Not your average Easter basket: builder and grower baskets in Belgian club deals
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As exceptions to different negative covenants, baskets have been an ever-present discussion point in financing agreements. A trend that entered the European and Belgian financial markets over the last years is the use of performance-linked baskets. These may be composed as either builder or grower baskets. The latter in particular are becoming increasingly popular, as they perfectly blend in with the entrepreneurial spirit of rapidly expanding companies and the buy & build strategy of private equity investors. How are these baskets constructed, and what should borrowers and investors keep in mind when negotiating their (acquisition) financing?
Basket principle
Through negative covenants, lenders classically attempt to (in a less or more stringent manner) gain some control over the borrower's activities over the course of the loan term and place a limit on investments, acquisitions, the incurrence of additional debt, etc. Financing agreements often contain 'baskets' as exceptions to such restrictive covenants, providing borrowers with enhanced flexibility to operate their business.
The principle of a basket consists of allowing the borrower, up to a maximum determined amount, to make restricted payments, disposals or investments, or take on incremental debt. Commonly, a basket is expressed as subject to restrictions based on a fixed ("hard cap") amount (e.g. may not exceed EUR 5,000,000).
Rise of builder and grower baskets
A trend that has been making its appearance from the US financial landscape in European transactions is the use of builder and grower baskets. Those types of baskets link the allowed cash leakage to the financial performance or size of the borrower. As the borrower becomes more profitable or larger in size, the basket will increase to the same extent, allowing the borrower a greater cash outflow without requiring consent of the lender(s). This might for instance be particularly useful for companies that have an intensive M&A policy or PE driven deals ("buy & build") that are aiming for high and rapid growth. Builder and grower baskets are two associated tools; however, as they "grow" differently, their features should be clearly distinguished:
Basket principle
Through negative covenants, lenders classically attempt to (in a less or more stringent manner) gain some control over the borrower's activities over the course of the loan term and place a limit on investments, acquisitions, the incurrence of additional debt, etc. Financing agreements often contain 'baskets' as exceptions to such restrictive covenants, providing borrowers with enhanced flexibility to operate their business.
The principle of a basket consists of allowing the borrower, up to a maximum determined amount, to make restricted payments, disposals or investments, or take on incremental debt. Commonly, a basket is expressed as subject to restrictions based on a fixed ("hard cap") amount (e.g. may not exceed EUR 5,000,000).
Rise of builder and grower baskets
A trend that has been making its appearance from the US financial landscape in European transactions is the use of builder and grower baskets. Those types of baskets link the allowed cash leakage to the financial performance or size of the borrower. As the borrower becomes more profitable or larger in size, the basket will increase to the same extent, allowing the borrower a greater cash outflow without requiring consent of the lender(s). This might for instance be particularly useful for companies that have an intensive M&A policy or PE driven deals ("buy & build") that are aiming for high and rapid growth. Builder and grower baskets are two associated tools; however, as they "grow" differently, their features should be clearly distinguished:
- Builder baskets
Builder baskets are also referred to as "available basket amounts", or "cumulative credit baskets". The idea behind a builder basket is to reward the borrower for its improved financial performance, by allowing an increase of the basket(s) in certain restrictive covenants (e.g. restricted payments or investment covenants).
A builder basket typically contains the following elements: (i) a "starter basket amount", which is mostly determined on a case-by-case basis through negotiations between the lenders and the borrower, and (ii) retained excess cash flow or (a percentage, commonly 50%, of) consolidated net income. When using a builder basket mechanism, the borrower may immediately use the starter basket, and as retained excess cash flow or consolidated net income increases over time, the basket amount also "builds up".
A particularity of builder baskets is that the amounts that have once been added to the basket will remain available to the borrower, even when he faces a period of financial decline. This is however only the case when retained excess cash flow is used as basket component. If the basket is based upon consolidated net income as variable component, the amount may be reduced when the borrower experiences a profitability drop.
It is fairly common that lenders subject the use of builder baskets to additional conditions, such as the absence of any events of defaults, or meeting of a specific leverage. We typically see these in respect of permitted dividend distributions, payments in respect of mezzanine or subordinated debt, permitted incremental indebtedness, permitted acquisitions and other investments.
A builder basket typically contains the following elements: (i) a "starter basket amount", which is mostly determined on a case-by-case basis through negotiations between the lenders and the borrower, and (ii) retained excess cash flow or (a percentage, commonly 50%, of) consolidated net income. When using a builder basket mechanism, the borrower may immediately use the starter basket, and as retained excess cash flow or consolidated net income increases over time, the basket amount also "builds up".
A particularity of builder baskets is that the amounts that have once been added to the basket will remain available to the borrower, even when he faces a period of financial decline. This is however only the case when retained excess cash flow is used as basket component. If the basket is based upon consolidated net income as variable component, the amount may be reduced when the borrower experiences a profitability drop.
It is fairly common that lenders subject the use of builder baskets to additional conditions, such as the absence of any events of defaults, or meeting of a specific leverage. We typically see these in respect of permitted dividend distributions, payments in respect of mezzanine or subordinated debt, permitted incremental indebtedness, permitted acquisitions and other investments.
- Grower baskets
Grower baskets are typically structured as the greater of a fixed amount and a percentage of a variable, usually EBITDA. The main drawback however of using EBITDA is that, depending on the nature of the borrower's business, this might be subject to a high volatility. Another variable that may be used is the amount of total assets, which may be better suited for companies detaining a substantial amount of tangible assets such as real estate focused businesses. In recent transactions, we have also seen the turnover being used as the variable component.
