Mezzanine and the Private Equity Space.pdf

It has been around four decades now since the first LBOs leveraged buy outs emerged A novel concept in the 70s whereby investment firms took ownership of a company often 100 but definitely a majority stake and funded the acquisition with only a sliver of their own equity and the rest with a syndication of all sorts of debt instruments The idea was that the acquisition debt would be paid off to a large degree by the time that the firm was resold or brought back to the public market A definition of an LBO could therefore be A transaction in which an investor group acquires a company by taking on an extraordinary amount of debt with plans to repay the debt with funds generated from the company or with rev enues earned from selling off the newly acquired company s assets It seeks to force realization of the firm s potential by taking control of the firm The leveraging up of the purchase is a temporary state pending the realization of that excess value It allows for a democratic means of ownership and control i e a management team can take a firm to the next level or spin off and follow its own independent course The target market for this kind of transaction was Private businesses where the owner wanted to exit the business Private or public businesses where the management wanted to take control of the firm and take the firm to the next step later known as MBO management buy out or where new management came in MBI management buy in who were looking for ownership but lacked the equity funding to acquire full ownership that way Public businesses which for whatever reason had fallen from grace in the public market At a later stage that was complemented with businesses which had to go through some sort of restructuring or totally re invent themselves and where the public markets didn t show any compassion so there was a need for the firm to go through that phase in the quietness of private ownership P2P public to private transactions Most of these firms ultimately ended up being relisted again after the conversion was completed and the firm could follow its own course Generally companies with low levels of existing debt on their books Companies with quite a lot of fixed assets which could be used as collateral Sizeable scope for creating efficiencies cost reductions or creating value by reorganizing the firm Strong predictable operating cash flows with which the leveraged company could service and pay down acquisition debt Mature steady non cyclical and perhaps even boring companies Well established business and products and leading industry position Moderate capex and product development R 5 7 years payback 2x interest coverage Second lienSenior debt second lien up to 5 25 5 75x EBITDA although currently lower 7 10 years payback 20 25 of total fundingMezzanine High yieldCash interest debt up to 6 5 7x EBITDA PIK notesNon cash interest debt 25 30 of total funding EquityProvided by PE fund 4 7 years exit Prior to the financial crisis of 2008 this part often constituted only as little as 10 15 of the total funding volume the rest being made up by the other categories The crisis rebalanced that somewhat and it is currently common for banks to want to see more skin in the game from PE firms 234 Mezzanine Financing 8 2 1 Senior debt This portion has priority over all other instruments and normally comes in different tranches hence the indication Term Loan A B or C They tend to carry different maturities For example Term A 5 7 years amortizing Provided by banks Term B 5 8 years bullet Provided by institutional investors This layer of debt usually involves nominal amortization repayment over 5 to 8 years with a large bullet payment in the last year Term Loan B allows borrowers to defer repayment of a large portion of the loan but is more costly to borrowers than Term Loan A Term C 9 years bullet Provided by institutional investors Floating rate LIBOR spread often partly swapped for fixed rate These instruments carry the lowest risk as they come with tight covenant conditions and have priority in terms of repayment also in cases of default or liquidation They tend to have either fixed or marginally floating interest charges usually the latter but always with spreads significantly over LIBOR attached and normally have a grace period of up to 2 3 years Depending on the credit terms bank debt may or may not be repaid early without penalty Part of this tranche is typically a revolver facility which can be used by the firms on a need to have basis across the cycle of the intended investment see Chapter 10 How much of the total deal can be financed with senior debt depends on the level of existing debt in the firm the value of the collateral how much FCF is available and or expected as discussed earlier and where that puts the firm on a peer review basis in the industry Part of this chunk of the total financing package which is all bank debt qualifies as Bridge finance see further for different meanings of the same concept Short term bank loans typically to be refinanced in 1 6 months which are put in place to get the deal done and cover expenses and which may be characterized by step up spreads and other incentives to pay down early Revolver Bank facility the company can draw down for working capital functions like a credit card certain capital investments or unforeseen costs They come with ongoing fees borrowing limits covenants and conservative repayment terms A company will draw down the revolver up to the credit limit when it needs cash and repay the revolver when excess cash is available there is no repayment penalty The revolver offers companies flexibility with respect to their capital needs allowing them access to cash without having to seek ad ditional debt or equity financing There are two costs associated with revolving lines of credit The interest rate charged on the revolver s drawn balance and an undrawn commitment fee The interest rate charged on the revolver balance