"Call protection" (which you may also hear referred to variously as a "prepayment fee", "prepayment premium", "call premium", "prepayment penalty", "non-call", "hard call", "soft call" or "make-whole") is a core economic term on leveraged financings. The underlying premise behind the concept is that, having advanced a loan, a lender should have contractual assurance that it will earn the agreed level of yield on that loan for a certain period of time after closing (and that it will not be permitted for the borrower to prepay the loan the following day, for example, thus depriving the lender of substantially all the interest income it expected to earn when executing the transaction). Lenders will most acutely feel the risk of being prepaid early on a transaction when they fear a near-term decline in interest rates. Currently the bank-driven credit markets remain unsettled, and there is an acknowledgement from market participants that the levels of pricing for new private credit deals are very attractive in comparison to the last couple of years of this credit cycle. Accordingly, lenders will be eager to lock in these returns for a reasonable period, rather than risk being quickly refinanced with cheaper debt if more optimal credit conditions suddenly return. This is particularly the case for private credit providers that are increasingly financing deals that would previously have gone to the broadly syndicated market. While that market currently remains largely closed to new primary underwriting, in the event it fully reopens in the near future the pricing levels that are achievable will likely be inside of the minimum rates of return for most private credit providers.
This deep dive with Daniel Hendon (Partner) and Phil Anscombe (Associate), lawyers in Proskauer's Private Credit Group in London, will explain how call protection is commonly achieved in today's market and how sponsors have sought to limit its scope, as well as describing the current hot topics and potential pitfalls for various deal sizes.
There have broadly been three methods of achieving call protection for lenders historically:
- Firstly, by agreeing that the loan cannot be prepaid (or, in
the language of bonds, cannot be "called") within a
certain period. This is what was originally meant by
"non-call" and it is in reality no longer seen in the
European or US loan markets.
- Secondly, by agreeing that, if the loan is prepaid within a
certain period (confusingly, this is sometimes referred to as a
"non-call period", despite the fact the loan can actually
be "called" or prepaid during that period) then the
borrower must nonetheless pay all the interest that would otherwise
have accrued on the amount being prepaid up until the end of that
period. This is a "make-whole" (as the lender is
"made whole" for the interest it anticipated otherwise
receiving for that period) and remains a common feature of the
European market and in lower middle-market sponsored and
sponsorless US transactions. This will typically include not only
the margin but also the appropriate prevailing reference rate at
the time of prepayment (and giving effect to any reference rate
floor).
- Thirdly, by agreeing that, if the loan is prepaid within a certain period, a simple premium amount must be paid (calculated as a percentage of the principal amount being prepaid). This remains a very prevalent feature of the market.
It is common for the second and third approaches above to be combined on any particular transaction – for example, it might be agreed that for the first year after closing the borrower must be "made whole" with the full projected interest accrual for that period and that, during the second year after closing, a premium will apply instead. There is a well-established system of shorthand for describing a call protection regime, which it is helpful for market participants to understand in order to be able to navigate grids and term sheets. A reference to NC[X] (e.g., NC1, NC2, NC3) means that any prepayment will be subject to a "make-whole" for X number of years after closing. If you see a protection expressed as 102 or 103, for example, that means that a premium of 2% or 3% applies on the principal amount being prepaid in the relevant year. These data points being expressed sequentially suggests that these regimes follow one another sequentially in time for that particular deal, so for example if you see "NC1/102", that means that there is a make-whole in year one and a 2% premium in year two. If you see 102/101, that means no make-whole applies and there is simply a 2% premium in year one and a 1% premium in year two. Where, on a particular transaction, a make-whole period is followed by a period in which a premium is payable, it is important to draft this so that the make-whole is calculated as the higher of (i) the projected interest accrual for the rest of the make-whole period and (ii) the premium that would otherwise have been due if the payment was made in the following year. Otherwise, mathematically you would end up in the clearly illogical position that a prepayment made on the last day of a make-whole period attracts almost no call protection, whilst a prepayment made the following day attracts a material premium. It should be noted that it was formerly the case that the make-whole would be the sum of those items (i.e., projected interest accrual plus the premium that would have been due in the following year) but that has become relatively uncommon in the European market.
In recent years, sponsors have increasingly used their market power to limit the amount of any call protection that might be payable, the time period during which it applies and also circumstances in which it might become due. While this is generally subject to significant commercial negotiation between principals, the areas of contention are commonly as follows:
- High-level terms – Until recent months,
there had been consistent downward pressure on the levels of call
protection afforded to lenders for a number of years in the private
credit market. While a make-whole was formerly standard in at least
the first year after closing, Proskauer's 2022 European private
credit deal data showed make-wholes only now apply on a little over
60% of European private credit deals in year one, with c.65% of
deals having either a 2% or 1% premium in year two (rather than a
make-whole) and over 80% of deals having no call protection from
year three onwards. This still remains on average more conservative
than in the US, where the most common formulation from our 2022
data was a simple 102/101. It is worth noting that there is some
variation within product type, with sponsorless transactions and
subordinated instruments (whether second lien, holdco PIK or
otherwise) typically commanding a more robust call protection
regime. Signs are that lenders are insisting on better call
protection in the current market but further time will need to pass
before it can be determined whether this will be a sustained
trend.
