Incremental Facility: a Worked Example

A sponsor-owned group that buys businesses for a living cannot know at signing how much it will need to borrow, or when. Without an incremental clause, each new loan would mean an amendment to the agreement, a vote of the lender group, and a negotiation over whether the new money may share the security. With one, the borrower can add new term loans, or new revolving commitments, under the same document and the same guarantees, from existing lenders or new ones, in a matter of weeks.

For the lenders already in the loan, the clause is a pre-agreed dilution. Debt added under it commonly ranks equally with theirs against the same assets, and new lenders join the vote. That is why the clause is negotiated as hard as the margin. It belongs mainly to leveraged and sponsor-backed lending. In bank-led mid-market lending, the same need is often met by an accordion, or simply by a request to the bank.

The ratio amount is the one that grows. It is tested on pro forma EBITDA, so the definition of earnings, and how much expected savings it lets in, decides the room as much as the ratio does. Agreements also say which leverage applies: first-lien leverage for debt that will share the first-ranking security, a total or secured measure for debt that will rank behind it. Many agreements test the ratio leaving out any fixed-amount debt raised on the same day, and let the borrower later reclassify fixed-amount debt as ratio debt once earnings allow, which refills the fixed amount.

The price protection is usually called a most-favoured-nation clause. It compares yields rather than margins: the margin, any interest-rate floor, and any discount or upfront fee shared with the lenders, spread over an assumed life the agreement sets. If the new term debt yields more than the existing loan by more than an agreed cushion, the existing margin rises until the gap equals the cushion. The clause may lapse after a period, and may exclude debt raised under the fixed amount, debt for acquisitions, debt that matures well after the existing loan, or debt that is not a syndicated term loan.

A sponsor-backed insurance-broking group, constructed for this page like every figure on it, has a US$240m first-lien term loan at a margin of 4.50%, cash of US$20m and EBITDA, as its agreement defines it, of US$60m. Its incremental clause allows a fixed amount of the greater of US$30m and 40% of EBITDA, plus any amount that keeps first-lien net leverage at or below 4.00 times. It agrees to buy a rival broker earning US$10m for US$75m, funded entirely with incremental debt. The levels are the example's, not a market norm.

The group borrows US$75m: US$60m under the ratio and US$15m under the fixed amount. Net debt becomes US$295m and leverage 4.21 times (295 ÷ 70), above the 4.00 ratio, and permitted, because the fixed amount was not tested against it. The ratio in the clause is a test for one part of the capacity, not a ceiling on leverage.

The new loan is priced at a margin of 4.75% and issued at 98, a two-point discount. Spread over the four-year life this agreement assumes, the discount is worth 0.50% a year. The cushion is 0.50%.

Had the clause excluded debt raised for acquisitions, or lapsed twelve months after signing, the existing lenders would hold a loan yielding 0.75% less than the debt now ranking beside it, with no step-up at all.

Both let a borrower add debt under an agreement it has already signed, and in neither is the new money committed. The difference is in what can be added. A mid-market accordion often enlarges an existing facility on its existing terms, up to a fixed sum, subject to a leverage test on the day. An incremental clause can create new tranches with their own margin, maturity and amortisation, within limits such as a maturity no earlier than the existing term loan, with capacity that grows with earnings.

That freedom is why fungibility matters. A new term loan written on identical terms to the old one becomes a fungible term loan, one class that votes and trades together; one that differs on any term becomes a separate tranche. Debt raised outside the agreement altogether, under the debt covenant's permitted baskets, may escape the price protection entirely unless the document carries it across.

DEFINED IN ONE PARAGRAPH → · ACCORDION FACILITY → · FUNGIBLE TERM LOAN →

A lender reading a leveraged loan at signing can test the credit at full capacity as well as at opening leverage: if every dollar of the fixed and ratio amounts were borrowed against today's earnings, what would leverage and interest cover be, and what would the security cover? In the example, with no acquisition the capacity on today's earnings is US$50m (US$20m under the ratio and the US$30m fixed amount), which would take leverage from 3.67 to 4.50 times (270 ÷ 60) with nothing new to show for it.

The second reading is the protection. A cushion of 0.50% means little if acquisition debt is carved out and the group is an acquirer. The third is the earnings definition, because every allowance for expected savings becomes debt capacity at the stated multiple. When a request arrives later, each lender's decision to take part is a fresh credit decision on a larger business.

PRO FORMA EBITDA → · DEBT TO EBITDA → · PERMITTED BASKETS →