is usually LIBOR plus a premium which depends on the credit characteristics of the borrowing company The undrawn commitment fee compen sates the bank for committing to lend up to the revolver s limit and is usually calculated as a fixed rate multiplied by the difference between the revolver s limit and any drawn amount Subordinated bridge facilities and PIK bridge facilities are normally refinanced before maturity often through the target s holding issuing debt instruments Mezzanine and the Private Equity Space 235 8 2 2 Second lien Often used in conjunction with mezzanine debt in a mix that is usually driven by what the market will tolerate Providers are often alpha seeking higher risk tolerant institutional inves tors like hedge funds They are considered secured as senior debt though obviously with a weaker link and at a cost often closer to senior debt than traditional mezzanine instruments More and more banks offer the unitranche model as a package for both senior and slightly beyond senior debt at rates which keep the total cost of funding at acceptable levels The maturity of these instruments is in principle longer than the longest term loan Term Loan C as an earlier maturity would implicitly break the seniority schedule A second lien or mezzanine loan which would mature before all senior loans is still more junior to the senior loans but would drain cash flow from the cash flow waterfall which is earmarked for repay ment of the senior debt interest and principal and would make the senior debt more risky and less secured than intended The senior and mezzanine loans are often structured with a bullet payment at the end at least for the principal part The second lien product group is senior to the unsecured mezzanine group but junior to the senior tranches It is therefore not subordinated in right of payment to first lien lenders DIFFERENCE BETWEEN DEBT SUBORDINATION AND LIEN SUBORDINATION 1 Basics In traditional contractual subordination the debt claim itself is subordinated If a subordinated debt holder obtains anything of value in a bankruptcy from any source it agrees to turn it over to the holders of senior debt until the senior debt is paid in full In lien subordination the liens are subordinated the underlying debt claim is not What this means is that the holder of second lien debt only agrees to turn over proceeds from sales of shared collateral to the holders of first lien debt The holder of a second lien secured claim does not have to turn over funds to the holders of first lien debt distributed to it from other sources 2 Priority vis vis the trade In its simplest terms debt subordination places the subordinated debt behind the senior debt but does not place it ahead of any other of the borrower s debt unless holders of that other debt agree in turn to subordinate their debt to the subordinated debt By contrast although lien subordination does place second lien debt behind first lien debt to the extent of the value of the first lien creditor s interest in the collateral it also places the second lien debt ahead of the trade and other unsecured creditors to the extent of the value of its interest in the collateral This is the key benefit for second lien creditors 3 Anti layering covenant issues A typical anti layering covenant will prohibit an issuer from incurring new debt which is subordinated in right of payment unless that new debt is also subordinated to or pari passu with the debt containing the anti layering provision However a typical anti layering covenant does not restrict the incurrence of second lien debt because it isn t subordinated in right of payment 4 Payment blockage issues Unlike traditional subordinated debt second lien debt is not typically subject to payment blockage provisions of any kind 236 Mezzanine Financing 8 2 3 Mezzanine HY loans This is where most of the structuring takes place Both product groups are contractually sub ordinated see further in this chapter The more senior mezzanine products which have no roll up of interest enjoy upstream guarantees into the holding the more they are structurally subordinated The junior mezzanine products roll up of interest payments and PIK notes don t enjoy upstream guarantees and are ranked after trade creditors In effect they are equity owners and deeply subordinated In contrast to most mezzanine loans the HY yield group which pays a fixed interest in contrast to most mezzanine loans is often also structurally subordinated but with light covenants 5 Remedy standstill provisions The remedy bars in second lien deals typically only apply to remedies associated with the collateral Most second lien deals specifically preserve all or almost all of the remedies which would be available to an unsecured creditor with a few exceptions as we will discuss below In the case of bond deals issued in public offerings or in private placements with registration rights certain legislation like the US Trust Indenture Act or similar Acts prohibits any bar on ac tions to collect payments due and owing to bond holders but it does allow limits on enforcement actions against collateral What is a covenant light loan A covenant light loan is a loan without maintenance style financial covenants such as maximum leverage minimum interest coverage and cash flow cover which are required to be tested and passed each quarter or half year Maintenance coverage is typically set at a 20 30 headroom against the financial base case used to structure the deal The purpose of such maintenance covenants is to allow creditors to monitor the issuer s actual performance against the anticipated perfor mance and since the covenants typically assume improving metrics over the life of the loan they cement the de risking profile of the borrower over time Should there be a breach in any of these tests creditors have either the option to amend the covenants normally with a fee via a loan amendment if the causes of the breach are considered temporary or to waive the breach