LBO Loan Term Sheets: Covenants and Events of Default That Shape Post-Acquisition Management

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

When a draft term sheet for an LBO loan arrives from a financial institution, borrowers and buyers look first at the loan amount, the interest rate and the fees. These are the figures that determine the economics of the acquisition, so this is a natural reaction. The covenants and events of default listed in the second half of the term sheet, on the other hand, are set out matter-of-factly in table form, which makes them easy to skim over.

It is at the term sheet stage that the loan terms can be changed in substance. The loan agreement itself is generally signed a few business days before the closing date, which leaves only a short time for negotiating the loan agreement. The provisions in the second half of the term sheet determine the extent to which the management of the company after the acquisition depends on the financial institution's consent until the loan is repaid in full.

A Map of the Issues

The issue to put at the center is the extent to which the management of the company after the acquisition depends on the financial institution's consent until the loan is repaid in full. Its substance is determined by three provisions: mandatory prepayment, covenants and events of default.

Around it are issues that shape the premises of the loan terms. These are terms such as the flow of documents up to the arrival of the term sheet and exclusivity over the arrangement (syndication), fees and who bears the costs, whether voluntary prepayment is permitted, and who can become a creditor. In addition, the scope of the representations and warranties that the borrower gives about a target company it does not yet control affects how onerous the covenants and events of default are.

Documents Before the Term Sheet Arrives and the Terms of the Arrangement

In acquisition finance, several documents are prepared before the loan agreement. The document a financial institution issues at the early stage of negotiations is the indication letter, which outlines the proposed terms, centered on economic terms such as the interest rate. It is a proposal made before the financial institution has completed its internal review and has no legal binding force. Buyers also obtain indication letters from several financial institutions to compare the terms and narrow down which ones to negotiate with. Regarding domestic LBO loans, the fiscal 2025 report (published in March 2026) of a study group for which the Japanese Bankers Association serves as the secretariat states that pricing is left to individual negotiations and that there is no common benchmark for gauging price levels across the market as a whole. Since there is no way to check the level against an external benchmark, lining up several proposals is itself a useful point of reference.

The next stage is the commitment letter. It is a document in which the financial institution states that it is prepared to make the loan on the terms described in it, and it is generally considered to have a certain degree of legal binding force. How strongly it binds, however, varies greatly from deal to deal. It has been pointed out that in some cases the letter has, in substance, virtually no binding force, because it is subject to conditions precedent that the financial institution can treat as unsatisfied at its discretion, or because key terms are left to subsequent negotiations. The term sheet is usually attached to this commitment letter. It is also common to give that financial institution an exclusive position in the arrangement in exchange for the commitment letter.

The template mandate letter published by the Japan Syndication and Loan-trading Association (JSLA) in February 2025 is a standard form designed for syndicated loans in general, but it provides that, during the arrangement period, the borrower will not mandate anyone other than the arranger to arrange the same loan. A clause extending the scope of exclusivity to subsidiaries and affiliates, a clause prohibiting direct negotiations with the financial institutions invited to participate, and whether to set a specific deadline for the arrangement period are provided in the template as options. If no deadline is set, the arrangement period is structured to continue until the signing date of the loan agreement. For a buyer that wants to hold discussions with several financial institutions in parallel, these are the clauses that determine from what point it can no longer talk to other banks.

Under the same template, if the terms are changed in the course of the arrangement, the arranger is to obtain the borrower's consent. On the other hand, where a material change occurs in the borrower's financial condition, where an event occurs that has a material effect on the financial or market environment in Japan or overseas, or where the borrower's cooperation in providing information cannot be obtained, among other cases, the arranger may, after consulting with the borrower, discontinue the arrangement at its discretion and bears no liability for discontinuing it. As for the type of mandate, the template also offers a choice between an underwritten commitment, under which the arranger takes up any shortfall from the arrangement amount, and best efforts, which carries no underwriting obligation; under the latter, the risk that the arrangement is not completed remains with the borrower.

