13.2 Why is debt necessary in a private equity transaction?

Chapter 13 Debt Mark Darley Partner Skadden, Arps, Slate, Meagher & Flom LLP 13.1 Introduction This chapter gives an overview of the use of debt i...
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Chapter 13

Debt Mark Darley Partner Skadden, Arps, Slate, Meagher & Flom LLP

13.1

Introduction

This chapter gives an overview of the use of debt in the funding of private equity transactions, the roles of the main participants and the types of debt instruments that are used. It also explores how the debt package is put together – the order of events and the key agreements – and considers some of the more frequently debated provisions. The objective is to provide a better understanding of how the debt piece of a transaction fits into the overall structure and to explain some of the basic structures and issues. With the credit markets in their current turmoil it is exceptionally difficult to be specific as to structures and terms – many of the transactions that are funded are bespoke with atypical terms. Rather than try to describe such features, this chapter concentrates on the characteristics of funding in an orderly market.

13.2

Why is debt necessary in a private equity transaction?

There are a host of reasons why debt is used in a private equity transaction, but two principal reasons are described below. 13.2.1

Spreading the risk

In recent years private equity houses have raised many billions of dollars to fund acquisitions, but even these funds are dwarfed by the size of the business that has been put up for sale. Without debt to

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supplement their own funds the PE houses would be unable to fund the larger acquisitions or would find that the number of investments they could make would be much smaller and the risk more concentrated.

The ability of the PE houses to borrow on a limited recourse basis has given them the opportunity to absorb much larger transactions and to spread their exposure. In crude terms, without debt, a £billion PE fund would have a purchasing power of just £1 billion, whereas with debt, the same fund would have a purchasing power of potentially £2.5 billion (assuming it invests 40 per cent of its funds and borrows 60 per cent for each purchase). Assuming the same investment strategy, this allows a theoretical 2.5 times greater diversification in investments and exposure.

That is not to say that using bank debt is the only approach PE houses have to bidding for large, multi-billion pound acquisitions or to diversification. Increasingly, PE houses have clubbed together so that a consortium of two or more PE houses might make a joint acquisition. Inevitably, at the peak of the market, larger private equity acquisitions were a combination of multi-house consortia, lower equity investments and higher bank borrowings.

13.2.2

Debt is cheaper than equity

Equity share capital is commonly referred to as “risk capital”. It carries with it no guarantee of any return, whether in the form of regular income (dividends), in final pay-out (e.g. through a secondary sale or liquidity on an initial public offering (“IPO”)) or in recovery of amount invested (if the investment fails). To compensate, shareholders expect a higher return over the life of their investment than someone with less risk.

Lenders, on the other hand, will typically say they are not in the business of taking risks, just providing funding. They expect regular compensation (interest) for the money they provide and complete repayment of the loan no later than the end of its term. As a creditor, they will rank ahead of the shareholders and, as most private equity debt is fully secured, they will also rank ahead of most trade and other creditors. In brief, lenders will do all they can to minimise their risk, and as their risk reduces so should their return.

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13.3

13.3.1

Debt

The cast

PE house/borrower side

13.3.1.1 The PE house The PE house, as architect of the acquisition, will take responsibility for coordinating the borrower’s financing. At an early stage in the acquisition it will call on the lenders with whom it has worked closely in the past (and whose affiliates may have invested in the PE house’s funds) (“relationship banks”) to offer financing terms. The PE house expects that the relationship banks’ familiarity with the PE house’s business strategy, risk management procedures and typical financing terms will lead to the cheapest terms and fastest execution of the transaction. In many ways the interests of the PE house and its lenders are aligned: (a)

(b) (c)

both will want to diligence the investment (or “Target”) to identify inherent risks (and areas of potential efficiency) before committing to acquire or fund the asset; both are interested in ensuring the acquisition is structured in the most tax-efficient manner; and both are interested in ensuring that the business will be profitable over its life (albeit for different reasons).

However, although aligned in many respects, the PE house will not want to be party to any agreement with the banks: unlimited exposure could lead to disastrous losses for the PE house, its managers and its funds.

13.3.1.2 Bidco Bidco is the structural name commonly given to the vehicle used by the PE house to make the acquisition. This entity (normally a limited liability company) will borrow all or a large majority of the debt required for the acquisition. It will most probably be a special purpose vehicle (“SPV”; i.e. a newly created entity that has no previous trade, assets or (importantly) liabilities) established in a jurisdiction that gives tax efficiency and maximises the collateral opportunities for the lenders. Its ultimate shareholders will be the PE

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house funds, (commonly) Target management and potentially other strategic investors (collectively, the “investors”), all of whom will be keen to ensure that they have no exposure to the investment other than their shareholding (and so will shy away from any contractual obligations to the lenders). Bidco’s assets will be quite limited, often just the shares in Target, contractual rights under the acquisition agreement and claims against report providers (see below) – no true hard assets such as real property or machinery – but yet it is the principal borrower. Therefore, the lenders will be extremely keen to ensure that they can get full security over such limited assets as it has and to limit its ability to carry on trade (and so incur competing liabilities). 13.3.1.3 Intermediate Holdcos Aside from tax reasons, intermediate Holdcos (i.e. companies placed between the investors and the Bidco) are used principally to achieve subordination between competing classes of lenders. Subordination – the means of ensuring one class of creditor is paid in priority to another class when there are insufficient funds to pay all out in full – can be achieved in three principal ways: (a) (b) (c)

by granting security to one class but not another; by contractual arrangements between the different classes of lenders; and by structural subordination.

The use of an intermediate Holdco helps to achieve structural subordination: the subordinated lenders are required to lend to this entity whilst the senior lenders lend direct to the Bidco or even Target and its subsidiaries. As the intermediate Holdco’s only asset is the equity in Bidco, it will only ever receive a return on a failure of the investment (and so its creditors, the subordinated lenders, will only ever receive repayment) if Bidco has any value/assets after the repayment in full of all Bidco’s creditors (e.g. the senior lenders). Which class of lender will be required to fund via an intermediate Holdco will depend on negotiating strength, independence of the subordinated lender from the senior lender and marketability of the class of debt. Invariably, the investor, if it advances money by debt (as

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Figure 13.1

Debt

Typical debt structure

it may wish to do so for tax reasons) will be required to invest by an intermediate Holdco, as will high-yield debt providers. The position of mezzanine lenders is less clear.

13.3.1.4 The target The target may be a trading company or a pure holding company for the operating companies.

Frequently the target group will have bank borrowings at the time of the acquisition which the new lenders will want to ensure are repaid,

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both to avoid competing creditors and because the existing banks are unlikely to allow Target to give collateral to the new lenders.

It is commonplace for acquisitions to be made with existing Target debt still in place (and an appropriate reduction in the purchase price) and for that debt to be refinanced out of the new lender loans. The total amount (of debt and purchase price) that the investors pay (and the lenders advance) is no greater and there is one key advantage to the lenders in structuring the transaction in this way: as will be seen below, most jurisdictions restrict the ability of companies to give collateral for debt used to fund the acquisition of their own or their parent’s shares, but there is no such restriction on giving collateral for a company’s own borrowings. If the new lenders are able to structure their financing so that part is borrowed by (or “pushed down” to) the operating companies in the target group (i.e. to enable them to repay existing debt), the lenders will then have a direct claim against the operating companies for which they can take security and so rank ahead of unsecured creditors (e.g. trade creditors). 13.3.1.5 Report providers Report providers are the professionals who carry out diligence or research or who provide advice (such as on matters of tax, key contract terms, insurance or environmental hazards) to the PE houses.

The nature of the reports required for an acquisition vary according to the target business but would typically include tax, business and financial, pensions, environmental, insurance and legal. The reports are provided to the Bidco who may “rely” on them (i.e. claim against the report providers if they are negligently incorrect) and also the PE houses. In the European market, the practice has developed that the lenders too may have these reports addressed to them and “rely” on them to avoid the cost of the lenders duplicating the work by having separate reports provided to them. The practice in the US is markedly different and typically such reports would not be addressed to the lenders although they may be allowed to see them on a “non-reliance” basis. Indirectly, the lenders benefit from the reports addressed to the Bidco as they take security over all of its assets (one of which may be the right to claim against the report providers).

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The extent to which lenders can rely on reports can be hotly debated between them and the report providers, and it is always best to start resolution of this issue early in a transaction, although most major professionals will have terms they have agreed in previous transactions with the same or similar lenders as well as (in some instances) industry guidelines. Hot topics usually include: (a) (b) (c)

a financial liability limit; a long-stop date for claims; and who can claim (arrangers will want all lenders to be able to claim, whether they are initial lenders or join in syndication or subsequent transfer, whilst report providers will want only the initial lenders to have that right).

In view of the potential limitation on liability, lenders will want to restrict the ability of the PE houses to claim against a report provider in competition with them. How this plays out is a matter for debate, but solutions can include an agreement that no PE house claim can be made whilst the lenders have outstanding debt or that any monies the PE houses recover will be invested in the Bidco.