- Type of prepayment – While it was once
the case that any prepayment of the term facilities would attract
call protection, that is now very rarely the agreed regime. In the
European large cap syndicated market and in sponsor-favorable upper
middle market US transactions, the protection is typically limited
to what is known as "soft call" (and in that market
lenders commonly receive 101 protection for six months only from
closing and on a "soft call" basis). What is meant by
"soft call" is that lenders are only protected in the
instance of a "repricing event". What this broadly means
(although there are sometimes additional nuances) is that the
protection only applies upon a voluntary prepayment of the
facility, funded by new indebtedness, where the primary purpose of
that refinancing was to reduce the applicable cost of debt to the
group. There would likely be an exception for any such debt
incurred in connection with a change of control/IPO or a
transformative acquisition, so that this would really be limited to
a scenario where the borrower is opportunistically taking advantage
of declining interest rates. This "soft call" regime has
generally been strongly resisted by the European private credit
community. Instead, the most common formulation within private
credit will be that any voluntary prepayment (for whatever purpose)
will attract call protection, as well any prepayment (whether
voluntary or mandatory) made in connection with a major liquidity
event for the sponsor (i.e., any change of control, sale of
substantially all assets or any IPO), though in the US, these
liquidity events may trigger only a "discounted" premium,
i.e., 50% of the call protection that would otherwise be payable.
It is also typical for US transactions to include call protection
with respect to any mandatory prepayments made with debt incurrence
proceeds (noting this is not a typical prepayment event in Europe).
It has become significantly less common both in Europe and the US
to see call protection for other classes of mandatory prepayment
(e.g., excess cashflow sweeps, proceeds of asset sales, etc.) on
the basis that these are credit-enhancing payments that were
contractually required by the lender, rather than directly
benefiting the sponsor, but certain of these are still seen on a
small minority of deals. Some lenders also require call protection
to apply upon acceleration (such that their claim upon enforcement
crystallises the call protection amount as being due and payable)
or when being "yanked" from a deal (meaning either being
prepaid or replaced by another lender, due to refusing to consent
to certain amendments, being replaced due to an illegality issue or
otherwise); these remain relatively uncommon in Europe, but US
transactions may still require a premium upon a
"yank".
- Net present value – Where a
"make-whole" applies, sponsors often look to reduce the
amount of call protection that becomes due, by applying a net
present value calculation to the projected interest accrual. The
rationale for this is that, if the facility had otherwise remained
outstanding, the lender would have received its usual interest
payments periodically up until the end of the relevant period.
Instead, it will be receiving the equivalent amount of call
protection in cash up-front on the date of prepayment, meaning that
cash could in theory be reinvested in risk-free assets with an
almost guaranteed level of economic return for the rest of the
make-whole period. As a result, sponsors will suggest that the
projected interest accrual amount be discounted (at an annual rate
approximate to a risk-free rate) from the end of the make-whole
period back to the date of prepayment, so as to ensure the lender
is not better off than it would have been had the deal continued.
While this is not always accepted by lenders, it is a relatively
common feature of the private credit market. In terms of the rate
that is used for discounting, this is typically tied to the
relevant currency (so for example it may be US treasuries of the
equivalent tenor for USD, UK gilts for GBP and German bunds for
EUR). When rates were very low, it became common to use a rate with
0.50% headroom to those government rates but in the current market
some lenders prefer to remove the headroom concept.
- Annual de minimis – Sponsors have
increasingly pushed to be allowed a certain quantum of principal
prepayments to be made per annum without attracting call
protection. This basket, where accepted (and its acceptance remains
mixed in the market), is typically sized by reference to the amount
of the term facilities. For example, it might be agreed that 10% of
the aggregate principal amount of the term facilities may be
prepaid per annum without attracting call protection – where
this is agreed, lenders should take care to ensure that it is 10%
of drawn amounts only (so borrowers cannot benefit from 10% of the
amount of any delayed draw facility if it has not actually been
utilised or has been cancelled/reduced). Certain lenders view this
basket as designed to permit ordinary course deleveraging (i.e.,
using excess cash) and that such deleveraging should not be
penalised – however, they may take the view that on a
material sponsor liquidity event (e.g., a full prepayment on an
exit) this de minimis should not apply and full call protection
should be due. The annual de minimis threshold is less common in US
transactions, but the underlying mandatory prepayment triggers,
particularly as it relates to excess cashflow sweeps and asset
sales, will commonly include threshold amounts below which no
prepayment (and hence, no premium in the rare circumstances where
it otherwise applies), is required. There is typically not an
annual de minimis threshold with respect to voluntary prepayments
in US transactions.
