US borrowers try again with high-water mark provisions

Charles Tricomi

In the US, high-water marking of EBITDA was rebuffed back in 2022. But the concept has been used regularly in Europe and US borrowers are once again slipping it into credit agreements

In a reversal of the usual flow of bad terms, high-water marking of EBITDA has been relatively unheard of in US loans despite having appeared in Europe for several years. But we have recently seen new iterations of the mechanic.

We first noted the emergence of high-water marking in European loans in our Xtract Research Special Report dated 12 August 2021. We sounded the alarm when it was sighted in US loans in early 2022. To their credit, US lenders rebuffed the attempt to introduce the concept, and the threat seemed to subside. But US borrowers are trying it on again and, in at least one case, the mechanic has cleared the market.

High-water marking of EBITDA is a self-executing method of increasing the size of grower baskets (ie, those styled as “the greater of $XX and YY% of EBITDA”). It is accomplished in one of two ways.

The first way is that, as EBITDA grows, so does the dollar prong of the basket, so the dollar prong becomes an ever-increasing floor. Even if EBITDA later declines, the dollar basket remains set at an amount equal to the equivalent percentage of the highest level of EBITDA ever achieved. For example, assume a basket equal to the greater of USD 100 and 100% of EBITDA at closing. A year after closing, EBITDA grows to USD 150; the basket is thus deemed to be the greater of USD 150 and 100% of EBITDA. When EBITDA decreases the next year to USD 50, the basket is still deemed to be the greater of USD 150 and 100% of EBITDA.

To date, we have seen this iteration of high-water marking only in draft agreements and term sheets, and only in the context of an increase in EBITDA resulting from an acquisition. The following is an example:

SECTION 1.03. Pro Forma Calculations; Certain Compliance Determinations.

(l) If any financial ratio, calculation, test or any other similar or related term, concept or measurement that is to be calculated by reference to the greater of a fixed amount (a “numerical permission”) and a percentage of Consolidated EBITDA and/or total assets (a “grower permission”) and the grower permission of such metric exceeds the applicable numerical permission at any time as a result of an acquisition or Investment that is permitted under this Agreement, the numerical permission shall be deemed to be increased to the highest amount of the grower permission reached from time to time as a result of any such acquisitions and/or Investments and shall not subsequently be reduced as a result of any decrease in the grower permission.

In both versions the borrower gets the benefit of increased EBITDA without suffering the detriment of falling EBITDA

Referencing highest EBITDA ever

The second way to effect high-water marking is to deem the EBITDA prong of the grower basket to refer to the highest level of EBITDA ever achieved, whether or not EBITDA for the trailing 12 months was lower than that. In the previous example, the dollar prong in all three scenarios would remain fixed at USD 100, but in the second year after closing (when EBITDA has declined to USD 50), the basket would be equal to USD 150, because the EBITDA prong of the basket would be deemed to equal USD 150 (ie, the highest level of EBITDA achieved to date).

An example of this iteration of high-water marking appears in the credit agreement of Surgery Center Holdings Inc, which was filed with the SEC on 20 December 2023. It reads:

1.11 (d) With respect to any Fixed Basket in this Agreement that is determined by reference to a percentage of Consolidated EBITDA as of the most recently ended Test Period as of such time of determination (including on a “greater of” basis), the Consolidated EBITDA shall be deemed to be the greater of (x) Consolidated EBITDA as of the applicable most recently ended Test Period as of such time of determination as set forth in such Fixed Basket and (y) the greatest Consolidated EBITDA of the Borrower for any trailing four fiscal quarter period ending prior to such Test Period as to which Section 9.1 Financials have been delivered to the Administrative Agent.

In both versions of high-water marking the borrower gets the benefit of increased EBITDA without suffering the detriment of falling EBITDA, and the provisions are hidden in the agreement under “Interpretive Provisions” or some similarly anodyne heading. As with the silent first lien of a few years ago, in which clauses were buried in the Administrative Agent section, it is a grim reminder that a credit agreement is full of crannies in which to hide terms that hobble lender protections.

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