Unrestricted Subsidiary: How Value Leaves the Covenants

A group bound by one set of covenants cannot easily do things that need a different set: a joint venture with a partner who will not accept the group lenders' restrictions, a project or property company financed on its own assets with debt that has no recourse to the rest of the group, a new venture the owners want to fund separately. The unrestricted subsidiary is how a leveraged agreement allows for that. The trade is balanced on paper: the company escapes the covenants, and in return its earnings stop counting in the ratios and its assets stop supporting the lenders.

The mechanism comes from US high-yield bonds and appears mainly in sponsor-backed leveraged loans in the US and Europe, the UK included. In practice it is rare in bank lending to mid-sized businesses in New Zealand and Australia, where a facility that needs a similar effect more often excludes a named non-recourse vehicle from its definition of the group.

Designation is usually treated as an investment by the restricted group in the subsidiary, equal to the fair market value of what it holds, often as the borrower's board determines it. The borrower therefore needs room in its investment or restricted payment baskets at least equal to that value. Common further conditions are that no default exists, that the subsidiary holds no shares in, debt of or security over the restricted group, and that the restricted group is not liable for its debt. Some agreements add a leverage test after the designation, or a cap on the total value designated.

The baskets do the real work. A document may offer a dedicated basket for unrestricted subsidiaries, a general investment basket, a builder basket that grows with retained earnings, and ratio-based capacity that is unlimited while leverage stays below a set level, and these can often be combined. Bringing a company back in is commonly treated as the restricted group taking on the subsidiary's debt and security at that moment, which must then fit the debt and security covenants.

A maker of specialist industrial adhesives owned by a private equity fund, constructed for this page like every figure in it, has a covenant-lite term loan of US$180m and EBITDA of US$30m. Its formulations, patents and brand sit in a restricted subsidiary that guarantees the loan and has given security over them. Trading has weakened and the owners need new money. The term loan has these investment baskets, none unusual on its own, all of them the example's, in US$m:

Each step used a permission the lenders had agreed to. The IP company left the restricted group, and its guarantee and security fell away under the agreement's own release terms. It then licensed the formulations back to the operating companies for a royalty, which gives it the income to service US$40m of new debt secured on the very assets that used to support the term loan. The term lenders now hold a claim on a business that pays to use its own products, with no maintenance covenant to test the higher leverage, and the new lenders rank first on the IP. Whether US$35m was a fair value was the board's determination, and a lower figure is what made it fit.

The two are confused because neither guarantees the debt. A restricted subsidiary that gives no guarantee is still bound by the covenants and counted in the ratios; its borrowing is capped and its payments controlled. An unrestricted subsidiary is neither bound nor counted. The first weakens the lender's claim; the second takes the company out of the agreement. They also connect: some documents let value pass from guarantors to a non-guarantor restricted subsidiary under one basket and from there to an unrestricted subsidiary under another, a route that later drafting has closed in many agreements.

Lender protections grew out of a run of US transactions from 2016 onward in which intellectual property was moved this way. They include a blocker that bars an unrestricted subsidiary from owning or exclusively licensing material intellectual property or other material assets, a cap on the total value designated, sometimes set as a share of EBITDA or assets, and a bar on funding unrestricted subsidiaries from any basket but the dedicated one. Commentary on these blockers notes common gaps: catching the designation of a company that already owns the asset but not a later transfer into it, or ownership but not an exclusive licence.

DEFINED IN ONE PARAGRAPH → · RESTRICTED GROUP → · PERMITTED BASKETS →

For a lender joining a sponsor-backed loan, the question is capacity: on the day of signing, how much value could leave through designation, using every basket that can be combined, at a valuation the borrower sets? A lender that adds those baskets up and sets the total against the value of the group's most important assets knows how much of its security is, in practice, permanent.

For a bank lending to a mid-sized business in New Zealand or Australia, the term usually arrives in one of two ways: a sponsor's draft modelled on leveraged documents, or a borrower that wants a project or property vehicle kept outside the facility. The reading is the same in both. A named carve-out for a non-recourse vehicle is one thing; an open right to designate, funded by baskets, is another, and the documents should make clear which is being agreed.

COVENANT-LITE LOANS → · TERM LOAN B → · SPONSOR-BACKED LENDING →