A Practical Guide to Private Equity Transactions

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167

Loan note instrument

Whilst on the face of the instrument the principal sum outstanding under the

loan notes may become repayable in particular circumstances, the intercredi-

tor agreement will usually prohibit the investors from enforcing any rights to

demand such repayment, at the very least until a standstill time period (typi-

cally, between 90 and 180 days) has expired, or more often until all prior-

ranking debt has been repaid.

6.4 Transfer of notes

Loan notes are usually transferred simply by the completion of a stock transfer

form for the securities, as for shares. A transferee of the loan notes may be

required to adhere to the investment agreement, and will almost invariably be

required to adhere to the intercreditor agreement with the bank funders.

Loan notes are freely transferable unless the instrument or some other

agreement restricts or prohibits transfer. In a private equity context, the trans-

fer of loan notes is often limited by the instrument. A typical restriction would

be that the holder may only transfer notes to someone to whom it could transfer

investor shares as a permitted transfer without pre-emption rights applying

under the articles of association of Newco.

Formal stapling is sometimes also seen, so that the loan notes may only be

transferred alongside the accompanying shares, and in the same overall pro-

portions. However, this can lead to adverse tax consequences, as it can result

in the interest on the loan notes being treated as a distribution for tax purposes,

and therefore not tax deductible for the issuer of the note.

It is partly to over-

come this issue that it is common to have more than one Newco in the deal

structure. This then allows the investor loan notes to be stapled to shares in

a company which is different to the company which issues the loan notes, as

it is widely considered that such stapling does not result in the interest being

treated as a distribution for tax purposes.

6.5 Changes to the loan note instrument and consents

Where the consent of the note holders is required to a particular matter under

the instrument, a threshold will normally be set based on a proportion of the

principal amount of loan notes in issue (usually 75 per cent), such that a consent

at or above that threshold will bind all note holders. Typically, this requires a

written consent at the relevant level, or consent being obtained from such pro-

portion of the note holders by way of votes at a meeting of the note holders.

If a meeting is contemplated, the instrument will normally set out the notice,

quorum and voting requirements for such a note holder meeting, which are

largely similar to the provisions typically included in a company’s articles of

association for shareholder meetings.

54 See section 209(2)(e)(vi) of the Income and Corporation Taxes Act 1988.

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Equity documentation

The most common reason for a consent to be sought is for a change in the

terms of the instrument, for example to agree to a rescheduling of the principal

sum or the reduction or deferral of interest payments as part of a restructuring

in the event of underperformance.

7 Conclusion

We have seen in this chapter that the investment agreement and the articles

set out the principal contractual relations between the investors on the one

hand, and Newco and the managers on the other. Clearly, other documents are

also relevant (most obviously the loan note instrument and related intercredi-

tor documents, and the service agreements entered into by the managers), but

these two documents set out the core terms agreed between the shareholders,

and are designed to regulate in advance some of the situations which experi-

ence shows will often arise during the life of an investment. These documents

also anticipate likely exit scenarios for the investment, and seek to provide

appropriate protections and mechanisms to deal with them. Chapters 11 and

13 touch upon how the provisions in the investment agreement and the articles

can impact on the issues encountered during the life of the investment and on

exit, respectively.

It is worth bearing in mind, however, that there are limits on how effec-

tively these contractual arrangements can protect private equity investors and

other interested parties in every likely scenario. For example, the arrange-

ments around cessation of employment will often protect Newco and the

investors to a large extent if one or two of the managers leave (or are required

to leave), but may be of little use if there is a complete breakdown in the work-

ing relationship between the investors and the management team as a whole.

Similarly, although warranties can be important for bringing out information

(in particular in relation to the affairs of Target) and enabling Newco, backed

by private equity, to maximise its negotiating position and contractual pro-

tections against the seller(s), the investment agreement warranties will not

provide an effective remedy if there is a material problem in the future with

the investment.