13.3.2

Lender side – bank debt

13.3.2.1 The arrangers Putting together a loan package that the investors can be confident will be sufficiently attractive for banks to be willing to fund the acquisition is a specialist task. Whilst, in a normal credit environment, the investors may have a good feel for what is “market”, they will take comfort from having an “independent” person with whom to negotiate terms and who has daily exposure to what is and is not acceptable to banks. The person to whom the investors turn is called an “arranger”.

Typically, the investors are likely to approach a number of their relationship banks to be arranger and ask them to submit their best terms for their engagement and the financing. One or more arrangers will then be appointed from this competitive process. The arrangers’ functions can be summarised as:

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(a) (b)

structuring the debt package; diligencing or reviewing the diligence provided by the report providers; (c) reviewing and stress testing the PE houses’ financial model; (d) negotiating the legal documentation; (e) pricing (at least initially and subject to any right to flex) the loans; and (f) attempting to market/sell the loan to the funding banks. In return for their services, the arrangers are paid a fee (the “arrangement fee”), typically a certain percentage of the amount of the loans they arrange.

The more sizeable and complex transactions are likely to have a number of arrangers who will divide the various tasks amongst themselves. Engaging a number of arrangers not only helps in the division of labour but also indicates that more than one financier is confident that the financing is marketable on the terms presented to the bank market and this can be persuasive in syndicating the loan. Amongst a group of arrangers, one or more may be appointed “lead arranger(s)” or “mandated lead arranger(s)” (i.e. first among equals): this role is prestigious and important for the bank’s industry league table ranking. The mandated lead arranger (“MLA”) acts as a coordinator and bears the principal role of arranging the loan. Its appointment will be driven by a number of factors including relationships, track record in selling loans, terms it believes can be sold and, importantly, the amount of the loan that it (or its affiliates) commit to take up itself. Although a lender, in its capacity as arranger, has no obligation to lend, typically it will commit to provide (or “underwrite”) all or part of the loan (in this capacity it is an “underwriter”). The nature of that commitment needs to be carefully examined by the borrower as often it is conditional upon a number of matters such as “acceptable diligence and documentation”, other lenders joining the syndicate (i.e. it is just a partial commitment not for the whole amount of the loan) or the absence of any material adverse change (“MAC”) in the financial markets or the target business. The acceptability of such conditions depends on whether these matters can be resolved before Bidco signs a binding acquisition agreement or whether that agreement has a

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“financing out”. A fee is payable for the underwriting commitment, though this is usually included as part of the arrangement fee.

The legal relationship between the arranger and Bidco is contained in a “mandate letter” and will provide that the arranger has little liability to Bidco (other than in its capacity as underwriter). The extent to which the arranger has duties to the lenders to whom it sells the loan has been the subject of debate and litigation. The credit agreement will try to exclude all liability, but this contractual arrangement will only be binding once the lenders have signed the agreement – it will not avoid the risk of potential liability if the arranger has made misrepresentations that induced the lenders to sign the credit agreement. The arranger will market the loan using an information memorandum put together by it but at Bidco’s request and for which Bidco assumes responsibility. This document will contain carefully crafted wording making it clear that the arranger assumes no responsibility for the content of the information memorandum, no responsibility to update the information and no duty of care to the potential lenders. The efficacy of this language has been tested in court and, on the facts of that case, found to be effective1.

13.3.2.2 The facility agent The role of the facility agent (also called the administrative agent) is administrative in nature, acting as an intermediary between the borrowers and the lenders for which it is paid an annual agency fee. Its principal functions are to: (a)

(b) (c)

(d)

(e) 1

collate and pass on to the lenders information provided by the borrowers (as required by the credit agreement), which in some credit agreements can be very extensive; pass communications between lenders and borrowers; process requests from the borrowers for loans, letters of credit or new interest periods; set interest rates (based on the appropriate interbank rates or base rates plus the margin (see Section 13.4.1.3 ”Interest payments”); act as a conduit for the flow of payments and receipts between the lenders and the borrowers;

See IFE Fund SA v Goldman Sachs International [2007] 2 Lloyd’s Rep 449.

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(f) (g)

process transfers of loans between lenders; and comply with instructions given by the requisite majority of the lenders in taking any action permitted by the credit agreement but for which no specific provision is made in the documents.

Importantly, the facility agent owes no duty to the lenders to ensure that the legal documents are enforceable or to advise or monitor the performance of the borrowers or their compliance with the documents, although it will be required to tell the lenders if it has actual knowledge of an event of default. Furthermore, unless it is specifically required to take action by the credit agreement, the facility agent may refuse to act, and even when required to act, may refuse to do so until appropriately indemnified by the lenders. 13.3.2.3 The security trustee The security trustee (also called the security agent or the collateral agent) again has only an administrative function for which it is paid an annual security trustee fee. It is commonplace for the roles of security trustee and facility agent to be performed by the same institution and for the fees to be combined. As the title implies, its primary role is to: (a) (b) (c)

act as the holder of the security granted for the loans; take whatever action it is legally entitled to take as directed by the lenders (subject to an appropriate indemnity) on enforcement of the security following a default under the credit agreement; and distribute the proceeds of enforcement in accordance with the order of priority set out in the credit agreement or the intercreditor agreement.

In the absence of a security trustee, lenders might only get the benefit of security if it was granted to each of them individually. This would be prohibitively burdensome and costly in all but the smallest loans as any transfer of a loan from one lender to a new lender would require new security to be executed (which might start new hardening periods running) and registered and, in some jurisdictions, notarised and taxed.

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Not all jurisdictions recognise the effectiveness of a security trust or agency arrangement. However, and in those jurisdictions a parallel debt approach is needed under which all sums owed to the lenders are deemed to be owed also to the security trustee so that the security granted to the security trustee covers the totality of the debt. The borrower is not exposed to “double dipping”, as provision is made that discharge of the debt owed to the lenders discharges an equal amount of debt notionally owed to the security trustee under the parallel debt arrangement. The complexity of taking security in various jurisdictions is a fascinating topic, but it is beyond the scope of this Guide. 13.3.2.4 The lenders The arranger will want to sell down (or syndicate) its underwriting participation in the loan to reduce its exposure and free up its capital to participate in further loans. The borrower will also benefit if the loan is successfully sold, but it will also be keen to ensure that it has a group of “friendly” lenders who will be sympathetic if it needs waivers.

A regular debate between PE houses and arrangers surrounds the topic of what control the borrower has over the composition of its syndicate: the borrower wanting consent rights and the arranger typically being willing only to grant consultation rights at most. There is no correct answer to this debate and much depends on the openness of the credit markets and the size and structure of the loan. At the peak of the borrower-dominant market, the borrower could expect to achieve consent control for small to mid-sized loans, but with the contraction of the credit markets, this position has changed markedly and it is now rare for borrowers to have a say in the identity of the lenders in any but the smallest loans.

13.3.2.5 Defaulting lenders With the collapse of several significant international banks there has been considerable debate about what protection borrowers should seek against one of their syndicate banks not being able or willing to fund loans (especially working capital loans). Should they be disenfranchised on voting? Should they continue to receive commitment fees? Should the borrower be able to draw additional sums from performing banks to make whole the shortfall etc.? This debate is

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ongoing and it is being actively promoted by the Loan Market Association (“LMA”). The New York market is far more developed in its approach to these matters. The debate is of course much more acute when the defaulting lender is also the agent through whom all payments should flow. 13.3.3

Lender side – bonds

Part of the debt funding for large PE transactions (especially acquisitions in the US) may take the form of bonds or notes issued by the borrower or an affiliate (the “issuer”) under an indenture or Trust Deed (the equivalent of the credit agreement). These are often (structurally) subordinated to the bank debt and the additional risk is compensated by a higher interest rate or yield (so-called “high-yield debt”). In broad terms, the bonds are arranged by managers (roughly the equivalent of the arrangers) and sold to noteholders (the equivalent of the lenders), who are mainly large institutional investors. Noteholders are not usually concerned with building a long-term relationship with the issuer; indeed often the issuer may not know the identity of the noteholders and this leads to difficulty in coordinating a group of sympathetic creditors if the issuer’s credit takes a turn for the worse.

However, the noteholders are keen to ensure a liquid market for the bonds so that they can be traded as necessary to meet the noteholders’ investment policy – there are generally no contractual constraints on the ability of the noteholders to transfer the notes. Liquidity comes through arranging for the notes to be traded on the public markets and credit rated by one or more of the internationally recognised rating agencies. The public nature of the notes creates additional responsibilities and potential liability for the issuer, its management and the managers as the marketing of the notes is by way of a public document (the offering memorandum), and periodically the issuer will be required to make further filings reflecting its financial position and to notify the market of material developments to its business. A high standard of accuracy and disclosure is expected from these filings which, if not met, can lead to significant liability for the issuer, its officers and advisers.

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Noteholders have little contact with the issuer unless the credit turns sour. Whilst noteholders monitor the public announcements, they rarely interface with the issuer as the bank lenders might.