Fees and Expenses, Prepayment and Changes of Lenders

The fees are of different natures: the arrangement fee, paid only to the arranger as consideration for the arrangement work; the agency fee, which is consideration for administrative work after drawdown; the upfront fee, paid at drawdown; and the commitment fee, which accrues according to the facility amount and the commitment period rather than the amount borrowed. Under the JSLA template mandate letter discussed above, the arrangement fee is payable on the signing date of the loan agreement, and its treatment if the agreement is not signed is a matter for consultation. The template provides that the borrower bears the various costs of the arrangement, including attorneys' fees and stamp duty, regardless of whether the agreement is signed or whether the loan is made. Before giving the mandate, check which costs would remain with you if the acquisition does not go through.

JSLA's 2013 (Heisei 25) version of the term loan agreement does not, as a rule, allow voluntary prepayment, being structured to require the prior written consent of all lenders and the agent, and it provides that a partial prepayment is applied first to the principal whose repayment date falls latest. For LBO loans, there is commentary premised on voluntary prepayment being made after advance notice is given a certain period before the intended repayment date, so the standard form is not used as is. If you are considering repaying ahead of schedule in a period when results exceed the plan, you need to pin down in the term sheet whether voluntary prepayment is written as the borrower's right, the notice period, whether a fee applies and the order of application.

Amounts payable in connection with a prepayment are of two different kinds. Breakage costs (break funding costs) are the difference that arises where repayment is made on a day other than an interest payment date and the reinvestment rate is lower than the rate applicable at that time; they compensate the lender for the loss it actually incurs. A prepayment fee requires, instead of or in addition to breakage costs, payment of an amount such as the prepaid principal multiplied by a fixed rate, and is said to be commonly seen in acquisition finance and similar transactions.

The lenders, too, may change before the loan is repaid in full. In LBO loans, it is said that the transfer of a lender's position before the lending obligation ends often requires the borrower's consent, while the assignment of loan receivables often requires no consent from the borrower but is limited to transferees that meet certain requirements. On the other hand, the fiscal 2023 report (published in March 2024) of the study group for which the Japanese Bankers Association serves as the secretariat states that cases were presented in which such restrictions on transfer became a constraint and some investors could not be brought into a syndication. For the buyer, these are the clauses that determine who can become a creditor.

Representations and Warranties About a Company You Do Not Control

Under a loan agreement, the buyer-side company that is the borrower is often required to give representations and warranties not only about itself but also about the target company and its group companies. They are given as of the signing date of the loan agreement and the drawdown date, both of which come at a stage when the buyer is not yet running the target company. The buyer's sources of information are limited to the materials obtained in DD and the seller's explanations.

Representations and warranties are linked to both the conditions precedent to drawdown and the events of default. The broader the representations and warranties about the target company, the wider the range of cases in which circumstances unknown to the buyer stop the loan from being made or lead the lender to assert acceleration after drawdown.

What the borrower negotiates is the exclusion of matters identified in DD and the exclusion of less significant subsidiaries. Items that are difficult to exclude entirely are adjusted by adding a qualifier limiting them to material respects, or a qualifier such as "to the best of its knowledge" or "to the best of its knowledge after reasonable inquiry."

Three Provisions That Shape Post-Acquisition Management

Mandatory Prepayment

Mandatory prepayment is a provision that requires early repayment, separate from the scheduled repayments, when certain events occur. Typical events include the generation of excess cash flow, the sale of assets, the receipt of insurance proceeds or compensation payments, and new borrowings or share issuances. Three points are negotiated: the scope of the events, the amount to be applied to repayment and the timing. The specific points of contention are setting a threshold below which amounts received need not be applied to repayment, the definition of excess cash flow and the percentage to be applied, and whether to keep the option of using asset sale proceeds or insurance proceeds to acquire replacement assets.

Covenants (Financial Covenants and Negative Covenants)

It is said that covenants are often the biggest point of negotiation in a loan agreement. Financial covenants used include the leverage ratio, DSCR (debt service coverage ratio), maintenance of net assets and maintenance of profits, and their levels are set based on the figures in the business plan that the buyer submitted to the financial institution. The monitoring report on domestic LBO loans that the Financial Services Agency published in June 2025 identifies as good practice examining the business plan, including under stress cases, and using the results to set covenant levels, and identifies as a problem uniform settings that do not reflect the characteristics of the company. The report therefore gives you a footing for seeking levels that fit your own plan.