The drag provides a useful mechanism to force an exit (and, in particular,

to prevent a single or small number of shareholders blocking the ability to

realise a 100 per cent exit), but the ability to drive the entire management

class into the sale is unlikely to produce a good overall nancial return for the

investors if, in practice, the managers do not co-operate with the sale process

or give warranties. Equally, the drag mechanism is of no practical use on an

IPO or similar public market exit. The absence of active co-operation from all

directors (executive and non-executive) in an IPO is show-stopping; unless,

of course, the board composition can be changed to remove any reluctant

directors.

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Conclusion

The contractual documentation can provide a sensible degree of protec-

tion but, rst and foremost, private equity is a relationship between the private

equity investors and the managers. The ability of the documentation to protect

the position of the private equity investors if they have backed the wrong busi-

ness (or the wrong team) is, in the last resort, very limited; the importance of

backing the right business, and the right team, remains critical.

170

Debt funding

1 Introduction

In this chapter, we turn to look in more detail at the debt nancing aspects

that need to be considered in the context of the acquisition of Target. We have

already seen in earlier chapters that private equity investors will, in all but a

small minority of situations, look to the debt nance markets for a signicant

proportion of the funding required to meet the purchase price of Target, and

to supply the necessary working capital facilities that will support Target’s

operations post-acquisition.

The nature and extent of debt nance packages supporting private-equity-

backed acquisitions has evolved rapidly in recent times and, it would be fair

to say, since the turn of the millennium we have already seen debt nancing

structures go more than full circle in terms of quantum, leverage, pricing and

gearing. This has been the result of a period of sustained growth in the private

equity and leveraged nance markets followed by a rather abrupt retrenchment

in the marketplace sparked by the widely reported credit crunch. As a result

(and to ensure the reader has a full understanding of what has and will shape

the nature of debt funding packages in the future), in this chapter we seek to

provide a brief overview of market trends in this nancing sector since the

early part of the new millennium, together with a short analysis of how these

trends were affected by the credit crunch which ensued in the latter part of

2007. That analysis and overview then sets the tone for (a) a more general

consideration of how the third party debt funding package may look in the

post-credit-crunch marketplace; (b) how investors might go about structuring

their debt funding requirements; (c) how the approach to banks and nancial

institutions might be made; and (d) what the core terms and conditions of the

debt facilities may look like.

To reiterate an observation that is made in chapter 3, funding struc-

tures (and therefore transaction structures) can vary depending upon the

size and/or complexity of the transaction in question. As in the rest of this

book, we have concentrated on the typical funding structures that would be

employed in connection with the acquisition of a medium-sized domestic UK

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An overview of recent history

Target

as the primary basis for discussion and analysis. However, brief details

of the alternative funding structures used during the boom period to facilitate

larger transactions is also included in section 6 below.

2 Debt ﬁnance in private equity transactions: an overview of recent history

In the second half of 2007 and throughout 2008, the UK banking sector (and,

more generally, the global banking community) found itself in the midst of one

of the worst nancial crises in recent memory sparked by (although it would be

unfair to say it was entirely as a result of) the collapse of the sub-prime lend-

ing market in America. To put that into context, in August 2007 we saw the

rst run on a major UK nancial institution (Northern Rock plc) for approxi-

mately 140 years leading to its nationalisation; to date we have seen the UK

government provide tens of billions of pounds in nancial support to bolster

the balance sheets of the big UK high street banks, and Lloyds TSB Bank plc

(now the Lloyds Banking Group plc) and the Royal Bank of Scotland plc have

been substantially nationalised through signicant injections of government

equity funding.

This book will not examine in detail the backdrop to or the reasons for this

credit crunch, although many readers will no doubt be familiar with the genesis

of the credit crunch and its effect on the global nancial services sector through

other works or the press. However, in the circumstances, it would be difcult to

launch into a meaningful examination of the debt nance options available in

the context of private equity transactions without at least providing:

(a) a brief overview of what the debt nance structures for equivalent trans-

actions looked like in the early part of the new millennium;

(b) a quick synopsis of how high levels of liquidity and an increase in bor-

rower power led to signicant changes in the way transactions were

nanced; and

nancial institutions and corporates work their way through the credit

crunch, its aftermath and (perhaps) the resulting revised approach to lev-

eraged debt nancing that will prevail for the foreseeable future.