subject to the borrower taking action to address the underlying causes The last option is to declare an event of default accelerate the loan and enforce their security rights Leveraged often syndicated loans Loans often provided in syndication by lenders to spread risk to leveraged borrowers those whose credit ratings are speculative grade traditionally double B plus and lower and who are paying spreads premiums above LIBOR or another base rate sufficient to attract the Mezzanine and the Private Equity Space 237 interest of non bank term loan investors that spread typically will be LIBOR 200 or higher though this threshold rises and falls depending on market conditions Banks which initially didn t lend to leveraged borrowers started doing so in the 80s 90s as it was an easy way to put quite a bit of money to work with little effort and at little cost to the firm There are three main types of leveraged loan syndications 7 An underwritten deal A best efforts syndication A club deal Underwritten deal In an underwritten deal the arrangers guarantee the entire amount committed and then syndicate the loan If the arrangers cannot get investors to fully subscribe the loan they are forced to absorb the difference which they may later try to sell This is easy of course if market conditions or the credit s fundamentals improve If not the arranger may be forced to sell at a discount and potentially even take a loss on the paper Or the arranger may just be left above their desired hold level over the credit So why do arrangers underwrite loans There are two main reasons 1 Offering an underwritten loan can be a competitive tool to win mandates 2 Underwritten loans usually require more lucrative fees because the agent is on the hook if potential lenders balk Of course with flex language now common underwriting a deal does not carry the same risk it once did when the pricing was set in stone prior to syndication Best efforts In a best efforts syndication the arranger group commits to underwrite less than the entire amount of the loan leaving the rest of the credit to the vicissitudes of the market If the loan is undersubscribed the credit may not close or may need major surgery such as an increase in pricing or additional equity from a private equity sponsor to clear the market Traditionally best efforts syndications were used for riskier borrowers or for complex transactions Since the late 1990s however the rapid acceptance of market flex language has made best efforts loans the rule even for investment grade transactions Club deal A club deal is a smaller loan usually US 25 million to US 100 million but as high as US 150 million which is pre marketed to a group of relationship lenders The arranger is generally a first among equals and each lender gets a full cut or nearly a full cut of the fees Syndicated leverage loans have a credit rating and an active secondary market Typically they are callable at par without penalty They can be secured or unsecured but are always senior debt Leveraged syndicated loans are typically senior to all other debt in the borrower s capital structure while syndicated loans of investment grade firms are often at the same level of seniority as senior bonds Leveraged loans need to be distinguished from leveraged secured credit which is an asset based loan secured by a company s A R inventory equipment etc whereby the lender 7 Further information can be found at 238 Mezzanine Financing takes a first lien on the assets being financed They can be attractive as they are profiled for lenders with different characteristics than traditional lenders They tend to come with fewer covenants and might free up more funding than would be justified if judged on a pure cash flow basis You can even take it a step further and securitize certain assets like franchise receivables or future contractual cash flow streams in order to lower funding costs and en hance flexibility High yield loans bonds8 aka junk bonds 9 Bonds which are non investment grade directly or after fall back Originally speculative grade bonds were bonds which had been investment grade at time of issue but where the credit rating of the issuer had slipped and the possibility of default increased significantly These bonds are called fallen angels Over time more and more of these facilities were provided to LBO operators but also to other corporations for operational purposes often if firms were constrained by bank credit availability These loans were then often repackaged into CLOs Collateralized Loan Obligations or CDOs Collateralized Debt Obligations with a view to providing a higher rating to the senior tranches above the rating of the original debt The senior tranches of high yield CDOs could meet the minimum credit rating requirements of pension funds and other institutional investors despite the significant risk in the original high yield debt The rest of the story is history HY loans come with tight covenants which are mainly centered around The inability to incur further indebtedness Performing restricted payments dividends or other distributions to shareholders intra group loan repayments or investments as well as asset transfers sale sale and leaseback etc Granting liens over its property or assets Entering into non arm s length dealing with other groups and or related companies Events of default include any failure to pay interest and or principal any breach of cov enants and the instigation of insolvency or other related proceedings against the issuer or the group Most often there is a cross holding default which implies that a default on one of the loans or bonds triggers an acceleration of all other instruments It typically also includes a grace period and a non redemption period HoldCo OpCos Bond holders Senior lenders Guarantee Guarantee and security 8 For valuation related issues of HY bonds Thomas S Y Ho and Sang Bin Lee Valuing High Yield Bonds a Business Modeling Approach Working Paper 2003 9 For a market perspective s