The flood of multi-billion dollar leveraged buyouts (LBOs) raises a number of questions for bidders, perhaps the most urgent being: how are you going to pay for that? Acquirers in traditional strategic mergers and acquisitions are usually able to put up their own equity as collateral and use bank loans to fund any gaps. Private equity firms in LBOs by definition cannot follow this route and must instead turn to the debt markets to support their takeover bids, often issuing high yield bonds via the target company.

The sheer scale of many recent deals, combined with pressure from targets, has increased the challenges of putting together financing packages. Fortunately for bidders, investment banks and lawyers are on hand to provide a tasty menu of innovative finance choices.

Covenant-lite

Perhaps most indicative of the private equity boom has been the recent growth of so-called covenant-lite financings, which combine bank loan and high yield bond technology. They have arisen in an environment where cash-rich private equity funds are chasing an increasingly small number of suitable companies while investment banks and lawyers chase their lucrative transaction fees. In this context target companies, starting with SunGard and Hertz in 2005, have been able to pressure buyers into accepting limited or non-existent financing condition protections. In turn, these valuable private equity clients have been bringing pressure to bear on the banks to provide them with the financing they need on the terms they want.

In this spirit, covenant-lites essentially enable borrowers to take out loans that behave like high yield debt. They are difficult for lenders to be able to press claims against but also offer greater flexibility, with floating rather than fixed interest rates. In model covenant-lites, lawyers take a standard bank credit agreement and replace the maintenance covenants, which prevent the borrower from holding debt except under certain conditions, with incurrence covenants, which allow the borrower to hold debt but not to incur new debt, as typically used in high yield bonds.

According to acquisition finance lawyers, however, more often borrowers use what one lawyer describes as "covenant-lites in disguise". In these instruments, rather than replacing maintenance covenants with incurrence covenants, the maintenance covenants are written to include a carve-out whereby the borrower is allowed to increase the amount of debt it holds provided it maintains certain financial ratios, such as a leverage test. This achieves the same ends as the model covenant-lites but does so without having to make substantial changes to the layout of the loan documents. The carve outs are less obvious to a casual observer than a wholesale swap of the covenant, which may benefit borrowers if investors are concerned about falling down the creditor pecking order.

Neil Cummings, Proskauer Rose

Although there are few available statistics, lawyers active in the field say that covenant-lites in various guises are increasingly common, often in combination with asset-based loans (ABLs) or other products. "I don't think covenant-lites are taking over, but if you want to do it there's an opportunity among investors that traditionally was not there," says Neil Cummings, a partner with Proskauer Rose in Los Angeles. In addition to their added flexibility, covenant-lites may be preferable to high yield bonds, in that as loans rather than capital market instruments they avoid the need for expensive and time-consuming roadshows and compliance with securities laws. By doing so they also give borrowers greater control over when they raise money, which is key in takeovers.

Securitization

Covenant-lites are not the only new string to the acquisition financier's bow. As well as looking for volume, bidders want flexible and low cost alternatives to traditional loans and high yield debt. Private equity funds need to secure debt against the target's assets, and are therefore keen to extract as much value as possible. ABLs, which are often used in conjunction with covenant-lites, are one means of doing this.

Another tool that helps monetize the target company is securitization. The use of asset-backed securities (ABS) came to prominence last year when a private equity consortium raised almost $5 billion though ABS issuance as part of the $15 billion Hertz LBO. Weil Gotshal & Manges advised the banks on financing the deal. Similar methods had been tried before but the Hertz deal was the first time that securitization had been used as the primary means of financing a buyout, and the structure spurred a lot of interest.

Aside from the higher advisory fees it involves, securitization can offer a cheaper means of raising capital than traditional debt, particularly when the target company has poor credit ratings. It does rely, however, on the company having suitable assets. In Hertz's case that was a fleet of rental cars, but observers have suggested that receivables including real estate, casinos, intellectual property (IP) rights and even wine harvests could all be used.

Dunkin' Brands made new breakthroughs over the summer when it raised $1.7 billion though the securitization of assets in its franchised fast food chains. The offering helped finance the company's buyout by the Carlyle Group, Thomas H Lee Partners and Bain Capital. Paul Weiss Rifkind Wharton & Garrison advised underwriter Lehman Brothers on the deal, Ropes & Gray acted for Dunkin' Brands and Cadwalader Wickersham & Taft represented monoline insurer Ambac.

Gregory Woods, Debevoise & Plimpton

The Dunkin' deal was the first time that a buyer had securitized franchise royalty payments, IP, leases and other licensing receivables. It was described as being as close to a whole business securitization as is possible under US law, potentially showing the way for a number of businesses for which such a structure would be necessary. "The Dunkin' Brands deal was a shot across the bow that helped people understand that this is a real alternative," says Gregory Woods, an acquisition finance specialist at Debevoise & Plimpton.

