A Practical Guide to Private Equity Transactions

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177

Overview of debt funding

part of 2009 suggest that debt providers are looking for a margin of between

3 per cent and 5 per cent over cost of funds in the case of senior debt, and a

margin upwards of 15 per cent over cost of funds in the case of mezzanine

debt. These gures are necessarily only a guide, and the actual margins that

may be negotiated in the context of a particular deal will be dependent upon

many factors.

3 Overview of debt funding

3.1 Debt structures

In chapter 3, we considered the various corporate structures that are typically

employed in a mid-market leveraged buyout of a UK Target. We will use those

structures as the basis for our analysis of the potential debt funding package

that may ultimately be put in place. The level of debt funding that can be

obtained for a particular transaction will necessarily be a function of the size

of the acquisition, the perceived credit prole and nancial prospects of the

Target, the results of the nancial modelling that is prepared by the investors,

prevailing market conditions and, more generally, appetite among the bank

lending community.

As discussed in chapter 3, the deal structure for a smaller acquisition where

the bank funding comprises only senior debt can be kept relatively straightfor-

ward and the debt funding will likely be provided directly to the bid vehicle.

In situations where multiple layers of third party debt funding are required

(including mezzanine nance) it may be necessary to employ a more complex

acquisition structure so as to achieve the structural separation of the different

tiers of indebtedness.

To allow for the possibility of multiple Newcos in the

structure, this chapter will again adopt the Topco, Midco and Bidco termin-

ology used in Figure 3.4 in chapter 3 where relevant.

3.2 Scoping the debt funding requirement

First and foremost, it will be necessary to give full consideration to the type

and extent of the debt nancing that will be required both to fund the acquisi-

tion and to provide for the ongoing operational needs of the Target. This will

include some or all of the following:

(a) Term funding. Sufcient term debt will need to be available to Bidco in

order to: (a) meet the purchase consideration that is due and payable in

cash to the seller(s); (b) to pay all costs and expenses that will be incurred

by Bidco, any Midcos that feature in the eventual corporate structure and

Topco in connection with the making of the acquisition; and (c) to enable

11 See Figure 3.1 in chapter 3.

12 See Figure 3.4 in chapter 3.

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Debt funding

Bidco to repay and discharge any existing indebtedness of Target so that

it is acquired on a debt-free basis. Debt providers will almost invariably

insist that Target is taken debt-free since they will wish to avoid having

to spend time and money negotiating potentially complex intercreditor

arrangements with the incumbent nancial creditors. In addition, they

will want to ensure that the assets of Target are free from encumbrances

which may have been given in favour of such creditors so that the new

debt funding package takes the benet of full rst-ranking security over

the assets of Target. The term funding will be made available either by

way of senior facilities in its entirety, or as a combination of senior facili-

ties and mezzanine facilities.

(b) Working capital funding. Following completion of the acquisition, Target

will most likely need access to working capital to facilitate ongoing busi-

ness operations. Thought will need to be given to the currencies in which

working capital may be needed and the potential requirement for one or

more members of the wider Target group to accede to the debt f acility

documentation as borrowers, so that they can directly draw on any work-

ing capital provision. The working capital facilities will be made avail-

able under the terms of the senior facilities agreement and will usually

comprise revolving credit facilities for drawing in cash. They may also

afford Target the ability to call for the provision of bank guarantees and

letters of credit in place of cash drawings in the event that such nancial

instruments are required to be issued in favour of contract counterparties

in the ordinary course of business.

may comprise overdraft facilities, guarantee facilities, bonding facilities,

BACS facilities, credit card facilities and/or foreign exchange facilities.

The determination as to any ancillary facilities that may be required

will, by necessity, be made on a deal-by-deal basis.

(d) Capital expenditure facilities. It might be the case that Target is engaged

in a business requiring signicant immediate or short-to-medium-term

capital expenditure investment. Alternatively, the Business Plan may

involve a degree of capital expenditure investment in order to improve

operations, update or acquire and t out premises, increase production

capacity, and so on. To that end, the debt funding may need to include

specic provision for facilities to fund capital expenditure over the rst

two or possibly three years following completion of the acquisition.

(e) Future acquisition facilities. Creation of value in the Target post-acqui-

sition may be premised upon a buy-and-build strategy or an ability to

purchase other smaller complementary businesses that have been identi-

ed in order to achieve business synergies. As a result, it may be nec-

essary to consider how those potential acquisitions will be funded and

whether a specic debt funding line for future acquisitions should be

negotiated.

