Financing in 2024: A Year of Resilience and Adaptation
2024 presented significant financial challenges. Despite global economic fluctuations and geopolitical tensions, market players demonstrated remarkable resilience and adaptability amidst a backdrop of economic uncertainty and shifting financial landscapes. Although the European Central Bank initiated a rate reduction cycle in mid-2024, interest rates remained high, continuing to pressure debt costs.
In this context and coupled with stricter financial regulations, lenders have adopted a more cautious approach, tightening their lending criteria and becoming increasingly selective. Lenders have prioritised risk assessment and due diligence to mitigate potential defaults and ensure the stability of their portfolios. This approach also extended to the structuring of financing agreements, with lenders incorporating more stringent covenants and conditions to preserve their interests. Moreover, this conservative strategy is reflected in the types of financing offered. Lenders are more likely to prioritise companies with a solid financial background, stable income and leading market position.
Decrease in leverage
The debt finance market saw a notable decrease in leverage in 2024. Global default rates on leveraged loans increased from 2% in early 2022 to around 7% in June 2024. This shift was driven by economic instability and market activity, with lenders focusing on fewer but more tailored financial covenants.
The reduction in leverage is a strategic response to the evolving economic landscape. Lenders and borrowers alike recognise the need to adopt more sustainable financial practices. By reducing leverage, companies aim to enhance their financial resilience and mitigate the risks associated with high debt levels. This shift was particularly evident in sectors that had previously relied heavily on leveraged financing.
This reduction in leverage also has implications for the broader financial market. It contributes to a more stable and balanced financial ecosystem, reducing the likelihood of systemic risks and financial crisis. Additionally, the focus on tailored financial covenants allows lenders to better manage their interests while maintaining a more collaborative and transparent lending environment.
Mezzanine and PIK financing
Mezzanine and PIK (payment-in-kind) financing have seen a resurgence in interest since 2023, as companies seek more flexible financing options. Mezzanine financing, which bridges the gap between senior debt and equity, offers the potential for higher returns through low cash interest, PIK interest, potential ownership or participation payouts.
The demand for mezzanine and PIK financing has been driven by the flexibility of these financing solutions, which allow companies to access additional capital without significantly diluting equity or compromising control, and to counterbalance the aforementioned decrease of leverage within senior financings. This is particularly advantageous for businesses seeking to fund expansion projects or acquisitions. In certain market conditions, the higher returns associated with mezzanine and PIK financing also attract investors looking for attractive yield opportunities.
This flexibility is especially valuable for growth-stage companies.
Use of PIK toggle
High interest rates and the inflationary context have driven issuers to find solutions to reduce the immediate cash outflow. They include an existing mechanism, the PIK toggle (whereby borrowers can choose to capitalise a portion of the interests), which has gained traction as issuers can manage cash flow in a challenging environment. Such features are most commonly seen in unitranche financing and mezzanine. This flexibility is particularly important for companies characterised by cyclical revenues or high capital expenditure.
Generally, the PIK toggle can be activated subject to certain conditions such as:
- No Event of Default: To ensure that the PIK toggle will not be used to mask financial difficulties or a future payment default, lenders will require that no event of default is continuing during the PIK toggle period.
- Minimum Cash and Maximum PIK Conditions: Private credit lenders limit the amount of cash margin that may be capitalised by requiring a maximum PIK condition and/or a minimum cash condition. The maximum PIK condition requires that a maximum percentage of the margin may be capitalised. The minimum cash condition refers to the minimum amount that must be paid in cash. PIK toggle generally applies only to the cash margin and not to the reference rate (eg, EURIBOR). Such conditions protect lenders from issuers in financial distress.
- Premium: The PIK toggle is riskier for the lenders as the payment of a portion of interests will be deferred until the maturity date of the financing. As the lenders will assume an additional credit risk, the loan documentation generally provides for an additional compensation if the PIK toggle is activated – such compensation is called "premium". The premium can be either capitalised or, less commonly, paid in cash at the end of the relevant interest periods.
- Duration: In many cases, lenders limit the number of interest periods during which the borrowers can activate the PIK toggle and sometimes the PIK toggle cannot be used in consecutive interest periods.
Negotiation of EBITDA add-backs
EBITDA is an important metric assessing the borrowers' profitability and their capacity to generate cash flow. In finance agreements, leverage ratio is often calculated on the basis of an adjusted EBITDA which will account for certain income or expense items not considered as representative of the borrowers' operational performance. Adjusted EBITDA provides a clearer view of the financial situation of the borrowers.
With the decrease of the leverage, EBITDA add-backs continue to be a critical negotiation point in financing agreements. Borrowers, on the one hand, seek to maximise their adjusted EBITDA to enhance their borrowing capacity and improve their financial metrics. Lenders, on the other hand, scrutinise these adjustments to ensure they provide a true and fair representation of the borrower's financial health, assessing the impact on key provisions of the finance documentation, such as margin ratchet, permitted baskets, financial limits that grow with the borrowers' performance (grower basket) and permitted distributions.
Adjustments can be very detailed or determined with a broader approach. Even if the negotiations are historically borrower-friendly, lenders tend to limit EBITDA add-backs. Adjustments to mitigate the positive and negative effects of non-cash, non-recurring and exceptional items are generally not contentious but could be subject to caps. Key add-backs are "cost savings synergies" and "group initiatives", which are heavily discussed due to their prospective nature.
