Structuring Direct Lending Facilities

Structuring Direct Lending Facilities

Designs direct lending structures with pricing, covenant packages, and documentation tailored for middle-market borrowers, typically in the $25M–$500M range where borrowers lack broad syndicated market access.

When To Use

• Structuring a unitranche, first lien/second lien, or delayed-draw term loan for a middle-market sponsor or corporate borrower
• Designing a financial and operational covenant package for a direct lending facility
• Evaluating pricing (spread, OID, LIBOR/SOFR floor) relative to borrower credit profile and market conditions
• Comparing direct lending terms against broadly syndicated alternatives
• Reviewing or negotiating credit agreement provisions specific to direct lending (e.g., voting thresholds, amendment mechanics with a single or small lender group)

Inputs To Gather

• Borrower profile: Industry, revenue, EBITDA (and adjustments), ownership (sponsor vs. non-sponsor), capital structure history
• Transaction context: LBO, refinancing, dividend recap, add-on acquisition, growth capital
• Leverage parameters: Target total leverage, senior secured leverage, and any mezzanine or subordinated debt layers
• EBITDA adjustments: Proposed add-backs (cost savings, synergies, run-rate) with supporting detail — flag aggressive adjustments
• Requested facility features: Revolver size, term loan amount, delayed-draw needs, accordion capacity, incremental facility provisions
• Sponsor or borrower preferences: Covenant-lite expectations, call protection sensitivity, flexibility for future M&A or distributions
• Market benchmarks: Comparable recent direct lending transactions in the same sector and leverage band [VERIFY against current market data]

Workflow

1. Credit assessment and sizing

   • Analyze borrower EBITDA quality: recurring revenue mix, customer concentration, cyclicality, margin stability
   • Stress-test cash flows under downside scenarios (revenue decline of 10–25%, margin compression) to determine sustainable debt service capacity
   • Size the facility based on target leverage (e.g., 4.0–6.0x total for sponsor deals) and minimum DSCR of 1.2–1.5x under stress
   • Determine appropriate structure: unitranche (with or without first-out/last-out split), senior/sub split, or pure first lien

2. Pricing and economics

   • Set base rate spread relative to credit quality (typically SOFR + 500–700 bps for middle-market direct lending) [VERIFY against current market spreads]
   • Establish SOFR floor (commonly 75–100 bps) and OID (typically 97–99)
   • Define call protection schedule (e.g., 102/101/par or make-whole through Year 1, then 101/par)
   • Calculate undrawn fees on revolver and delayed-draw commitments (typically 50 bps)
   • Model all-in yield to lender including fees, OID, and floor value

3. Covenant package design

   • Financial covenants: Select maintenance vs. incurrence-based covenants
     • Maintenance (tested quarterly): Total Leverage Ratio, Fixed Charge Coverage Ratio, Minimum EBITDA
     • Set initial cushion of 20–30% above projected performance for leverage covenants
     • Define EBITDA calculation with permitted add-backs and a cap on pro forma / run-rate adjustments (commonly 15–25% of EBITDA)
   • Negative covenants: Draft restrictions on indebtedness, liens, restricted payments, investments, asset sales, affiliate transactions
     • Size baskets and carve-outs proportional to borrower EBITDA (e.g., general investment basket of $X or 10–15% of EBITDA)
     • Include builder basket mechanics tied to cumulative excess cash flow
   • Affirmative covenants: Monthly/quarterly financials delivery, annual audited statements, compliance certificates, budget delivery, insurance maintenance
   • Reporting requirements: Direct lenders typically require more frequent and granular reporting than syndicated deals — specify monthly financial packages with KPI dashboards

4. Documentation and structural provisions

   • Draft or review credit agreement based on borrower counsel's form or lender's preferred form (not LSTA standard for most direct deals) [VERIFY whether parties are using LSTA-based or custom documentation]
   • Key provisions to negotiate:
     • Amendment and waiver thresholds: In a single-lender or club deal, voting is simpler but consent rights must be clearly allocated
     • Equity cure rights: Number of cures permitted (typically 2–3 per year, 5 lifetime), cure amount mechanics (contributed equity vs. subordinated debt)
     • Incremental facility terms: MFN pricing protection (typically 50–75 bps sunset after 12–18 months), leverage incurrence test for incremental capacity
     • Restricted payment conditions: Leverage-based stepdowns (e.g., distributions permitted below 3.5x net leverage)
     • Change of control definition: Ensure sponsor transfer flexibility while protecting lender against non-approved ownership changes

5. Term sheet and final deliverable assembly

   • Produce a summary term sheet covering all economic and structural terms
   • Include a covenant compliance model showing projected performance against covenant levels for the first 3–5 years
   • Prepare a comparison matrix if evaluating multiple structure alternatives (unitranche vs. first/second lien split)
   • Flag any open negotiation points or borrower-requested flexibilities requiring further diligence

Output

A structured direct lending facility report containing:

• Executive summary: Transaction overview, recommended structure, and key terms
• Facility structure table: Tranche details (type, size, maturity, pricing, amortization)
• Covenant summary: Financial covenant levels with cushion analysis, negative covenant baskets with dollar/percentage thresholds
• Pricing benchmarking: Comparison to 3–5 comparable recent direct lending transactions
• Covenant compliance model: Projected base case and downside covenant testing over the facility life
• Open items list: Unresolved terms, requested flexibilities, and items requiring further credit diligence

Quality Checks

• Verify that leverage and coverage ratios are calculated consistently (same EBITDA definition) across the sizing model, covenant levels, and compliance projections
• Confirm call protection, prepayment mechanics, and excess cash flow sweep percentages are internally consistent
• Ensure covenant baskets (RP, investment, debt) do not inadvertently create leakage paths that undermine credit protections
• Cross-check EBITDA add-back caps and pro forma adjustment limits against the credit agreement definition section
• Validate that amendment/waiver mechanics reflect the actual lender composition (single lender vs. club)
• Mark any jurisdiction-dependent provisions (e.g., UCC perfection requirements, guarantor limitations for regulated entities) with [VERIFY]
• Stress-test the covenant compliance model: confirm the borrower trips covenants before liquidity is exhausted in the downside case (covenants should function as an early warning)