2.1 Why seek debt ﬁnance?

Debt nance has been and will continue to be a central feature of the vast

majority of private-equity-backed acquisitions for several reasons:

(a) by introducing leverage into an acquisition structure, the absolute

equity cash element required to be funded by the investors is kept to a

minimum;

1 Say, with an enterprise value in the region of £50 million to £300 million.

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Debt funding

(b) minimising the amount of the equity investment for each transaction ena-

bles the investors to engage in more transactions and therefore increase,

diversify and balance their portfolio (with the core aim being to maxi-

mise the ultimate value of the portfolio);

on the equity funds invested when a successful exit (by sale or otation)

is achieved; and

(d) (although perhaps not at the forefront of the active considerations when

looking to make an investment but nonetheless a benet) minimising

the amount of the equity investment in a particular transaction reduces

the potential loss to the private equity rm (and its funds) in the event

that the Target fails or is ultimately divested at a lower value than that

at which it was purchased due to poor performance, to other external

circumstances affecting the sector in which the Target operates, or to the

macro-economic environment.

2.2 What was the benchmark funding package in the early part

of the new millennium?

In the early part of the new millennium, debt nance packages for mid-mar-

ket acquisitions in the UK had become quasi-standardised. Although there

would inevitably be the usual level of negotiation around specic commer-

cial and legal terms on a deal-by-deal basis, the basic parameters of what the

debt nancing would look like were broadly identiable and would typically

include the following:

(a) Senior term debt. Except perhaps in smaller transactions with a debt

requirement below approximately £30 million, this would commonly

be split into three sub-tranches (tranches A, B and C, roughly in the

ratio 60:20:20) with seven-, eight- and nine-year maturities, respectively.

Tranche A would amortise (i.e. be repayable in instalments) over the

term; tranche B would be payable in two equal lump sum instalments

after seven-and-a-half and eight years; and tranche C would be payable

in one lump sum at the end of year nine. The cost of nancing would be

calculated by reference to a margin over LIBOR

(or, for debt denomi-

nated in euros, EURIBOR

) with the margins typically ranging from

2.25 per cent to 3.5 per cent across the three tranches of senior debt, with

tranche A being the lowest-priced tranche.

2 For the meaning of internal rate of return (IRR), see chapter 1, section 3.4.

3 The British Bankers Association interest settlement rate, being a reference rate based on the

interest rates at which banks can borrow unsecured funds in the London interbank market, as

displayed on Reuters.

4 The Euro interbank offered rate, being a reference rate based on the averaged interest rates at

which banks can borrow unsecured funds in the eurozone interbank market, as displayed on

Reuters.

173

An overview of recent history

(b) Senior working capital debt. This would be available for a seven-year

period on a revolving basis to provide the ongoing working capital fund-

ing for Target operations.

For mid-market transactions where the full debt funding requirement could

not be met by sufcient senior debt appetite, the structure would also typically

include:

term debt and senior working capital debt, with a maturity extending one

year beyond the nal maturity date of the senior term debt. It would be

repayable in one lump sum instalment after all the senior term and senior

working capital debt had been repaid and discharged in full. The cost of

mezzanine nancing would also be calculated by reference to a margin

over LIBOR (or, for debt denominated in euros, EURIBOR) with the

margins typically ranging from 8 per cent to 12 per cent.

2.3 Growth market, increased liquidity and rising borrower power?

As outlined already in chapter 1, during the period from 2003 to early 2007

activity in the debt nance, corporate acquisition and private equity markets

boomed. Private equity investors were able to raise larger funds, debt liquidity

increased with new types of funder and nancial product entering the market-

place (e.g. CDOs and CLOs,

hedge funds), competition among private equity

houses for target businesses became erce and competition among nancial

institutions to win mandates to arrange, underwrite and provide the debt

nancing packages supporting leveraged acquisitions was strong.