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Overview of debt funding

3.3 The ﬁnancing process

It is difcult to separate the debt nancing process from other aspects of the

transaction. Often, work streams will cross over each other as, to some degree,

the outcome of one work stream may impact upon others and therefore it will

be an evolving process. However, once the nature and scope of the preferred

debt nancing package has been formulated, the next step will be for the inves-

tors to approach potential funders to assess their appetite to provide nancing

at the required levels and to obtain indications as to pricing and terms.

To obtain these initial soundings from funders, the investors (or, possibly, the

seller(s), who increasingly look to secure debt funding as part of an auction proc-

ess) will prepare and circulate, against signature by the funder of a condentiality

letter, a short heads of terms together with an information memorandum which

describes the proposed transaction, gives some background information about

the nancial performance of Target, and sets out details as to the Business Plan

base case. The funders would then be requested to submit termsheets setting out

in detail the indicative terms and conditions on which they would be prepared to

provide the debt funding. Those termsheets would be negotiated, and ultimately

the funder(s) offering the most attractive terms would be selected.

During the period of boom prior to the credit crunch, a different practice

developed. Due to competition among funders being high, to some degree the

investors could dictate the terms on which they required the funding to be

provided. Consequently, in place of asking the funders to submit termsheets,

long-form detailed termsheets were prepared and submitted to the potential

funders setting out the optimum terms, conditions, pricing, covenant package

and so on required by the investors. The funders would then be invited to mark

up those provisions that they could not accept. Again, the termsheet would be

negotiated with each funder, and ultimately the funder(s) offering the most

attractive terms would be selected.

As noted in the commentary at the start of this chapter, current market

conditions and liquidity constraints mean that the balance of negotiation power

is highly likely in the short to medium term to rest with the banks.

3.4 Finance: bilateral, arrange-and-underwrite, or club?

Depending upon the amount of the desired debt nancing, it may be that

one funder is prepared to provide the debt nancing on a bilateral basis.

Consequently, for smaller mid-market acquisition transactions, it is quite often

the c ase that the full quantum of the debt funding requirement will be pro-

vided on a senior secured debt basis by one funding bank. However, this would

typically only be the case in situations where the total debt requirement does

not exceed, say, £15 million or £20 million (or possibly, in some cases, up

to £30 million), representing the levels at which banks operating in the UK

mid- market are comfortable taking and holding a debt position on their bal-

ance sheet in relation to any given mid-market leveraged buyout.

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Debt funding

For larger mid-market transactions, where the nancing requirement may be

signicantly in excess of these sums, the preferred practice for the investors would

be for one or two nancial institutions to arrange-and-underwrite the nancing

package. In other words, pursuant to the competitive tender process described

above, each potential funder would be asked to set out the terms on which it would

be willing to provide the full amount of the debt with a view to syndicating the

debt among a wider group of lenders following completion of the acquisition. From

the perspective of the investors, this approach has the advantage that, once the pre-

ferred sole or joint arranger(s) and underwriter(s) have been selected, there would

be only one or two counterparties to negotiate with in order to agree and nalise

the funding terms and documentation – leading to greater speed of process.

Historically, nancial institutions have been willing to assume arrange-

and-underwrite positions since they ha d a high degree of condence that the

debt could ultimately be syndicated, provided they had concluded the nan-

cing on terms that fell within sensible market parameters. Successful syndi-

cation would reduce their exposure to a more acceptable level that they are

prepared to take and hold on their balance sheet in relation to any one transac-

tion. Clearly, this level of condence will depend to a signicant degree on the

prevailing appetite among nancial institutions to purchase the debt and the

general levels of liquidity in the marketplace.

As we have already noted, one of the effects of the credit crunch has been

a period of contracting liquidity and therefore contracting syndication markets.

Some of the nancial institutions that assumed arrange-and-underwrite positions

on deals shortly before September 2007 found that they could not ultimately sell

the debt and were left with large balance sheet exposures to individual transac-

tions. The result has been an increasing move towards club nancing deals, that is

to say, a situation where a club of banks is formed at the outset whose aggregate

take-and-hold positions meet the full nancing requirement for the transaction.

For example, if an investor is looking for £100 million of debt nance, it might

need to form a club of between four and six banks, each funding between £15

million and £25 million. Generally, this has led to more difcult negotiations and

more protracted funding processes, as all members of the club become involved

in the detail of the negotiation and documentation of the nal nancing terms.