Securitization deals such as these also create opportunities for law firms that have top-flight structured finance teams but no equivalently strong M&A practice to get a foothold in a new area of work. Until now, however, the relatively small number of companies in buyouts with suitable assets has limited the number of deals being done.

Hybrids

Similarly, the use of hybrid securities to fund acquisitions has not been as successful in the US as it has been in Europe, although that may change over the next year. Hybrid securities combine features of debt and equity to enable issuers to gain both favourable credit ratings and tax treatment. A number of European companies have used them for acquisition financing but so far there has been little such activity in the US. In late 2005, however, Stanley Works sold hybrids to help pay for its acquisition of French company Facom Tools, with Sullivan & Cromwell advising the banks. Then earlier this year Swiss Re used hybrids to help pay for GE Insurance Solutions, with Paul Weiss and Willkie Farr & Gallagher the US law advisers.

Very few other deals have taken place in the US to date, in part because regulatory confusion has meant that hybrids have largely been issued by banks for regulatory capital purposes. With that confusion expected to be resolved this month, private equity funds may be able to bring a new wave of corporate issuers to market to raise money for their LBOs.

Among other less familiar products in the US markets, mezzanine financing for acquisitions has also shown a slight upsurge this year, and is particularly favoured by companies that wish to keep sensitive pricing information, which they would be required to disclose if they issued public bonds, from their competitors.

Payment-in-kind (PIK) bonds are also featuring on the menu in a small number of deals. PIK bonds allow the issuer to choose between making payments on its notes in either cash or additional bonds during specified periods. In the buyout of Neiman Marcus last year, for example, the issuer was able to secure the option that it would make PIK payments on one of its tranches of high yield bonds on a quarterly basis. This flexibility comes at a cost in terms of higher interest rates but is deemed to be worth it by issuers as protection against default in times when cash flow is tight. Like covenant-lites, PIK bonds are seen as a useful tool for when the next liquidity crunch inevitably strikes.

The right team

For law firms, the emergence of new acquisition finance techniques is just another present on the seemingly evergreen private equity Christmas tree. LBOs, and particularly club deals, require firms to bring to bear a wide array of resources. They must deploy an M&A team, a private equity team and a leveraged finance team, which in turn will often be divided into bank lending, capital markets and regulatory teams. The need to use such large numbers of lawyers across different practice areas, combined with close-knit institutional relationships, means that a limited number of large full, service firms tend to advise on the majority of large LBOs.

The developments in acquisition finance represent a particularly welcome challenge for finance partners at a time when lawyers acknowledge that it is not necessary to reinvent the wheel on the pure M&A side with each new multi-billion dollar club deal, even as they continue to represent enormous achievements for the law firms involved.

However, new products such as covenant-lites also raise questions for firms over how to use the specialist knowledge of their lawyers in the most efficient way. High yield specialists and banking lawyers, for example, have different skill sets, the former demanding experience in US securities laws and their associated disclosure requirements. But the market is changing. "The success of covenant-lite financings shows the convergence of the high yield and bank debt markets," says Gregory Woods. "As these products converge it will put more emphasis on lawyers being broadly based." The trend therefore poses a dilemma for firms where lawyers are separated into high yield and banking teams. Woods says that Debevoise tries to overcome this divide in covenant-lite work by grouping lawyers together who specialize in covenants.

According to Phillip Mills, an M&A partner with Davis Polk & Wardwell, high yield lawyers in his firm work closely with banking lawyers but are still separate. "There's always been a substantial overlap between high yield lawyers and acquisition finance lawyers," he says, and formally merging teams is not necessary, at least for now. But Mills acknowledges that the firm might consider restructuring if covenant-lites became the norm.

The demands of the blockbuster LBO, including its financing, offer great rewards to law firms but can also place high demands. In particular, it requires firms to be more flexible, not least because arranging finance packages is now often left until a winning bidder and/or consortium structure are determined. How that package will be structured, the products it will use and even when it will need to be prepared may all be unknown until the last minute, particularly as targets limit or remove financing conditions.

The twists and turns of the auction process that leads up to the formation of consortia can lead to law firms putting large teams together that ultimately do not get used fully if the client does not mark a successful bid or end up in a lead role. As Creighton Condon of Shearman & Sterling, who has acted on the SunGard and HCA deals, notes: "You'll have a certain number of hits and a certain number of misses." For the potential fees and exposure to high-profile active clients, most lawyers would agree that the hits are worth the misses. BM