitted amount of debt that can be raised or dividends that can be paid increases accordingly, affording businesses much more financial flexibility.

Credit quality is a key determinant of whether a borrower can negotiate these kinds of terms. Borrowers backed by high-quality private equity sponsors will be able to secure a document with predominantly US-style features. Conversely, higher-risk borrowers will remain subject to more restrictive, European-style maintenance covenants. Borrowers in the middle of the range will receive a mix of features and covenant packages.

The documentation a borrower is eligible for will be negotiated heavily at the outset, with advisers and legal counsel conducting detailed analyses of whether a borrower can secure grower baskets and US- or European-style covenants.

Taking advantage

As documentation in Europe continues to evolve, the next area of focus for European lenders will be to optimize documents with US-style features to protect against the liability management exercises (LMEs) that emerged in the US.

LMEs are strategic restructurings through which incoming lenders move ahead of incumbent senior lenders in capital structures, or that carve out specific assets from companies to serve as security for new money.

Several LMEs have progressed in the US, but these deals have been rare in Europe until recently. High-profile LMEs have emerged in the region in the past couple of years, such as those involving telecoms company Altice France and Dutch retailer Hunkemöller International.

European lenders are anxious about the gaps in US-style covenants that have—in the past—allowed LME deals to progress. However, lenders in Europe have learned a lot from the experiences of their US peers. Today, when dealmakers include US-style covenants in hybrid European documents, protections to block LMEs are a standard part of the document drafting process and negotiations.

The evolution of European debt markets and the emergence of a hybrid documentation style have provided borrowers with invaluable flexibility, especially during recent volatility periods. The market has taken advantage of these benefits and is now focusing on how best to protect lenders who offer flexible, hybrid financing packages.