The absence of any relationship and detailed knowledge of the business, together with the nature of the noteholders’ business models, results in a high probability that the issuer will need to pay a fee to the noteholders for any amendment to, or waiver of, the issuer’s obligations, so it is important that the terms of the notes are sufficiently flexible to allow the issuer and its affiliates to carry out whatever activity it anticipates over the (potentially lengthy) term of the notes. Consequently, the notes are typically far more flexible than the bank debt.

The trustee is in some ways similar to the agent in a bank lending in that it interfaces with the issuer. The trustee can approve changes to the notes, but unless they are of a minor or technical nature, they may only do so with the approval of the noteholders. In view of the potential liability for a trustee and the fact that noteholders are not aiming to build a long-term relationship with the issuer, it is rare for a trustee to exercise its discretion without getting directions. The trustee can, of course, also accelerate and enforce the notes at the behest of the noteholders. If the notes are secured, the security will be held by a security trustee, usually the same entity as the bank security trustee, and the noteholders and bank lenders will organise their priorities through the intercreditor agreement. 13.3.4

Lender side – bridge financing

Whilst it is possible for a note issuance to be synchronised with completion and funding of an acquisition, there is a degree of uncertainty in this approach (as the offering memorandum needs to contain detailed (and current) financial statements that may not be available at the time the notes need to be marketed and there needs to be a market for notes (of the type that all but disappeared in the second half of 2007)). The gap between the need for funds at completion of the acquisition and the uncertainty of when the note proceeds will be available, can be closed through the use of a short-term bridge facility provided, for a fee, by the managers. It is important to bear in mind that the managers will not want the bridge facility to be in place

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for long and will expect the issuer to do all it can to replace it with notes as soon as possible – the issuer can expect a high financial inducement to do so! 13.3.5

Stapled financing

In passing, it is worth mentioning a product or service that was common at the height of the borrower-dominant market. As the markets became increasingly hot, PE houses increasingly competitive and deals increasingly speedy, a product called stapled financing emerged. This was an offer to each bidder made by an affiliate of the financial adviser structuring the sale to arrange and underwrite the acquisition financing to each bidder on certain common terms.

Its promoters argued that because it had already looked at the Target when the financial adviser affiliate began working on the sale, it was familiar with Target’s business, had assessed the risk and was able to package the financing quicker than any external lender. This would mean that any investor who took up the offer of stapled financing would be ahead of the game and would not have to worry about the source or terms of its funding. The reality was somewhat different to the theory and few stapled financings were ever concluded. Investors found that their relationship banks were able to act just as quickly and that the terms they could obtain there were more in line with their expectations (frequently, the terms provided by the staple bank were little more than indicative or untailored standard forms). The provision of stapled financing in the US also caused issues of conflict that threatened liability.

13.4

The props (the types of debt funding commonly seen in a PE acquisition)

As a general rule, the larger and more leveraged an acquisition, the more layers of different types of debt there are likely to be.

Traditionally, most private equity transactions were funded with senior debt and mezzanine debt, supplemented occasionally by

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investor debt (as a substitute for PE house equity) and vendor debt and, for the larger transactions, high-yield debt. However, as the size of acquisitions grew and the availability of lender funding increased in the early 2000s, institutions started marketing ever more innovative debt products, such as second lien debt, PIK debt and PIK toggle debt. These new products had different security or payment rankings and were priced accordingly (so appealing to different investor groups). The remainder of this section highlights some of the key features of each of these products. 13.4.1

Senior debt

13.4.1.1 General description Senior debt is a feature of almost all transactions and is provided by specialist acquisition finance banks.

Senior debt is so called because it is structured to have the greatest likelihood of full repayment on default by the borrower. It is also priced accordingly, being the cheapest institutional debt in the structure. Senior debt priority comes in a number of ways: (a)

(b)

Guaranteed by all companies in the Bidco (and Target) group and secured over all of their assets to the extent that this is legally possible (and not prohibitively expensive) ahead of all other lenders. Typically, guarantees will only be provided by the “material subsidiaries”, that is, those subsidiaries that account for a certain percentage (2.5 per cent to 5 per cent) of consolidated EBITDA, gross assets or turnover of the group.

Ranking will be reinforced by an intercreditor agreement, to which all institutions providing debt for the acquisition (and potentially all significant members of the Bidco and Target groups providing intra-group debt) will be party. The intercreditor agreement will provide that the senior lenders can enforce first (and that all other parties will defer enforcing until the senior lenders have had a suitable opportunity to consider their position and what action they want to take) and that all recoveries on enforcement are applied first to the discharge of the senior debt.

A shorter maturity to the other debt pieces, typically six or seven years after being advanced.

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(c)

Amortising (at least in part), leading to increased security coverage (and a reduction in risk) as the amount of debt secured by Target assets reduces over its term. The reduction of the senior debt by amortisation is supplemented by various mandatory prepayment events.

13.4.1.2

Core terms

General The terms of the senior credit agreement are likely to be less flexible than other parts of the debt structure as the senior lenders want to ensure that: (a)

(b) (c)

the borrower runs the business in the way they were told it would when deciding whether (and at what price) to provide financing; the assets over which they expect to have security are not dissipated (including by moving assets from one group company from whom they have collateral to another from whom they do not); and their debt is repaid at least as quickly as they expected.

The senior lenders will expect extensive information rights concerning the business, its past performance, its future budgets and strategy: information flow and dialogue is key at this level of debt.

Facilities The senior facilities agreement will provide at the very least a “term facility” (which is used to fund the acquisition), almost invariably a “revolving credit facility” (“RCF”; which is used for the working capital needs of the Target business) and, depending on the nature of the Target business, it may provide one or more of the following as well: (a) (b) (c)

a “capital expenditure facility” (or “capex facility”); an “acquisition facility”; and a “bank guarantee facility”.

The “term facility” The term facility is the main part of the facility and provides the funding for the acquisition of the Target and the repayment of any

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long-term debt in the Target group. It will typically be available at the time of closing the acquisition and for a short period afterwards to fund any repayments that cannot be made at closing (although this is rare).

The borrower in respect of that part of the term facility used for the acquisition will be Bidco. There may be more than one Bidco depending on the structure of the acquisition, but if so, each will be expected to be jointly and severally liable (as guarantors) for the borrowings of the others.

The ultimate borrower in respect of the part of the term facility used to refinance long-term debt of the Target group may be Bidco or more typically the Target group members whose debt is being refinanced. There are a number of structural, tax and legal matters to be considered in deciding upon the best course, but to the extent possible, the lenders will prefer that the loan is at the level of the companies whose debt is being refinanced (especially if they are operating companies or companies with substantial assets) as this means there is less chance that they will be structurally subordinated to trade creditors and also helps to minimise limitations in certain jurisdictions on the giving of guarantees by Target group companies for debt of their parent. However, often Target group companies are unwilling to participate in the loan arrangements until after the acquisition has been completed whereas lenders will expect existing debt to be repaid immediately upon the acquisition being effective. This tension is resolved by Bidco borrowing to repay existing Target group debt, but with the relevant Target group borrowers assuming this part of the debt from Bidco as soon as possible after the acquisition is effective. This mechanic is known as “debt pushdown”. The revolving credit facility (“RCF”) The RCF is used to fund the group’s working capital requirements. In the context of an acquisition, the lenders may also allow the RCF to be used to fund working capital adjustments to the purchase price.

Borrowers It is usually in the interests of both the Target group and the lenders for all operating companies in the group to be borrowers under the RCF. However, whether this is appropriate in all cases depends on the

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ease with which lenders can lend into the required jurisdiction and whether interest can be paid free from withholding or similar taxes for which the banks would expect to be compensated. Where it is impractical to lend direct to an operating company, the borrowing will have to be made by another company in the group and on-lent intra-group. The facilities An RCF typically comprises two main facilities: a loan facility and a bank guarantee facility. It is common for the bank guarantee facility to be a sub-limit of the RCF amount (i.e. the full amount of the RCF could not be used just for bank guarantees), but this need not necessarily be the case if the business needs of the Target group dictate otherwise. RCF loan facility Unlike a loan under the term facility, an RCF loan is short-term (typically one, three or six months in duration), but can be reborrowed throughout the availability period for the RCF (typically the same period as the term facility). RCF bank guarantee facility Many businesses require bank guarantees, and the lenders agree that they will provide them under the RCF. Only one bank actually provides the bank guarantee, but each bank agrees to share in any losses that the Letter of Credit Bank (“L/c Bank”) suffers if the bank guarantee is called and not reimbursed by the borrower. Each bank receives a fee for this service equal to the margin and the L/c Bank also receives a fronting fee of (typically) 12.5 bps on the amount of the L/c in respect of the exposure it has should the other banks not reimburse it on default by the borrower.