Cost savings synergies represent the expected financial benefits, specifically reductions in expenses, resulting from an authorised acquisition and/or an authorised merger. Cost savings synergies are projected amounts determined in connection with actions already taken and/or actions committed to be taken or expected to be taken. The focus shall be on the measurable impact of such synergy. Cost savings synergies can also be considered on a run-rate basis. To avoid subjective adjustments or overoptimistic estimates of cost savings synergies, such add-back must be subject to certain limits:
- Time Period: Only the cost savings synergies achieved or expected to be achieved within 12/24 months may be considered.
- Caps: Cost savings synergies are generally capped at a fixed amount or a percentage of the most recent EBITDA.
- Third-Party Certification: Cost savings synergies must be evidenced and certified by the CFO/CEO. Above a certain quantum, a financial due diligence report by an accounting firm is required.
Group initiatives are broader than cost savings synergies; they could result from restructuring costs, reorganisation, operating improvements and/or similar actions. They are considered more speculative, and lenders are sometimes reluctant to accept such adjustments. Generally, when group initiatives can be added back to EBITDA, lenders require no double counting with exceptional items or cost savings synergies and a cap.
To avoid any overly generous view of the EBITDA add-backs, lenders may impose an aggregate cap on all applicable add-backs, which correspond to a percentage of EBITDA.
The negotiation process required a delicate balance between the interests of borrowers and lenders. Borrowers aimed to secure favourable terms that allowed them to optimise their financial metrics, while lenders sought to maintain the integrity and reliability of EBITDA as a measure of financial health. This dynamic negotiation process underscores the importance of transparency and collaboration in finance agreements.
ESG considerations
ESG considerations are firmly entrenched in the landscape of finance documentation and are a critical factor influencing financing terms, borrower access to capital, and lender risk assessment.
The global push for sustainable finance, driven by regulatory pressures, investor demands, and societal awareness, has accelerated the adoption of ESG criteria across financial markets. 2025 sees this trend solidified, with ESG becoming a mainstream element in finance transactions. Regulatory frameworks such as the EU Taxonomy, Sustainable Finance Disclosure Regulation (SFDR), and similar initiatives worldwide, have created a structured environment for ESG reporting and performance measurement. Further, increasing climate-related risks, social inequalities, and governance failures have underscored the importance of integrating ESG considerations into lending decisions.
Lenders recognise that ESG factors can significantly impact the company's long-term financial stability. Environmental risks, and social risks, can lead to financial losses. Consequently, efforts should focus on, for instance, reductions in greenhouse gas emissions, improvements in energy efficiency, diversity and inclusion metrics, and ethical supply chain practices. Moreover, lenders are increasingly subject to ESG reporting and disclosure requirements. Institutional investors are prioritising ESG-aligned investments, putting pressure on lenders to incorporate ESG considerations into their loan portfolios. Lenders and borrowers alike are seeking to enhance their reputations by demonstrating a commitment to sustainability.
A key consequence of ESG integration is the increasing prevalence of ESG-linked margin ratchets. These provisions tie the loan's interest rate to the borrower's ESG performance. Companies that achieve predetermined ESG targets can benefit from lower interest rates. Small numbers of deals also include higher rates if the borrower fails to meet targets. This mechanism incentivises borrowers to improve their ESG performance and align their interests with those of lenders seeking to promote sustainability.
In addition, finance documentation includes detailed ESG reporting undertakings, outlining the borrower's obligations to provide regular and comprehensive ESG data. In most deals, failure to deliver the ESG reporting will only have an impact on the ESG margin ratchet and will not constitute an event of default.
The determination of KPIs and sustainability performance targets (SPTs) is crucial for effective margin ratchets. The KPIs should be aligned with industry standards, focus on material issues that are relevant to the borrowers' operations, and they should be quantifiable and verifiable; this is why finance documentation commonly limits the numbers of KPIs to three. In addition, KPIs should reflect ambitious targets that drive meaningful improvements in ESG performance.
To ensure the credibility and reliability of ESG data, third-party auditors play a vital role in verifying the integrity of ESG considerations, borrowers' ESG performance and promoting the confidence of all parties involved. Lenders are increasingly requiring:
- Independent auditors with expertise in ESG reporting should verify borrowers' ESG data and performance against agreed-upon KPIs.
- Standardised verification procedures should be adopted to ensure consistency and comparability across borrowers.
- Auditors should be independent from the borrower to avoid conflicts of interest.
ESG considerations will continue to shape the landscape of loan documentation. Lenders and borrowers must collaborate to develop robust ESG frameworks that promote sustainable finance and drive positive environmental and social outcomes. As regulatory frameworks evolve and market practices mature, the integration of ESG into loan agreements will become even more sophisticated and impactful.
Conclusion
The French debt finance market in 2024 showcased resilience and adaptability, with market players navigating economic uncertainties and political shifts. Lenders adopted a cautious approach, focusing on tailored financial covenants and measured investments. The decrease in leverage, return of mezzanine and PIK financing, and the use of toggle options have highlighted the evolving strategies in debt financing. Negotiations around EBITDA add-backs and the growing emphasis on ESG considerations have underscored the market's commitment to sustainable and ethical investing. These trends will continue to shape the debt finance landscape in 2025, offering valuable insights for investors and market participants.
Originally published by Chambers and Partners Global Practice Guide, 29 April 2025
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