As a consequence:

(a) Sellers were able to demand premium prices for target businesses due to

competition among private equity and, occasionally, trade bidders.

(b) Increased purchase prices were accommodated due to a greater avail-

ability of funding in a highly liquid debt market. Multiples of total debt

to Target earnings (‘leverage’) moved gradually from a range of three to

ve times to a range of anything from ve to (at least in 2006 and 2007)

potentially ten or eleven times (and, in some well-publicised cases, even

more).

funders for traditional senior and mezzanine products. In addition, new

entrants to the funding market increased appetite for: (a) the longer

maturity non-amortising tranches of senior term debt (which started

5 Collateralised debt obligation funds and collateralised loan obligation funds. These are funds

established for the purposes of investing in a broad portfolio of collateralised debt with a view

to taking a passive investment on a term basis but seeking to take advantage of superior rates

of return achievable on the underlying loan asset.

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Debt funding

to form a larger part of the senior term debt package

); (b) alternative

forms of debt funding such as ‘second lien debt’ or ‘stretch senior debt’;

and (c) various additional types of junior mezzanine debt (for example,

‘pay if you can’ mezzanine, ‘pay if you want’ mezzanine or ‘payment in

kind’ (PIK) mezzanine

). These instruments helped to plug the funding

gap between the committed equity investment and the higher purchase

prices being demanded. They also afforded bidders a greater opportun-

ity to tailor their debt packages to help reduce the burden of expensive

debt service on immediate Target cash ow generation post-acquisition.

The increased risk associated with these types of debt instrument was

offset by higher interest rate margins above cost of funding. However,

condence was high that a swift exit in a buoyant market would bring

about a full redemption together with the associated commensurate rate

of return.

(d) An ability to access greater debt funding meant that debt-to-equity ratios

(‘gearing’) increased, with investors able to keep the size of their equity

investment per deal relatively small (therefore increasing internal rates

of return on investments upon successful exits).

(e) The increasing competition over time coupled with buoyant equity mar-

kets meant that investors were condent that successful exits from their

investments could be achieved. In addition to the traditional avenues

of exit (i.e. otation or sale to a trade buyer), exits were also possible

through secondary and (in some cases) tertiary buyouts of Target by

other investors who saw opportunities to make equity returns by access-

ing larger and cheaper debt packages and growing Target revenues and

prots. They, in turn, shared a similar condence in achieving an even-

tual successful exit due to the same buoyant equity markets.

(f) Signicant returns could be made relatively quickly by investors on

investments. In some cases, this could be done pursuing a strategy of

effective renancing and re-gearing, taking advantage of increasingly

favourable funding terms; in others, by exiting early through secondary

buyout and taking advantage of the increasing competition among buy-

ers. To a degree (although not always or as a general rule), these strate-

gies could be pursued to achieve superior returns alongside or, in some

6 With the split between tranches A, B and C of the senior term debt moving gradually from

60:20:20 to, in some cases, 33⅓:33⅓:33⅓.

7 A tier of debt designed to sit in terms of priority between traditional senior and traditional

mezzanine indebtedness. This concept originated in the US market and migrated across to the

UK market around 2005.

8 These types of junior mezzanine are deeply subordinated tranches of indebtedness customar-

ily providing for: (i) accrued interest to be (in some cases at the option of the borrower) rolled

up and added to the principal amount of the loan; and (ii) a maturity for the principal plus

accrued interest falling six months beyond the nal repayment of the traditional mezzanine

facility.

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An overview of recent history

cases, in preference to the more traditional methods of creating value

highlighted in chapter 1, such as seeking cost savings, increasing market

share through investment or adopting buy-and-build strategies to create

business synergies.