Ancillary facilities Ancillary facilities are used where a borrower needs a credit line that cannot easily be provided on a syndicated basis, for example a hedging line (such as for foreign exchange (“FX”) exposure), a BACS facility or a small bank guarantee or loan or an overdraft facility. An ancillary facility is a bilateral arrangement between the relevant RCF borrower and an RCF lender who agrees to provide the line (there is no obligation on the lender to provide the line of credit, but it is

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usually provided by the bank with whom the Target group has most of its operating accounts) and the fees it receives are determined by those bilateral negotiations. If the borrower defaults under the ancillary facility, there is an adjustment to each lender’s exposure to the borrower so that each shares in the ancillary facility lender’s loss. Other facilities A number of other specific facilities might be provided depending on the nature of the business being acquired. So, for example, a target group with a sizeable capital expenditure requirement would typically expect to receive a capex facility available to be drawn for specific, budgeted capital expenditure investments that could not be easily funded from its revenue. Similarly, a business whose development plans involved making complimentary acquisitions that might not be capable of being funded from its own revenue would seek an acquisition facility. The terms and nature of such facilities, whilst very common, are outside the scope of this Guide. 13.4.1.3 Common terms This section deals with terms of the credit agreement that are common to more than one of the facilities. Repayment In addition to any term amortisation repayments and RCF repayments, provision is also made for voluntary and mandatory prepayment.

(a)

Voluntary prepayment: borrowers are typically permitted to prepay all or (subject to an agreed minimum amount) part of the term facility at any time after a nominal amount of notice to the facility agent. Voluntary prepayment is allowed without the payment of any penalty or premium but is subject to the payment of break costs.

Lenders typically do not fund their loans off their own balance sheets but instead borrow the money they need from the interbank market. If the lender is repaid before the end of the interest period, it will still be required to pay interest in the interbank market on the amount it borrowed for the full period and, whilst it should be able to recoup part of the foregone interest by reinvesting the principal repayment it received in the interbank

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market, there remains the risk that this will not compensate it fully. Break costs reimburse the banks for this loss (but not the loss of margin).

(b)

Voluntary prepayments ordinarily reduce the debt owed to each lender under the relevant term facility on a pro-rata basis.

Mandatory prepayment: lenders require a borrower to prepay their debt not just in accordance with an agreed amortisation schedule or at the end of a term, but also (subject to certain exceptions and de minimis thresholds) where the business on which they based their credit assessment changes or where the borrower has more revenue than is needed for its business (i.e. revenues that, if there was no debt, might be returned to the PE fund as dividends). The main examples of this are as follows. (i)

(ii)

Business change:



– – – –

Bidco has a claim against the seller of the target business under the acquisition agreement as a result of a breach of representation or warranty under that agreement; Bidco has a claim against a report provider; there is a change of control of Bidco; Target group makes a material disposal; and Target group suffers a loss resulting in a receipt of insurance proceeds.

Surplus revenue:

– –

excess cash flow sweep (where, at the end of each financial year, the business has surplus revenue); and An IPO of the Target group.

The borrower should bear in mind that frequently the funds to be prepaid will not be held by the borrower but by a subsidiary or sister company and to make the mandatory prepayment at the borrower level it will be necessary to move the moneys to the borrower. In many jurisdictions it will not be possible to transfer the funds to a parent or sister company other than by way of dividend because of legal or fiscal constraints: the borrower needs to be mindful not to agree to something that it cannot perform. There are various compromises that

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can be reached here and different lenders have different stances depending on the circumstances.

Cancellation and commitment fees The borrower can cancel any part of the facilities that it no longer needs on nominal notice to the facility agent and without payment of any fee. The incentive for doing this is that the borrowers are charged a commitment fee of a certain percentage of the facilities that are available to it but unused and uncancelled; the fee reduces as the facilities are cancelled. Interest payments Interest payments comprise three elements: (a)

(b) (c)

the rate incurred by the banks when they borrow the amount of their loan in the interbank markets (being LIBOR or, in the case of euro loans, EURIBOR); a percentage to reflect the regulatory costs incurred by banks when lending, known as “mandatory costs”; and the margin, being the lenders’ “profit” based on their risk assessment of the loan.

In US syndicated financings, borrowers may also elect to pay interest on US dollar loans calculated by reference to Federal Reserve rates (base rate loans) instead of LIBOR.

LIBOR and EURIBOR rates vary according to the length of the interest period chosen by the borrower. Interest periods are typically one, three or six months. LIBOR/EURIBOR is generally calculated by the facility agent by reference to screen rates and there is provision for the screen rate not being available (the facility agent then asks three “reference banks”) or if no rates are available at all or they do not reflect the true cost of borrowing.

The margin is fixed at signing of the credit agreement. It is now common for the margin for certain facilities to step down (and back up) according to the leverage of the group. The leverage of the group will be calculated quarterly and the margin adjusted a few business days after delivery to the facility agent of the quarterly accounts that are used to calculate the leverage. If the accounts are not delivered or

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if there is an outstanding default, the margin will usually automatically increase to the highest level until the accounts are delivered or the default rectified.

Hedging The borrower’s exposure to changes in LIBOR and EURIBOR interest rates is typically mitigated by entering into an arrangement to hedge its interest rate exposure on a certain percentage of the floating rate debt. The hedging is ordinarily provided by one of the lenders and will rank pari passu with the senior debt for security purposes. Because the hedging can be lucrative, arrangers frequently ask for a right to match any proposal by a third-party bank. This is resisted on the basis that if it becomes known in the market, it may result in insufficient banks bidding to give fair competition on terms.

Representations and warranties The credit agreement will contain extensive representations and warranties designed to ensure the business is as anticipated by the lenders and to allocate the risk of certain occurrences to the borrower. A breach of the representations is considered serious and can lead to the lenders being entitled to refuse to lend or even demanding repayment of the debt. The representations will cover: (a)

the ability of the borrowers and guarantors to enter into the finance documents and the acquisition agreements; (b) the validity and enforceability of those documents; (c) the payment of related taxes; (d) the absence of significant litigation, environmental and tax liability; (e) the absence of unauthorised borrowings and collateral; (f) ownership of assets needed to run the business and over which the lenders intend to take security; (g) accuracy of information on which the lenders based their decision to lend (including the reports); (h) accuracy and fullness of disclosure in the information memorandum used for syndication; (i) accuracy of the financial statements; (j) absence of significant pension exposure; and (k) group structure and other representations specific to the transaction.

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The representations and warranties are made when the credit agreement is signed and selected elements are repeated on each drawdown and possibly also at the start of each interest period and on each interest payment date. Those representations relating to the information memorandum will be repeated only on initial drawdown, when the information memorandum is circulated and when syndication occurs. A point of contention between borrower and lenders is which of the representations and warranties are to be repeated. This is a matter for negotiation, but generally those that are also addressed by the covenants need not be repeated. Covenants or undertakings The covenants require the borrower group to do or refrain from doing certain acts. Whilst the representations establish (hopefully) that the target business is as anticipated by the lenders, the covenants are designed to ensure the business is conducted as the lenders expect. They can be divided into the following categories: (a)

Information covenants. There are two elements to these: financial information and general business information covenants. They are designed to ensure the lenders receive the information they need to monitor the group’s business and provide notice of difficulties in the business. The financial information covenants will require the borrower group to provide monthly, quarterly and semi-annual unaudited accounts, audited annual accounts, annual budgets (all prepared consistently and in line with the appropriate accounting standards) and compliance certificates (certifying compliance with the financial covenants (see below), calculation of any adjustment to the margin and the guarantor coverage ratio (see below)). To the extent that the compliance certificate calculates matters from the audited accounts, the auditors may be required to confirm the calculations (or the figures from which the calculations are derived). The general information covenants are intended to keep the banks appraised as to significant business developments and will include all information that as a matter of law is to be passed to shareholders or creditors generally, details of material litigation or other claims (e.g. under the acquisition agreement) and notice of any defaults under the finance documents. There

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is also a general provision requiring the borrowers to give the facility agent such other information as it reasonably requires.

(b)

It is also common for the borrower group to be required to give annual presentations to the lenders and for the facility agent to have inspection rights and access to the auditors of the group (though the borrower will normally only allow this if there is a default or event of default). Business covenants. The business covenants – both positive (requiring the group to take certain actions) and negative (requiring them to refrain from actions) – are intended to ensure the business is operated as the lenders were told it would be, to protect their collateral package and to ensure that there is no unexpected dissipation of the group’s assets. There are a number of ways in which the business covenants can be categorised; below is just one example.

Authorisations and compliance with laws: requiring the group to comply with all laws and obtain all authorisations necessary for the enforceability of the finance documents and the conduct of the group’s business; comply with environmental and pensions laws; and pay all taxes when due. Restrictions on business focus: restricting mergers and acquisitions of other companies and businesses; prohibiting a change from the general nature of the business as it was at the time of the financing; restricting Bidco from carrying out any activity other than a holding company; maintenance of IP rights; and requiring the group to maintain its assets in good order.

Restrictions on dealing with assets and security: requiring the group to ensure that the lenders’ claims rank at least pari passu with the claims of other unsecured creditors; a negative pledge prohibiting the group from having other security interests (NB: security interest may be defined very broadly to include retention of title and set-off arrangements as well as any other arrangement that has the effect of conferring preferential access to assets to a third party); and restrictions on the disposal of assets.