It would be fair to comment that, since the credit crunch, nancial institu-

tions remain wary of arrange-and-underwrite positions, particularly on larger

mid-market transactions. This will not be eased to the extent that recession

bites and general liquidity remains tight. Consequently, we can expect to see

a higher proportion of syndicated nancings done on a club basis throughout

the period of recession being experienced in the UK since the credit crunch.

3.5 Due diligence on the Target

The due diligence process will typically be conducted alongside the nan-

cing process. However, in some cases (particularly given the prevailing

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Financing documentation

challenging market conditions), the investors may wish to be comfortable

that they have taken initial soundings from potential funders which suggest

there is funding appetite before incurring signicant expenditure on detailed

diligence.

The debt providers to Bidco will be very interested in the results of the pre-

acquisition due diligence since they will be (a) looking to the cash ows and

nancial standing of the Target as their only source of repayment of indebt-

edness, and (b) reliant upon the assets of the Target as their only security for

the repayment of their debt. One must also remember that the debt funding

will often form the larger part of the overall (debt plus equity) funding being

provided to Bidco. Consequently, the debt providers need to be able to satisfy

themselves that their investment is prudent.

As a result, the private equity investor (both from its own investment per-

spective and from the perspective of achieving the optimum debt nancing

package) needs to ensure that all major risks have been highlighted as part

of the due diligence process and appropriately dealt with – perhaps by being

factored into the purchase price for the Target (possibly by means of pur-

chase price retentions or staged payments), or otherwise adequately allocated

between Bidco and the seller in the legal documentation (through warranties

and indemnities).

4 Financing documentation

The negotiation of the nancing documentation will reect, among other

things, the terms and conditions set out in the funding termsheets and the

results of the due diligence review. Set out below is an overview of the princi-

pal provisions of the core nancing documents.

4.1 Senior Facilities Agreement

The Senior Facilities Agreement (SFA) will set out the terms and conditions

attaching to the provision of the senior debt facilities required for the transac-

tion. This will invariably be the principal (and, in some cases, the only) form

of debt nance in a UK mid-market acquisition transaction. The agreement

will customarily be prepared using the Loan Market Association precedent for

leveraged nance transactions.

The SFA will include the following provisions:

(a) Facilities available

The facilities provided to Bidco will normally include:

(a) Term facilities, the proceeds of which will be used to pay the acquisi-

tion consideration, discharge the acquisition costs incurred by Bidco,

13 For an overview of due diligence, see chapter 2, section 4.

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Debt funding

any Midcos and Topco, and discharge all existing indebtedness within

the Target group. In many cases, the term facilities will be split into

more than one tranche, with each tranche attracting different terms and

conditions principally as to repayment maturity and interest rate.

(b) Revolving credit facilities to fund the ongoing working capital require-

ments of the Target group. The SFA will contain provisions allowing the

revolving credit facilities to be drawn by way of cash advances, letters or

credit or bank guarantees, and also by way of other ancillary facilities

(as described in section 3.2 above).

to the extent required or desirable in the context of the transaction (and

also as described in section 3.2 above).

Bidco will be the principal borrowing party under the SFA since it is the

vehicle that needs the term facilities to fund the acquisition. There will also be

provisions allowing members of the Target group to accede to the SFA post-

acquisition as borrowers. This will facilitate a direct ability on their part to

access the working capital facilities that have been made available.

(b) Drawdown period(s)

Based on the different purposes for which each of the facilities is to be used,

the facilities will be available for drawdown over differing periods (referred to

as the ‘Availability Period’ in each case):

(a) The term facilities will be available for drawdown for a relatively short

period since they will be used in full immediately upon the completion

of the acquisition. In the case of acquisitions of private companies, it is

not unusual to have the SFA executed on the day on which the acquisition

is due to complete, or shortly before. As a result, the Availability Period

for the term facilities may be as short as ve days or even less. Where

a private acquisition contemplates a split exchange and completion (for

example, because of competition clearance issues), the period for which

the term facilities are available for drawdown by Bidco will need to be

negotiated accordingly. This is because the SFA will generally be exe-

cuted at exchange to ensure the necessary funding is available when the

sale and purchase agreement is signed, but the funds will not be needed

until completion. In this context, it should be noted that the debt provid-

ers will not want to have the commitment risk for the term debt on their

balance sheet for a longer period of time than is absolutely necessary due

to their risk-weighted capital regulatory requirements. The investors can

therefore expect funders to require any periods between exchange and

completion to be kept to the minimum possible. Different requirements

as to Availability Periods arise in relation to acquisitions of public com-

panies and these are looked at in more detail in chapter 10.