2.4 The crunch point

Arguably, a funding boom in a discrete sector was always going to burst. As it

turned out, it was a funding boom in a sector other than the mergers and acqui-

sitions sector which brought about the onset of the credit crunch in August/

September 2007. The collapse of the American sub-prime mortgage market

was the rst domino to fall.

Things moved quickly in a global banking sector that is based on a high

degree of trust in the stability of other nancial institutions in the marketplace.

The collapse of the American sub-prime mortgage market led to a loss of trust

among nancial institutions. Financial institutions were not prepared to lend

to other nancial institutions as they had no immediate visibility on their level

of exposure to irrecoverable sub-prime debts and therefore, more generally, on

their nancial stability. As a consequence, the interbank market that funds and

essentially underpins global lending activity ground to a halt.

As the events unfolded over the fteen months following September 2007,

the full extent of the severity of the nancial crisis became known. During

that period, the most immediate consequences on the leveraged acquisitions

market were:

(a) Rapidly contracting liquidity. Banks were not prepared to lend to each

other, and, within themselves, nancial institutions were counting the

cost of their exposures, the level of their write-downs and the correspond-

ing impact on their own capital pool and ability to lend. Consequently,

overall levels of funding availability became very limited.

(b) Withdrawal of certain funders from the market. The credit crunch and

its immediate nancial consequences caused certain key players (such as

the main Icelandic banks, who had been very active lenders in the UK

buyout market) to withdraw from the market due to their own nancial

condition.

transaction. They either began to shy away from funding highly lever-

aged (and therefore technically higher risk) transactions, or demanded

higher pricing on the debt packages they were prepared to offer in order

to more appropriately price the risk.

(d) The debt syndication markets contracted. Even to the extent that a funder

was prepared to countenance funding a particular transaction they were

no longer prepared to underwrite the full amount of funding required.

9 See chapter 1, section 3.4.

176

Debt funding

The turmoil in the debt markets meant that they could no longer be con-

dent of reducing their exposure and transaction risk through a successful

post-completion syndication of the debt to other market participants.

(e) The appetite for some of the higher risk alternative nancing products

dwindled:

these products had become prevalent between 2003 and early

2007, but, after then, their popularity dwindled and funders retrenched

to the more traditional products.

In summary, lack of liquidity forced higher pricing, lower leverage multiples,

lower gearing and a need for investors (except for the smallest deals that could

be funded on a bilateral basis by one senior lender) to form ‘clubs’ of banks

in order to reach their desired debt funding quantum. This in turn led to more

protracted transaction processes, a longer and more difcult negotiation to

agree terms, and a higher risk of failure if one or more of the banks in the club

could not get the requisite credit approval.

2.5 So, what now?

Since 2008, the UK has been in the midst of a recession that some commenta-

tors have forecast may last for at least twenty-four months, and possibly longer.

There will no doubt be activity during this recession, but it will be muted and

at a slower pace than before with a general ight to quality. Investors will

most likely refocus on seeking investment opportunities where value can be

clearly created using the traditional methods of streamlining, lowering cost

bases, driving business synergies or perhaps adopting slower-burn buy-and-

build strategies (as well as the management of their existing investments dur-

ing such difcult times).

As for the availability of debt nance, immediate indications seem to be

that: (a) there will be a medium-term readjustment in approach to leverage

multiples and gearing; (b) pricing of debt packages will be increased to levels

that more appropriately reect the risk associated with a leveraged credit; and

structuring.

The pricing that will attach to the senior and mezzanine debt tranches in

future is very much dependent upon the amount of debt that is being provided,

the nancial strength of the Target group, the appetite among the senior and

mezzanine nance markets to invest in the particular transaction, and the pre-

vailing market and sector conditions.

Given the challenging nature of the market conditions that have prevailed

since the credit crunch, it is difcult to provide meaningful guidance as to the

pricing that may be achieved in respect of senior and mezzanine debt. The

small number of mid-market transactions that have taken place in the early

10 For example, second lien debt, junior mezzanine debt, high-yield bonds and securitisations,

as mentioned in section 2.3.