Restrictions on movements of cash: restrictions on group companies making loans, giving guarantees and paying dividends (except within the group itself of course) and other sums and fees to the investors and intermediate holding companies; restrictions on incurring additional financial indebtedness; and prohibiting hedging for speculative purposes.

Miscellaneous restrictions: ensuring that transactions with affiliates are on arm’slength terms and for fair market value; maintaining insurance; and not making amendments to the acquisition agreements.

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(c)

Of necessity the above are only illustrative and in practice the business covenants will be more extensive and tailored for the particular business. Management commentary on what is necessary should be sought as early as possible.

Financial covenants. The financial covenants are intended to monitor the financial performance of the group and to measure that performance against projections made to the lenders at the time they were considering lending. They are intended to act as early warning signals to the lenders that the business is not performing as well as was expected and so give the lenders an opportunity to talk to the borrower about the reasons for this and what might be done to get the business back on track before it is too late. However, most financial covenants are historic (i.e. they calculate the past performance of the group) being based on the most recently delivered quarterly, semi-annual and annual accounts. As such, there is the risk that by the time the problem comes to light, the source of the difficulty is embedded. The financial covenant thresholds are set at a level that is intended to take this into account. A detailed analysis of the financial covenants is outside the scope of this Guide. A common debate around the financial covenants is the borrower’s entitlement to an “equity cure”. Typically a breach of a financial covenant is considered to be so serious by the lenders that it results in an immediate event of default. In recent years it has become common for borrowers to be allowed to “cure” a breach of a financial covenant by the PE fund injecting equity or deeply subordinated debt. This right to cure is not unlimited and typically can only be exercised a few times during the life of the loan and not on consecutive testing dates.

Events of default The occurrence of an event of default entitles the lenders to accelerate the loan, demand repayment and enforce the guarantees and security they have. These events are clearly very serious and include: (a) (b) (c)

non-payment under the finance documents; breach of the financial covenants; breach of other obligations in the finance documents (in some cases, where capable of being remedied, a short “grace

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period” will be given before the breach becomes an event of default); (d) breach of representations (again, possibly with a grace period); (e) cross-default subject to a de minimis exception; (f) insolvency related matters; (g) unlawfulness or unenforceability of the finance documents; (h) cessation of business; (i) material adverse audit qualification; (j) repudiation of the finance documents; and (k) MAC clause (i.e. if there is a material adverse change in the business of the group taken as a whole).

Clean up Although the PE house will have conducted a thorough due diligence exercise and have spoken to Target management before committing to make the acquisition, it will not have full exposure to the business until the acquisition is completed and it is able to send its own officers in to examine the business from the inside. This is even more true where Target is a publicly listed company, as the extent to which information concerning the business can be disclosed to a bidder whilst the company is listed and it’s shares traded is very constrained. Consequently, the borrower usually negotiates a short period (around 90 days) after closing where a breach of a representation or covenant insofar as it is caused by the Target does not trigger an event of default or a drawstop. There will be conditions to this relaxation, including that it will not apply to certain events, that the breach must be capable of being remedied, that steps are being taken to remedy the breach and that it does not have a material adverse effect on the group as a whole.

Conditions precedent Conditions precedent fall into two general categories: documentary conditions precedent and event conditions precedent. The documentary conditions precedent need to be satisfied before the first drawing is made, whilst the event conditions precedent need to be satisfied before each drawing. Documentary conditions precedent include the facility agent being satisfied with:

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corporate resolutions of the borrower; the acquisition documents; the due diligence reports; the group structure; the tax structure paper (setting out how the acquisition will be effected and the tax consequences); agreed base case model; latest financial reports; “know your customer” checks; and legal opinions.

Event conditions precedent include the accuracy of the representations and warranties and the absence of any default.

Conditions subsequent It will not always be practicable for guarantors to accede to the finance documents before closing (as they will comprise Target group companies who will be unwilling to commit until they have been acquired on completion) and consequently there will be a series of conditions subsequent relating to the participation of these companies in the finance documents. There will be a grace period for these steps to happen (typically 90 days but possibly longer depending on the nature of the group and the jurisdictions involved). 13.4.2

Mezzanine debt

Mezzanine debt ranks behind senior debt on enforcement, both in terms of repayment and in terms of security. As a result, it attracts a higher rate of interest. The terms of the mezzanine facility agreement are very similar to the terms of the senior credit agreement and the security is identical (typically contained in the same document and held on behalf of the mezzanine lenders by the same security trustee). The subordination of the mezzanine debt is contained in the intercreditor deed (see 13.5 below). The main differences between the terms of the senior debt and the mezzanine debt are as described below.

13.4.2.1 Purpose The mezzanine debt is purely term debt provided for the purpose of the acquisition. It is drawn in one instalment at closing of the acquisition.

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13.4.2.2 Borrower Typically there is just one borrower, Bidco. The senior lenders would be reluctant to allow the mezzanine banks to lend direct to operating companies (even if part of the mezzanine debt is to be used to refinance existing debt in the Target group) as this would mean that the mezzanine banks would be structurally on a par (or ahead of) the senior lenders. 13.4.2.3 Term Reflecting its subordinated status, the mezzanine debt matures later than the last tranche of the senior debt (generally 6–12 months later). It is repayable in one bullet instalment (i.e. no amortisation).

13.4.2.4 Interest The margin commonly comprises two elements: a cash pay element and a PIK element (roughly equal in amounts). The cash pay element is paid at the end of each interest period whereas the PIK element is rolled up and added to the principal amount of the loan (and so attracts interest itself). The PIK element is only finally paid out when the loan is repaid. 13.4.2.5 Prepayment Prepayment of all or any part of the mezzanine debt within a certain period from signing will result in the payment of a prepayment premium. How much depends on market conditions, but it will generally be a higher percentage if prepayment occurs earlier in the term of the facility.

Prepayment premia would not normally be required on mandatory prepayments (apart from for change of control or on an IPO) or a voluntary prepayment of just one bank (e.g. on yank the bank; if prepayment rather than transfer is allowed in this instance).

13.4.2.6 Financial covenants With the exception of the cash-flow covenant, there is usually extra headroom under the financial covenants in the mezzanine facility agreement to ensure that the senior debt covenants are tripped first (and so to avoid the mezzanine being able to hold the senior lenders to ransom).

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13.4.2.7 Board observer rights Mezzanine lenders occasionally ask for board observer rights that would give them the right to have one of their officers sit in on board meetings but without the right to speak or vote. Borrowers are against this for the reason that they do not necessarily want to air their problems to the mezzanine lenders before discussing them amongst themselves. It is not common for such observer rights to be given.

13.4.2.8 Warrants In broad terms as part of the cost of obtaining mezzanine debt, a borrower might be required to give warrants to the mezzanine lenders. These allow the mezzanine lenders to subscribe for shares in the borrower at a predetermined price upon certain trigger events occurring (such as a change of control, a sale or an IPO). The warrant instrument would contain tag-along rights, which would provide that if the investors are selling the shares in the borrower to a third party, the mezzanine lenders have the right to have their shares purchased at the same price. In summary, warrants give the mezzanine lenders the opportunity to participate in the equity of the borrower and in the equity returns of the investors. The percentage of shares in which they could invest would be set at the time of signing the agreement and might contain elaborate adjustment mechanics to cater for additional issues of shares to the investors or the creation of new classes of shares with different voting or economic rights.

Inevitably, this potential dilution of the equity interests of the investors is not attractive to them and is resisted. 13.4.3

Investor debt

As mentioned above, often there are tax advantages for investors if they advance their part of the acquisition funds in the form of investor debt. As also mentioned above, the investor debt will be advances to an intermediate Holdco.

The investor debt will provide that it is long term in nature and that interest payments can be capitalised and added to the principal amount of the loan rather than cash paid (for the reason that the senior and mezzanine lenders will restrict the ability of the Bidco to

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pay dividends or make payments to the intermediate Holdco as long as they are outstanding and, consequently, there will be no funds to meet any cash payments to the investors). What rate of interest accrues on the investor debt will be a factor of the return ultimately required and the tax effect on both the intermediate Holdco and the investors. Provided neither senior lenders not mezzanine lenders have any credit exposure to the intermediate Holdco, it should not be necessary for the investors to be party to any intercreditor agreement with the lenders subordinating their claims. 13.4.4

Vendor debt

Occasionally the seller of the Target group may agree to reinvest part of the sale proceeds or to leave some of the purchase price outstanding in the form of vendor debt.

This will usually be treated as akin to investor debt by the commercial lenders, that is, it will be subordinated (structurally and, if necessary, contractually) to their debt. However, on occasions, the vendor may insist on being treated as an arm’s-length third-party lender. How this debate concludes depends on the market and respective negotiating powers, but it will in all but the most exceptional cases be subordinated to the lender debt.