14 See chapter 10, section 4.2.

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Financing documentation

(b) The revolving credit facilities will be available for a longer period (typ-

ically, co-extensive with the term of the senior term facilities) as they

represent the ongoing working capital funding that is supporting the

costs incurred in connection with the ongoing operations of the Target

group.

most likely be made available for a period of one to three years. This is

because they are principally being used to ensure that identied capi-

tal expenditure investment and/or other identied acquisition targets

(where a buy-and-build strategy is being pursued) can be made and/or

purchased (as the case may be) within a sensible period following the

acquisition.

The repayment proles of the different facilities will vary. As a result, the

interest costs attaching to each of the facilities will also vary commensurate

with the overall risk analysis and rate of return prole modelled by the debt

providers:

(a) Depending upon continued market appetite for tranches of longer matu-

rity, non-amortising senior debt instruments, and depending upon the

total quantum of term debt required by Bidco, the senior term debt may

well be split into two or three tranches. In contrast to the position prior to

the credit crunch (as described in section 2.2 of this chapter), indications

in the rst half of 2009 are that appetite for the tranche B and tranche

C facilities of old

will be scarce. As a result, the senior term facilities

being offered are predominantly single tranche amortising facilities with

a term of no more than ve years. There are, however, some signs that

dual tranche structures may be contemplated whereby a second tranche

of non-amortising debt with a tenure of six years is also offered. The

shape of the senior term debt package will no doubt evolve and change

as nancial institutions look to structure their nancing packages most

appropriately as the economic climate and deal activity improves.

(b) The revolving credit facilities will be drawn and repayable over shorter

periods of time (commonly three or six months and set in line with the

time periods used to calculate the interest payable in respect of those

loans). However, Bidco (or such other member of the Target group that is

the borrower) will have the ability (subject to there being no subsisting

event of default under the SFA) to roll over each loan on its repayment

date into a new loan. This avoids the physical repayment and redrawing

of cash advances that continue to be required to fund the business.

15 See the description of these tranches in section 2.2 above.

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Debt funding

amortise in line with the senior term debt. However, in each case, the

amortisation will only commence once the Availability Period for each

such facility has expired (potentially, two or three years after comple-

tion of the acquisition). Since the total amount that will actually be

drawndown under those facilities may not be certain when the SFA is

signed, it may well be the case that the SFA provides for a straight-line

amortisation of the actual drawn debt under each facility from year two

(or three) on the same semi-annual repayment dates as those applicable

to tranche A. It should be noted that securing these types of facility

has become more difcult. The prevailing economic climate since the

credit crunch has led to nancial institutions being more alert to how

and where they tie up their capital base. Whilst it may still be possible

to secure these types of facilities where there is a clear and imminent

intention to fund capital expenditure or pursue strategic and clearly

identied acquisition opportunities, investors will likely struggle to

secure these types of committed facilities where plans are less certain

and the aim is more to achieve funding exibility for opportunities that

may (but are not certain to) arise in the future.

In all cases, interest will be payable at a specied margin over LIBOR (or pos-

sibly EURIBOR in relation to drawings in euros) and some commentary as to

likely levels of pricing is set out in section 2.5 above.

(d) Mandatory prepayments

The SFA will set out provisions indicating those circumstances where Bidco

is required to procure the mandatory prepayment of the facilities prior to

their scheduled maturity. Customarily, these circumstances will include the

following:

(a) Sale, change of control and listing. The funders have agreed to provide

specic nancing for the acquisition of the Target group by a certain

private equity rm that they are prepared to support against the agreed

base case model in the Business Plan. To the extent that the Target

group (or indeed Bidco or Topco) is sold by the private equity rm to

a third party, the debt providers will want to ensure that their facilities

are prepaid and discharged in full. The same is true where, as opposed

to a complete divestment of the group, there is a partial divestment or

co-investment which results in a change in control of the group (most

obviously, where a private equity rm’s funds cease to hold sufcient

shares to control a Target which it previously controlled). The ration-

ale is that the new owners or new controlling shareholders may have

different plans for the business. They will likely have different fund-

ing requirements and may want to pursue a growth and development

185

Financing documentation

strategy that is different to the one that was originally presented to the

funders and that underpinned their nancial analysis, their risk assess-

ment and, overall, their willingness to invest in the transaction by pro-

viding the debt funding.