Negative covenants include restrictions on dividends, officers' compensation, additional borrowing, capital expenditure, and investments and loans. For the cap on capital expenditure, the amount of headroom and the carry-forward of any unused allowance to the next period are negotiated. Whether to permit an equity cure, under which a likely breach of a financial covenant is avoided through an additional capital contribution from the sponsor, is also an issue, but an additional contribution is at the sponsor's discretion and cannot always be counted on. It is common for the mechanism to be subject to restrictions such as a limit on the number of times it can be used, and for the money contributed to be applied to prepayment of the loan.

Events of Default

Events of default upon which the loan is accelerated at the financial institution's demand include breach of financial covenants, breach of representations and warranties, linkage with other debts (cross-default), change of control, the key person clause, and the materialization of contingent liabilities such as unpaid wages or additional tax assessments. What is negotiated is limiting breaches to material ones, setting monetary thresholds, and seeking a cure period, which is not included as a matter of course. Another subject of negotiation is narrowing the wording of catch-all events of default upon the lender's demand, such as "where the business has deteriorated significantly and it is necessary to preserve the claims," so that the situations they cover are made specific.

Another issue is whether the automatic events of default cover only the borrower and the guarantors or extend to the entire target company group. It has been pointed out that extending them too far makes it easier to trigger cross-default clauses in contracts that the target company has entered into with other counterparties, which could end up impairing the value of the business, an outcome that harms the financial institution as well. The creation of security over the target company's assets and guarantees are discussed in LBO Loan Security and Guarantees.

When You Receive a Term Sheet in a Business Succession Acquisition

Here, I assume a deal in which a company established by the successor or the management team borrows acquisition funds from a financial institution and buys out the owner's shares. Where the buyer side has limited room for additional capital contributions, I believe it is difficult to adopt a structure that relies on an equity cure. In that case, the negotiations will center on headroom in the financial covenant levels and on securing cure periods.

When you receive a draft term sheet, first apply the figures in the business plan submitted to the financial institution to each test date for the financial covenants. By looking not only at the headroom if things go according to plan but also at which metric would be breached first in a period when sales fall below the plan, you can determine which levels to negotiate. For the cap on capital expenditure, check whether the timing of equipment replacement is concentrated in particular periods, and if it is, add whether a carry-forward is allowed to the items to negotiate.

If curing the matters identified in DD is among the conditions precedent to drawdown, check item by item whether each can be cured by drawdown, and ask for those that cannot be cured in time to be moved to post-drawdown covenants. It is also not uncommon for these to be agreed as best-efforts obligations only.

In a deal where the owner steps down, care is also needed regarding who is covered by the key person clause. If the outgoing former owner or executives who are expected to be replaced after the handover are covered, merely carrying out the succession as planned will constitute an event of default. The same applies if there are plans to transfer part of the shareholding to officers or business partners in the future; decide at the term sheet stage the percentage of voting rights that must be maintained so that the transfer does not constitute a change of control.

A draft term sheet may include a personal guarantee by the successor as a condition. The special rules on business succession under the Guidelines for Personal Guarantees Provided by Business Owners, formulated in December 2019, set out as a principle that financial institutions should not require double guarantees from both the former business owner and the successor. They also call on financial institutions not to have the successor take over the guarantee as a matter of course but to re-examine whether it is necessary, and to explain individually which aspects are insufficient such that a guarantee is needed. As measures where a guarantee must unavoidably be requested, they list limiting the guaranteed amount according to the use of funds, a guarantee agreement subject to a condition precedent, which does not take effect unless the special covenants are breached, and a guarantee agreement subject to a condition subsequent, which ceases to have effect if those covenants are satisfied.

However, these guidelines and special rules assume that the principal debtor is a small or medium-sized enterprise and that the guarantor is its business owner, and I have not been able to find any passage that squarely addresses a situation in which the successor personally guarantees the borrowings of a company established for the acquisition. Even so, I believe they serve as a basis for asking for an explanation of why a guarantee is required and for proposing a cap on the amount or a conditional guarantee.

The materials to have at hand for this review are as follows.

• List of findings from legal DD and financial DD
• Business plan and capital expenditure plan submitted to the financial institution
• Composition of officers after the share acquisition and the succession schedule
• Cross-default clauses and change of control clauses in the target company's key contracts