As between the investors and the seller, the terms of the vendor debt will be a matter for negotiation though the vendor debt is likely to rank ahead of and be repayable before any investor debt and before payment of any dividends to the investors. The vendor debt will most probably be unsecured (but if secured, it will not be secured at the same level as the commercial lenders) and interest payments will roll up in the same way as (and for the same reasons as) for investor debt.

13.4.5

High-yield debt

Although high-yield debt (“HYD”) has fallen out of favour since the credit crunch, this is likely to be only a temporary phenomenon and it is anticipated that it will re-establish itself as an important part of the funding structure for larger acquisitions.

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HYD emerged from the US where it was a common feature of most sizeable acquisitions. In Europe, however, HYD was really only seen in the larger acquisitions. This difference probably reflects the different maturity and depth of the two markets.

HYD has two significant attractions for the funds by whom it is provided: it is long term in nature (typically more than 10 years) and it attracts a higher interest rate than can be earned on most other debt instruments. The instrument is typically listed and is rated, so in theory (and in an orderly market) it is easily tradeable. These factors combined to make HYD extremely popular with large institutional funds who were keen to allocate significant amounts of capital to HYD. In turn, this means that, in normal market conditions, HYD is an easily accessible source of funding for borrowers. The key features of HYD are: (a)

Subordinated: HYD is subordinated to senior and mezzanine debt, usually both structurally and contractually. In the structure considered here, it would be lent in at an intermediate Holdco level and on-lent by the intermediate Holdco to the Bidco. (b) Collateral: HYD traditionally has limited collateral rights. Typically, it might have first-ranking security over the shares in the borrower of the HYD and second-ranking security (behind the senior and mezzanine lenders) in the on-loan to the Bidco of the HYD proceeds but no more. Recently, however, it has become more common for the holders of the HYD to benefit from at least part of the guarantees and security given to the senior and mezzanine lenders. Where this happens, it will be clear that the rights of the HYD holders (both to enforce and on recovery following enforcement) rank behind those of the senior lenders. (c) Repayment and prepayment: repayment is in a bullet at the end of the term of the HYD. Prepayment is allowed but subject to a make-whole payment in respect of future interest payments. (d) Interest payments: the interest periods are set at the time of the issue of the HYD and are generally quarterly. Interest is expected to be kept current and provision will need to be made for payments to be made by Bidco to the intermediate Holdco to service the HYD. There will be a prohibition in the HYD

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(e)

documents on any “burdensome covenant” under any other agreement that restricts the payment of dividends or upstream loans such that the HYD interest payments might be threatened. Interest is generally charged at a fixed rate. Covenants: HYD covenants will be more relaxed than covenants contained in the senior debt for a combination of the following reasons. The rate of return received by HYD holders is higher than the lenders of the senior debt, so it is appropriate that they take greater risk and have less control.

(f)

Whilst HYD holders are keen to receive information about the credit and to ensure that the rating (and value) of their investment is not under threat, they do not play as active a role in the day-to-day monitoring of the business of the borrower as the senior lenders. Their function is one of investor, and they do not necessarily have the same interest as the senior lenders in building a long-term relationship with the borrower. Consequently, should it be necessary for the borrower to seek a waiver or amendment from the HYD holders, it is likely that they will see this as an opportunity to get more return by requiring a “consent fee”. Naturally, the borrower wants to limit the occasions it might need to approach the HYD holders and for this reasons seeks less-restrictive terms. This is not reflected in the fact that there are few pure negative covenants (absolutely prohibiting actions) but instead a series of “incurrence” covenants that allow, for example, the incurrence of new financial indebtedness or security provided certain financial covenant tests can be met both before and after the new financial indebtedness or security is incurred. Rated and listed: the pricing of HYD and its attraction to the market will depend on what long-term debt rating is given to it by the institutional rating agencies. The rating agencies continue to monitor the debt throughout its life and this will affect the marketability of the investment.

Listing the HYD adds to its marketability and attraction (and hence may result in cheaper rates). However, to maintain a listing a high degree of information must be published on a regular basis and this can add considerably to the cost and burden of

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HYD (especially as the reporting may extend to guarantors) and potential liability for the issuer, its management and advisers.

13.4.6

Bridge financing

As explained above, bridge financing covers the period between when funding is needed to complete the acquisition and when it is possible to effect an HYD issue (the proceeds of the HYD issue would be used to repay the bridge financing). The borrower under the bridge financing is likely to be the same person as the ultimate issuer of the HYD, whilst the lenders will be the banks who agree to arrange and underwrite the HYD issue. The bridge financing is likely to benefit from the same level of collateral as is proposed for the HYD.

The borrower will be incentivised to take out the bridge with the HYD at the earliest opportunity by periodic increases in the margin charged under the bridge: the longer it remains outstanding, the more expensive it gets, up to a capped amount. Fees are paid for arranging the bridge. Fees are also payable to the arrangers of the HYD, but these are offset against the fees paid under the bridge. Again, to encourage the borrower to take out the bridge as soon as possible, the rebate on the HYD arrangement fees reduces as time passes. In the event that the bridge is not replaced by HYD after a period of time, the arrangers can call for the replacement of the bridge with HYD and, if they do not call within a certain period of the bridge being drawn (generally 12 months), the bridge financing will convert to permanent financing at the higher margin. The bridge financing terms may be more relaxed than the senior facilities (and the borrower will want them to be akin to those for the HYD), but it is not unusual for de minimis carve-outs for the covenants to be tighter, given the shorter-term nature of the borrowing.

13.5

The intercreditor deed

The various rankings of the different creditors of the group are addressed by structural subordination in some instances but also by each creditor signing up to an “intercreditor deed”.

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The parties to this contractual arrangement will include each borrower as well as each creditor. As it is likely that there will be intra-group loans, each member of the group will also participate in the intercreditor arrangement by agreeing that, on acceleration of the institutional debt, their claims against their fellow group companies will be subordinated to the claims of the institutional lenders and that they will not take any steps to accelerate or enforce any of their intragroup debt as long as the prior ranking debt remains outstanding.

The intercreditor deed is structured as a series of double protection covenants: the most junior creditor will covenant that, for example, it will not take any security and will not demand repayment of its debt as long as the more senior debt is outstanding, and the relevant borrower will covenant that it will not give such security or make such payment. This is repeated in respect of each creditor. There are a few provisions of interest, including: (a)

(b)

(c)

There will be a limit on the amount of additional senior debt that can be incurred by the borrower without the consent of the junior lenders: the more senior debt is incurred, the less likely it is that the junior creditors will be paid out in full on an insolvency. The junior creditors agree certain “standstill periods” during which, even if there is an event of default under their own instrument, they cannot enforce if more senior debt is still outstanding. However, the lenders under the senior debt cannot simply stand by and take no action, so prejudicing the junior creditors. To protect against this risk, it is agreed that after the expiry of the standstill period, the junior creditors can commence enforcement. This provision is often called “fish or cut bait”. Frequently, senior creditors can require junior creditors to release any collateral they have or claims they have against the borrower group (though their debt remains to be settled) as this may be the only way that the senior creditors can maximise the value of the borrower group on enforcement (the value would be much less if the borrower group were to be sold subject to that debt and security remaining in place). This can be contentious and it is not unusual for junior creditors to agree to this only if an investment bank has certified that fair value is

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being obtained and it is necessary to realise the full value of the group. One additional point to note here is that if the junior creditors have actual claims outstanding against the company being sold on enforcement by the senior creditors, the release of those claims may crystallise a tax gain in the released company (which again may depress its price). (d) On enforcement, the security trustee need have regard only to the instructions of the senior lenders until they are paid out in full, then the trustee has regard to the directions of the next most senior creditor, and so on. (e) The intercreditor deed will contain various protections for the security trustee and will also contain the provisions constituting the security trust. (f) “Turnover trust” terms will be included such that if a junior creditor receives a payment that it should not have received, it agrees to hold that receipt on trust for and pay it over to the senior creditors.

13.6

Guarantees and security

Lenders of senior debt expect to get the greatest possible level of guarantees and security from the borrower group. In practice there may be a number of companies in the group that are just too small to merit the cost of taking guarantees or security and consequently the lenders usually agree that they may be excluded: a test of 2.5 per cent to 5.0 per cent of the group’s EBITDA, revenue or gross assets is a common threshold for this purpose, provided the banks get in aggregate from all such companies at least 75–85 per cent of the group’s EBITDA, revenue and gross assets. Compliance with these ratios is generally tested annually.