The concept of a grower basket is to grant the borrower increased availability under the basket when its financial performance improves or the size of its business significantly expands over time. To illustrate the operation of a grower basket, let's take an example: the borrower agrees to a hard cap amount set at EUR 750,000. Initially, he has an EBITDA of EUR 7,500,000. The relevant basket clause stipulates that the cash available to the borrower consist of the greater of the hard cap, and 10% of borrower's EBITDA. This means that, in case the EBITDA grows to EUR 8,500,000, the availability under the basket will increase to EUR 850,000.
Inversely, however, the increased headroom under the grower basket shall also decrease when there is a downward movement in the borrower's performance, though without it ever falling below the hard cap amount.
Unlike builder baskets, a grower basket will thus fluctuate over time depending on the profitability or size of the borrower.
Practical considerations – use of grower baskets in Belgian club deals
In Belgian club deals, grower baskets in particular have won in popularity over the last years. This does not come as a surprise, as basket amounts used to be a classic point of discussion and negotiation between the lenders and the borrower. On the one hand, borrowers want to obtain high flexibility in their basket (taking into account their future growth plans). Lenders, on the other hand, are reluctant to allow a high degree of flexibility, as they want to maintain as much control as possible over the borrower's outgoing cash flows. A grower basket may thus present an efficient compromise to reconcile the conflicting interests of both borrowers and lenders.
When a company (or group) is growing or expanding, the relevant basket(s) will increase and the borrower will be permitted to incur additional incremental debt, make additional disposals, etc. However, if at any point in time thereafter, EBITDA (or any other relevant variable) falls back, a borrower may find itself all of the sudden in a default situation. A financing agreement could for instance permit the borrower to enter into financial leases up to a certain value (linked to the EBITDA position in the form of a grower basket), whereby a financial fallback could result in the borrower ending up with a total value of leased items exceeding the amount allowed under the grower basket. As a result of the economic crisis caused by the Covid 19-pandemic, this scenario has unfortunately become a very topical issue.
In this respect, it is worth noting that it is fairly common for a financing agreement to provide that the mere fact that a company has utilised an amount in excess of what was permitted under the basket, solely as a result of the decrease of EBITDA or turnover (or another variable used), does not constitute an event of default. This, of course, only applies as long as there are no other events of default triggered (which may for instance be the case when there is a financial covenant breach).
As indicated above, the greatest attraction of grower baskets lies in the compatibility with the entrepreneurial mindset, i.e. the aim to grow a business (organically, through acquisitions, or through both channels). Therefore, we expect these grower baskets to only gain in popularity and to earn their place in Belgian financing agreements.
Please consult our Banking & Finance Partner Sofie Heremans in case you would like to learn more about these developments.
The concept of a grower basket is to grant the borrower increased availability under the basket when its financial performance improves or the size of its business significantly expands over time. To illustrate the operation of a grower basket, let's take an example: the borrower agrees to a hard cap amount set at EUR 750,000. Initially, he has an EBITDA of EUR 7,500,000. The relevant basket clause stipulates that the cash available to the borrower consist of the greater of the hard cap, and 10% of borrower's EBITDA. This means that, in case the EBITDA grows to EUR 8,500,000, the availability under the basket will increase to EUR 850,000.
Inversely, however, the increased headroom under the grower basket shall also decrease when there is a downward movement in the borrower's performance, though without it ever falling below the hard cap amount.
Unlike builder baskets, a grower basket will thus fluctuate over time depending on the profitability or size of the borrower.
Practical considerations – use of grower baskets in Belgian club deals
In Belgian club deals, grower baskets in particular have won in popularity over the last years. This does not come as a surprise, as basket amounts used to be a classic point of discussion and negotiation between the lenders and the borrower. On the one hand, borrowers want to obtain high flexibility in their basket (taking into account their future growth plans). Lenders, on the other hand, are reluctant to allow a high degree of flexibility, as they want to maintain as much control as possible over the borrower's outgoing cash flows. A grower basket may thus present an efficient compromise to reconcile the conflicting interests of both borrowers and lenders.
When a company (or group) is growing or expanding, the relevant basket(s) will increase and the borrower will be permitted to incur additional incremental debt, make additional disposals, etc. However, if at any point in time thereafter, EBITDA (or any other relevant variable) falls back, a borrower may find itself all of the sudden in a default situation. A financing agreement could for instance permit the borrower to enter into financial leases up to a certain value (linked to the EBITDA position in the form of a grower basket), whereby a financial fallback could result in the borrower ending up with a total value of leased items exceeding the amount allowed under the grower basket. As a result of the economic crisis caused by the Covid 19-pandemic, this scenario has unfortunately become a very topical issue.
In this respect, it is worth noting that it is fairly common for a financing agreement to provide that the mere fact that a company has utilised an amount in excess of what was permitted under the basket, solely as a result of the decrease of EBITDA or turnover (or another variable used), does not constitute an event of default. This, of course, only applies as long as there are no other events of default triggered (which may for instance be the case when there is a financial covenant breach).
As indicated above, the greatest attraction of grower baskets lies in the compatibility with the entrepreneurial mindset, i.e. the aim to grow a business (organically, through acquisitions, or through both channels). Therefore, we expect these grower baskets to only gain in popularity and to earn their place in Belgian financing agreements.
Please consult our Banking & Finance Partner Sofie Heremans in case you would like to learn more about these developments.