(b) Sales of assets. The undertakings given by Bidco in the SFA (discussed

below) will limit the circumstances in which members of the group can

sell their assets. The reasoning is quite clear: the assets will form a core

part of the value of the group and be required for operational purposes.

As noted earlier in this chapter, the debt providers are reliant upon the

operational revenues and assets to support and provide collateral for

the funding they have made available to Bidco. They will therefore be

conscious not to allow valuable assets or assets that are important to the

operations of the business (and therefore the generation of revenues) to

be sold. That said, there will be certain negotiated and agreed excep-

tions to this general prohibition which will permit certain categories of

assets to be sold to third parties (for example, assets that are required to

be sold in the ordinary course of trade, obsolete and redundant assets,

assets connected with or related to non-core businesses etc.). Even

where certain types of assets are permitted to be sold, the debt provid-

ers will seek to have the proceeds of sale reinvested in replacement

assets or other assets useful to the business. To the extent that proceeds

are not so reinvested or perhaps exceed a certain agreed material value,

the debt funders will expect those proceeds to be applied in prepayment

of the debt rather than used for other general corporate purposes within

the business or to repay the investors.

(b) above, insurance proceeds received by the group in connection with

the loss or destruction of, or damage to, assets will be required to be used

in prepayment of the debt facilities unless they are applied in reinstate-

ment of the relevant assets or in the purchase of replacement assets. It

will be necessary for the investors to consider whether certain types

of insurance proceeds should be excluded from the prepayment provi-

sions. For example, those proceeds that are required to be paid across

to third parties under public liability insurance and those proceeds that

are intended to compensate the group for loss of earnings or business

interruption.

(d) Proceeds of claims against the sellers of the Target group. Although

it is preferable to identify potential problems through the diligence

process, Bidco will typically have the benet of certain indemnities

and warranties in the sale and purchase documentation as described

in chapter 4. Claims under those indemnities and warranties will, to

a large degree, represent compensation to Bidco for issues that have

resulted in a loss of value in the Target group. Since the quantum of

186

Debt funding

the debt funding will have been premised upon an analysis of that

value, the debt providers will look for the proceeds of any claims

against the seller(s) to be passed back to them in the form of a man-

datory prepayment of the debt. Investors will need to consider care-

fully whether to negotiate certain materiality limits (below which

no prepayment is required) or indeed whether certain types of claim

(for example, claims for unpaid tax liabilities from prior years) offset

liabilities to third parties and must therefore be excluded from the pre-

payment obligation.

(e) Excess cash ow. In the context of leveraged acquisitions, the debt pro-

viders will be very keen to see the risk de-leverage quickly. As a result,

they will usually look to ensure that, where the group generates excess

cash ow in a given nancial year, a proportion of that excess cash ow

is used to retire (i.e. prepay) the debt. Negotiating the exact percentage

of excess cash ow that is required to be applied in prepayment will

be dependent on how highly leveraged the transaction is at the outset.

It may be possible to negotiate that the percentage threshold reduces

as the transaction de-levers and certain reduced leverage multiples are

achieved.

(e) Representations and warranties

Each member of the group that is a borrower and/or guarantor of the debt will

be required to give certain representations and warranties for the benet of

the debt providers in relation to itself and each of its subsidiaries. Figure 6.1

lists the matters that customary representations and warranties would seek to

address in respect of the borrower and its group.

Clearly, the full language of the actual representation or warranty will be

negotiated based on the facts and the results of due diligence. In the context

of a particular transaction, additional representations may be included to deal

with specic matters relating to that transaction, specic circumstances affect-

ing the Target group or the type of business in which it is engaged. All of the

representations and warranties will be deemed to be made on the day on which

the SFA is signed, and (if different) the day on which the acquisition completes

and the facilities are rst drawndown.

A smaller sub-set of the representations and warranties (typically, being

those that relate to matters that are not adequately covered by the positive and

negative undertakings set out in the SFA: see below) will be deemed to be

repeated on the date of each other drawdown of the facilities, and on the peri-

odic dates throughout the term of the facilities upon which payments of inter-

est are due. The aim of these representations and warranties is really to provide

an early warning system for the debt providers. A breach of representation or

warranty will permit the acceleration and/or cancellation of the facilities in