However, there are significant legal and fiscal constraints in a number of jurisdictions on the giving of “upstream” and “cross guarantees” (i.e. guarantees by subsidiaries of their parent’s debt and guarantees by one company of its sister company’s debt) and security supporting those guarantees. Such constraints include: (a)

Financial assistance for the acquisition of a company’s own shares or those of its parent. For example, if the Target was to

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give a guarantee or security for the debt incurred by Bidco to buy shares in the Target. In most European countries this is prohibited (sometimes it is illegal) or subject to limitations on the amount that can be guaranteed. The effect of a breach can vary: it will almost invariably result in civil liability for the directors of the company giving the guarantee/security, but it may also be unlawful (i.e. a criminal offence) for the directors and the company giving the guarantee. Importantly for the lending banks, the guarantee and security may be unenforceable. (b) Corporate benefit. Typically in European jurisdictions guarantees and security can only be given if there is real corporate benefit for the company giving the collateral. In establishing whether there is corporate benefit, the interests of the individual company are often considered in isolation from the interests of the group as a whole. Corporate interest could be demonstrated, for example, in respect of the guarantee given for the debt of the Bidco to the extent that such debt is intended to be on-lent to the guaranteeing company (e.g. to refinance existing debt on better terms or to fund working capital needs). In the absence of corporate benefit, the amount that can be guaranteed is typically limited to the amount of distributable reserves or such amount as would mean the company would be able to pay all of its other creditors and avoid insolvency. (c) Tax. Giving collateral can result in adverse tax treatment in certain jurisdictions and this should be considered early on in the negotiations. (d) General. It is important to agree, at an early stage in the negotiations, the principles on which security is to be taken.

In some jurisdictions the cost of taking security can almost outweigh any advantage to the lenders, leaving the professionals that put it in place or the local tax authorities as the only true beneficiaries. By way of example, in some countries security attracts a tax based on the value of the asset or even the amount of debt that is being secured. In many jurisdictions the security needs to be notarised and in some countries this can be very expensive.

Equally, whilst effecting the security may in itself be relatively cheap, the costs of perfecting it by registration can be costly (e.g. if it is necessary to register the IP security around the world).

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Commercially, the steps needed to perfect security may not be acceptable. For example, to perfect a security assignment of a contract it may be necessary to give notice to the borrower’s counterparty. If the contract is sensitive, or if there are a series of contracts with customers who may not understand the reason for the notice, this could be detrimental to the business. In some instances, assignment or giving security over the contract may be prohibited by the terms of the contract or could lead to a breach, so jeopardising the existence of a valuable arrangement. Bank accounts are particularly tricky, as the only way to obtain the best form of security over them is to ensure that monies cannot be paid out of them without the express approval of the security trustee on a case-by-case basis. This is clearly impractical if the account is an operating account. All of these matters need to be negotiated and resolved ahead of signing the loan document.

One final observation on security is that in most jurisdictions it is subject to “hardening periods”. This means that if the grantor of the security becomes insolvent within a certain period of granting the security (a period that can vary from months to years depending on the jurisdiction), there is a risk that the security can be set aside. The circumstances in which this may happen and the possible defences are beyond the scope of this chapter.

13.7

Upstream and cross-company loans

The main borrower, Bidco, will be a special purpose vehicle with no independent revenue generating business. How, then, is it able to meet its interest and principal payment obligations?

A proportion of its debt service requirements may be met by the Target companies paying dividends to Bidco. However, this is not a secure arrangement as it depends on each company in the chain through which the dividends flow having distributable reserves. If one company has a significant realised loss, that may act as a “dividend block” and prevent the funds moving further to Bidco.

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To cater for Bidco’s debt service requirements, it is common for the cashgenerative operating companies to lend money up to Bidco as and when required. The arrangement is usually documented in a short intra-group loan agreement. There are a few points to bear in mind here: (a) (b) (c)

13.8

this arrangement may amount to financial assistance (see above); it may be necessary to demonstrate real corporate benefit for the lending company (which will not receive any repayment until after all institutional debt is repaid); and the lending company will be expected to accede to the intercreditor deed to subordinate its claim against Bidco to the claims of the institutional lenders.

Certain funds

Where a company is bidding for a listed public company in the UK and intends to purchase the target shares for cash, the bidder’s financial adviser has to issue what is known as a “cash confirmation”; that is, a confirmation that the funding is available. If the financial adviser is reckless in making that statement, it can be required to provide the funding itself. For this reason, in the context of the acquisition of a public company in the UK, it is the norm for all financing documents to be fully negotiated and executed before an announcement of the offer is made. As described above, however, a drawing under a loan agreement is subject to both documentary and event conditions precedent. If any of these conditions precedent is not satisfied, the drawing cannot be made and the funding would not be available. Accordingly, the practice has evolved in UK public bid financings to limit the number of conditions precedent that need to be satisfied.

The documentary conditions precedent will not be limited, but it will be necessary for them either to be satisfied by the time the credit agreement is signed (e.g. for the lenders to acknowledge that they are satisfied with the accounts, the base case model, the reports, all due diligence, the acquisition agreements etc.) or for those documents to be entirely within the control of the borrower (e.g. corporate resolutions).

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However, the event conditions precedent will be considerably more limited in scope. In particular, the only defaults that will act as a drawstop will be: (a)

non-payment under the finance documents (comfort can be taken that until drawdown to fund the acquisition has occurred, no payments will be due under the finance documents in any event); (b) breach of certain “building blocks” representations; (c) breach of “certain funds covenants”; (d) insolvency and creditor’s process in respect of the borrower (but comfort can be taken that the borrower is a newly formed SPV – these events of default are not typically triggered by the insolvency of the Target; (e) illegality; and (f) repudiation of the finance documents. The building blocks representations, breach of which would act as a drawstop, are those that relate to the capacity of the borrower (not Target), due authorisation, legality, enforceability and non-conflict. The certain funds covenants are core elements such as no unauthorised acquisitions or disposals, no unauthorised financial indebtedness or security, and no waivers of any conditions precedent under the acquisition agreement or the offer document unless the interests of the banks are not prejudiced or unless required by law or a regulator (including the Takeover Panel). Taking into consideration that the borrower is a newly formed SPV, few of these should present concerns for it or its financial adviser. Although the practice of ensuring “certain funds” as described above began with public bid financing, it soon moved to the highly competitive PE acquisition market. Absent certain funds in their financing, a PE house would have to take the risk that it might have to fund the acquisition itself if financing could not be found or to include the obtaining of bank funding as a condition to its bid. Such conditionality would clearly put it at a disadvantage to other bidders who may have their funding in place and, as a consequence, certain funds financing for private acquisitions became commonplace. As most large European financings are documented under English law or syndicated through London, banks familiar with the practice on

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public bid financings were generally willing to extend the practice to European private acquisition financings. However, in the US there is no requirement for a cash confirmation on a public bid, so lenders there were less familiar with and accepting of certain funds financing. Nonetheless, the practice in the US is moving towards that of Europe, and the “Sungard” provisions adopted there are not too dissimilar from the European standard.

13.9

Order of events

Pulling all the above together, a typical PE financing would play out in the following way: (a)

(b)

(c)

(d) (e) (f)

(g)

PE houses engage their advisers to consider the possible structure for the acquisition and the likely funding structure. After an appropriate tax structure has been prepared and stress tested for the anticipated financing and after satisfactory results have been obtained from the initial due diligence exercise, the PE houses approach their relationship banks with an outline of the transaction and possibly (if sufficiently advanced) a draft tax structure paper. The banks react with a brief summary outline of key economic and structure terms. The PE houses respond with their counter proposal. The counter proposal is considered and revised terms are submitted by the banks. Depending on how diverse the banks’ individual proposals are, the PE houses may decide to drop one of the banks at this stage or, more likely, keep all in the running. Commitment papers (i.e. the commitment letter and the term sheet outlining the financing terms) are prepared. The larger PE houses typically ask their lawyers to prepare these documents based on the PE houses’ form with which the banks will be familiar. This helps the PE houses compare the terms ultimately offered by the banks and reduces the amount of work, time and costs in doing so. Commitment papers vary in detail, but most are quite exhaustive running in some cases to between 70 and 100 pages so as to ensure that before a bank is appointed as arranger, as many of the financing terms as possible (and

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(h)

(i) (j)

(k)

certainly all of the key terms) have been agreed. Before the credit crunch it was not unheard of for PE houses to be prepared to sign acquisition agreements before the full financing documents were in place (again because of the competitive nature of the market and the speed with which deals “needed” to be executed) and for this reason, they required as much uncertainty to be taken out of the financing terms as possible. Since the credit crunch, it is not so clear that PE houses will be prepared to be as confident, especially in the light of the Clear Channel case in the US where a disagreement between the banks and the borrower as to what was required by the commitment papers led to litigation and ultimately a change in the underlying transaction. If certain funds are required, it is important to ensure that there is no business or market MAC in the commitment papers – again, the US case of Solutia made for interesting reading as to the different parties’ interpretation of what constituted a market MAC, but either way, it would not be acceptable in an English public bid financing. There will follow a series of negotiations over the terms of the commitment papers with those banks still in the running. Ultimately, the PE House will most probably negotiate terms with just one bank (which will be appointed lead arranger) and suggest that the other banks combine as Co-Arrangers and adopt the negotiated terms. In tandem with these steps, the banks will receive iterations of the due diligence reports, the tax structure paper and possibly the PE houses’ financial model. Commitment papers will then be signed along with a separate fee letter setting out the fees that the arrangers and the facility agent are to receive and, if there is an HYD, an engagement letter appointing the relevant banks as HYD arrangers. If the PE houses intend to commit to the acquisition at this stage, the banks will be asked to confirm that they are satisfied with the results of the diligence, the reports and the model, and that those conditions precedent can be treated as satisfied. Ideally, all other conditions precedent should by now be in the PE houses’ control. After execution of the commitment papers, work will begin in earnest on the underlying financing documents described at (c)–(e) above. Important parallel processes need to be