- Permitted refinancings – Sponsors
frequently propose that where a prepayment is made in connection
with a refinancing (whether that is a refinancing led by the same
sponsor or a refinancing in connection with a change of
control/exit) and the same lender participates in the new
financing, then call protection will not apply. The rationale for
this is that the lender will likely be earning "new
money" fees for the new financing and should therefore not
also receive a premium on the prepayment of the existing debt.
While lenders are generally amenable to this, they look to ensure
they are in no worse a position as a result. They either achieve
this by saying the exception applies on a lender-by-lender basis,
or by saying that the exception only applies to the extent their
aggregate institutional commitments under the new facilities
(across all of their lending vehicles) are in no less an amount
than their aggregate commitments under the existing facilities
– if there is an overall reduction in the aggregate hold,
call protection would typically still apply to that net deficit.
Care should also be taken by private credit institutions to ensure
any such arrangement does not cause issues from a fund management
standpoint – if the new financing is provided out of a new
vintage of fund, with a different set of underlying limited
partners, then it may raise questions as to whether it is
appropriate (or "arms-length") for the limited partners
of the previous lending fund to forego their call protection so
that limited partners under the new fund can earn fees for a new
financing. If this creates difficulties for certain private credit
lenders, they may look to limit the exception so that it applies
only to refinancings out of the same fund.
- Deemed cash – It has become common in
the European private credit market for borrowers to have some
(limited) ability to capitalise a portion of their interest
payments, rather than pay the interest in full and in cash, by way
of exercising a "PIK toggle". The PIK toggle is also a
feature in the US but more commonly limited to certain lower
middle-market and non-sponsored transactions. For example, if a
facility has a margin of 7.00%, it might be possible for 2% of that
margin to be capitalised (perhaps for a limited number of interest
periods and subject to certain caveats) provided that capitalised
margin is paid with a PIK premium of 0.5% (i.e., the cash pay
margin would be 5.00% and the capitalised margin would be 2.50%).
This feature is a particularly hot topic in the current market,
with spiralling interest rates on floating rate debt meaning the
pressure on company cashflows to meet their interest costs are
often very significant (and a PIK toggle can help alleviate some of
that pressure). The PIK premium (i.e., the extra interest that is
charged when interest is to be capitalised) is justified on the
basis that the lender is effectively taking on additional credit
risk by agreeing to defer actually receiving that cash payment
until maturity. Some sponsors therefore argue that when calculating
a make-whole, you should calculate it on the basis that all
interest would be 100% paid in cash (on the basis that the
make-whole is received today, so there is no such additional risk
that warrants additional premium). However, certain lenders will
take the view that projected interest accruals should assume the
same level of PIK toggle usage that is currently in effect at that
time. Where there is an actual permanent PIK component to a
facility (as opposed to a temporary PIK toggle usage) this debate
becomes even more contentious, as the assumed PIK capitalisations
may form a core part of the lender's projected return on its
investment.
- PIK – Certain aggressive sponsors have
proposed that prepayments of principal that constitutes previously
capitalised PIK interest (as opposed to principal that was
originally advanced as a loan) be exempt from call protection. In
general, this is resisted by private credit providers in both the
US and Europe.
- Delayed draw timing – Some lenders traditionally took the view that the relevant call protection period for a facility should run from the date on which that facility is first drawn. As such, an acquisition financing facility, refinancing facility or other day one facility would have a call protection period running from the original closing date. However, for delayed draw facilities (bolt-on acquisition facilities, capex facilities or similar), such lenders would take the view that the period for such facilities should run from the date on which they were first drawn (or even that each individual loan should have a call protection period running from the date on which it is drawn). Sponsors have consistently pushed back on this, insisting that call protection periods for all committed facilities should run from the original closing date – while there are exceptions, this has become the most common market position. However, in both Europe and the US, lenders can still be successful at "resetting" the call protection clock when subsequent new money is funded by way of incremental facilities, but that is a negotiated point in each deal.
In summary, current market conditions have led lenders to take a slightly more conservative view of the appropriate call protection regimes applicable to the term facilities they underwrite. Notwithstanding that fact, there remain numerous means by which sponsors look to limit such premia – not just limited to headline terms but also complex exceptions, carve-outs and discounts. We expect this pressure from sponsors to continue, particularly as the private credit product continues to evolve and compete directly with the syndicated lending markets (and we may see an increasing bifurcation between large deals and true mid-market deals). For any related questions on this topic, please reach out to your contact within Proskauer's Private Credit Group.
Private Credit Deep Dives – Call Protection
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