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progressed in respect of the conditions precedent and security documents, especially in other jurisdictions. The coordination of these parallel processes can be a full-time job for more than one person. (l) Ultimately, the core documents will be executed: the credit agreements (senior, mezzanine, bridge etc.), the intercreditor deed, any warrant instrument, hedging side letters (setting out the terms on which the hedging will be implemented), a composite security document from Bidco and a charge over the shares in Bidco. (m) Final conditions precedent in the PE houses’ control are satisfied and investor funding is put in place. Funds flow to a central account in the facility agent’s control (ideally both PE houses and sellers will use the same bank as this speeds the movement of funds). The complexity and time that this step takes should not be underestimated: it can take some hours for funds to move, especially if funding is required in more than one currency or is to cross borders. It is often a source of eleventhhour frustration. (n) As soon as completion of the acquisition has occurred, steps will be taken to perfect the security that the lenders have taken over the shares in the Target. At this stage, that may be all the security that the banks can get in respect of the Target. Nonetheless, the focus of attention will now be in executing the full security package, including following the whitewash procedure in the UK. Typically, there is a grace period of around 90 days to put in place all agreed security, although there is an obligation to do this as soon as possible. (o) At the same time, the arrangers will begin syndication. It is possible that this process will have begun before, but if a company whose shares were listed was the Target, there will be a limit on the amount of information that can have been disclosed before the acquisition closed. The borrower and Target group will assist the arrangers through the preparation of a detailed information memorandum describing the business and giving financial information and projections and participating in roadshows. (p) At the same time, if there is to be an HYD issue, work will begin on the preparation of an offering memorandum and briefing rating agencies on the business and the nature of the debt.

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(q)

(r)

(s) (t)

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If the arrangers are finding it difficult to sell the bank debt, they may exercise certain rights to “flex” the terms of the debt which they will have agreed in their fee letter. There are a number of different types of flex, both pricing and structural. These might include: increasing the margin, re-allocating part of the senior debt to the mezzanine debt, increasing the prepayment premium on the mezzanine, charging an additional up-front fee (sometimes portrayed as original issue discount) or setting a LIBOR floor on any US dollar borrowings (i.e. a provision that says LIBOR can never fall below, say, 3 per cent for the purposes of calculating the interest). The flex provisions at the height of the borrower-dominant market were generally restricted to a margin increase of around 25 bps, but since the credit crunch all of the above have been seen (in some cases at the same time). Conversely, if the loan is selling well, the arrangers may be able to cheapen its terms (so-called “reverse flexing”). Within three months of closing, or on successful syndication if earlier, the hedging will be put in place. Ultimately, the HYD offering memorandum will be issued in preliminary form to potential investors, it will be marketed through a series of roadshows and priced according to demand.

13.10

Exit

13.10.1

Sale to a third party

13.10.2

IPO

There are a number of ways in which the PE house might exit its investment, but all will almost always result in repayment of the third-party institutional debt: Typical exit scenarios include the following. This will constitute a change of control which will (except in very special cases) trigger mandatory prepayment. Again, an IPO will trigger mandatory prepayment. If the IPO does not lead to a change of control (so there is only a partial flotation), mandatory prepayment of the third-party debt may only be required

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in part by its terms. However, the terms of a leveraged financing used for the original PE acquisition will be so significantly different to those terms that a listed company would expect, that a full refinancing is most probable.

13.11

13.11.1

Refinancing

Background

In a stable credit environment it is common for the financing written for the original acquisition to be replaced before its scheduled final maturity date. There are three main reasons why this might be attractive to the borrower and/or the PE houses: (a)

(b) (c)

Changes in the credit markets making more attractive financing terms available. Changes in the risk profile of the borrower and Target group (e.g. as a result of an IPO – see above) making more attractive financing terms available. To enable the PE houses to recoup part of their investment (by funding a repayment of investor debt, a reduction of share capital or some other form of distribution). This form of refinancing will lead to an increased debt burden for the borrower as the investor funding would most probably not have required cash payments nor have been secured, whereas any incremental refinancing debt will need to be serviced on a current basis and be secured. Consequently, a refinancing to enable a potential investor exit is unlikely to be available unless the borrower and Target group business has increased in strength since the original acquisition such that it can readily support the increased debt burden.

13.11.2

Forms of refinancing

If the purpose of the refinancing is simply to achieve more favourable terms, it may be possible to structure this not as a new refinancing but as a series of amendments to the existing financing. The advantage of this approach is that it is likely to be cheaper (both in terms of bank fees (see 13.11.3 below) and legal documentation fees) and may mean that the collateral package (guarantees and security) does not need to

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be replaced, so triggering the start of new hardening periods (see above), even though it may as a minimum need to reaffirmed.

The practical difficulty with implementing new terms through amendments is that it requires, at the very minimum, the majority lenders to approve those changes, and for some changes all lender approval is required. Notably, if any change is being proposed that reduces the amount a lender might receive (e.g. a reduction in its margin), all lender consent will be required. This can typically be very difficult to obtain in a syndicated financing and gives the opportunity for lender “hold-out” or ransom. 13.11.3

Key elements of the refinancing

A refinancing is a new financing, replacing all or a significant proportion of the original acquisition financing, most components of which will severely restrict the ability to incur new indebtedness (even if replacing existing borrowings) or any incremental debt. Although it may be possible to acquire the consent of the requisite majority of lenders of senior debt to approve the incurrence of additional debt, the more lowly ranking lenders may be less incentivised to approve additional debt that ranks ahead of their own claims. The one exception of this is the high-yield debt: it is not uncommon for such instruments to allow the additional borrowings provided certain ratio-based incurrence tests can be met. The refinancing will have many of the same features as the original acquisition financing (though of course not all are now relevant). The main areas for discussion will be: (a)

(b)

Fees: whilst a new arrangement fee is likely to be charged, the borrower will argue for a much smaller arrangement fee on the basis that the credit profile of the borrower is better and the existing syndicate of lenders knows it well so it should be less difficult to syndicate. Prepayment premia: as mentioned above, fees are typically payable on certain components of debt if it is prepaid within a certain period of time. This is most costly if HYD is to be prepaid and often it may be cheaper to tender for the notes and/or to defease (payment or covenant).

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(c)

Hedging break costs: any hedging that has been implemented may terminate if the underlying debt is repaid. This can be avoided if all are willing to roll over the hedging. However, it should not be forgotten that the borrower may be “in the money” on the hedging and so it may be to its financial advantage to close-out (though not necessarily if it has to replace the hedging for the new financing). (d) Debt structure: the complexity of the debt structure will depend on the size of the new financing and the liquidity of the credit markets. The borrower will want it to be as simple and with as few tiers of debt as possible, but how far the lenders can go to achieving this depends on the level of leverage. In the larger financings, it is more likely that HYD would play a central role both because of its more relaxed covenants and its longer duration, though this has to be balanced with its cost. (e) Diligence: the need for new (or “bring-down”) diligence should depend on the size of the financing, whether the lenders are likely to be substantially new to the borrower or to know its business, and how much time has passed since the original financing. The borrower will argue that detailed diligence is no longer necessary and that the lenders should not get this as the borrower itself is not requiring it (unlike at the original financing). This argument has less strength when a publicly traded HYD instrument is to be issued as that will require a very detailed and carefully prepared offering memorandum which in turn may necessitate such diligence. (f) General terms: arguing that the credit is now stronger, the borrower will want more relaxed business terms and baskets, in particular on: (i) (ii) (iii) (iv) (v)

(vi)

mandatory prepayment from excess cash flow; ability to make acquisitions and disposals; ability to incur financial indebtedness; ability to make loans and guarantees to other companies in the group outside the collateral net; ability to make restricted payments (obviously if the refinancing is in connection with an IPO, the borrower will want the ability to pay the same level of dividends); the level of monitoring information and meetings that need to be made available to the lenders.

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Guarantees and security: if the credit is now stronger, the borrower may want to give fewer guarantees and less security to ensure greater business flexibility. Whether this is achievable will depend on the leverage level and the willingness of the credit markets. New guarantees and security given in connection with a refinancing suffer from substantially the same constraints as have been described above in connection with the original financing, including issues of financial assistance which can often apply if the collateral supports debt that refinances funds used to acquire shares in the guarantor/charger or its parent company.

13.12

Conclusion

The topic of debt funding for private equity acquisitions is fascinating and dynamic. The adviser’s role is to know as much about what is happening in the market and past and present trends as it is to be able to advise on the specifics of their discipline. This experience and knowledge will give the adviser one of the most valuable tools for debt financing: an understanding of what is important. With that comes flexibility and the ability to seek sensible solutions for novel issues that constantly emerge.

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