Maximizing debt quantum has always been a consideration for
sponsors in the private equity market when weighing up financing
proposals. Unprecedented levels of liquidity across the bank
markets, sponsors' desire to invest their capital sooner rather
than later, and vendors driving highly competitive auction
processes have all contributed to rising LBO asset prices. In these
market conditions, debt quantum has become of paramount
importance.
Constraints on debt quantum arise from modelling the target's
cashflows, reflecting the ongoing risks associated with the
performance of the business. The value of the real estate on the
target's balance sheet is not taken into account in assessing the
ability of the business to service debt going forward.
Value locked up in a property portfolio can be released
(post-whitewash) to assist in financing a bid by property
financiers willing to lend to a bankruptcy-remote, property-owning
SPV on a loan-to-value basis backed by a flow of lease rentals from
the operating company. A loan-to-value of 80% to 85% is not
unusual. Sponsors have (along with many corporates) recognized
that, although rights of occupation are a pre-requisite to conduct
the business, rights of ownership are not.
The requirements, expectations and risk appetites of lenders in
the LBO and property finance markets are different so the deal must
be structured in a way that enables both groups to successfully
syndicate the debt into their respective markets.
To successfully structure and implement these deals, the risks
and rewards associated with the operational business (the OpCo)
must be separated from those associated with owning and leasing the
properties (undertaken by the PropCo). The OpCo/PropCo structure
was used on the Debenhams public-to-private and the acquisitions of
NCP, Travelodge and Vendex.
The sponsor's perspective
Despite the ever-declining proportions of equity contributed
towards LBO structures in today's market, LBO lenders will still
insist on a more comfortable equity cushion than that required by
property financiers. Incorporating a well-structured property
financing on the basis of a high LTV will increase debt quantum and
enhance the return on equity while also reducing the overall cost
of capital.
Implementing the structure will allow the sponsor to maintain
control over, and rights of occupation in respect of, the property
portfolio. Flexibility is preserved because properties can be
disposed of in line with market conditions, provided that the
disposal proceeds exceed a minimum threshold linked to the amount
of debt allocated to each property and are applied in prepayment of
the debt. If excess sale proceeds are to be extracted from the
structure then this requires careful advance planning and
negotiation. The hedging strategy needs to be tailored to the
business plan if it expects disposals.
The sponsor will seek to retain maximum flexibility as to the
nature and scope of the arrangements to refinance the portion of
the bridge attributable to the property financing. This means it
will seek as long a bridge period as is possible so that it is not
forced into an unattractive refinancing imposed upon it by an
impending bridge maturity date.
The sponsor will ideally wish to conduct an operational
assessment of each property during the first 12 to 18 months of
ownership. This will be a particularly important consideration if
only a limited amount of property due diligence was conducted
before closing (perhaps on the basis of samples by value and
location or even solely on the basis of publicly available
information if in the context of a hostile public bid). There might
also be business separation issues to overcome.
The OpCo lenders' perspective
The OpCo lenders will have probably underwritten the property
bridge, so they will be keen to limit the bridge period to allow
enough time for the reorganization to be carried out but to
encourage swift resolution of discussions on the optimal long-term
property financing solution. Imposing a margin that increases
periodically towards the back end of the bridge period will also
spur early action.
If a structure for the reorganization has been agreed with the
sponsor before closing (often containing specified steps to make
the reorganization as tax efficient as possible), the OpCo lenders
will seek undertakings in the loan documentation requiring
implementation in accordance with the agreed steps.
To ensure a successful syndication of the OpCo debt, the OpCo
lenders will require that, once the credit is separated into OpCo
and PropCo financings, ringfencing provisions be imposed to ensure
that the risks of financing the separate credits are allocated
appropriately. These will include restrictions:
- blocking any recourse that PropCo might have to the
cashflows of OpCo, save for the payment of rent from OpCo to
PropCo for occupation of the properties under the agreed form
leases;
- on the granting of guarantees and/or indemnities by OpCo in
respect of any PropCo liabilities or expenditure;
- preventing amendments being made to the agreed form leases
and capping the amount by which lease rentals may increase upon
rent review during the life of the leases;
- on granting loans or any other financial accommodation
(including transferring capital allowances from OpCo to
PropCo);
- on transfers of value (by way of disposals or otherwise) by
OpCo to PropCo;
- on capital expenditure to be applied by OpCo in maintenance
of the properties; and
- clearly defining the extent of the OpCo group before and
after the property reorganization so that the extent of the
restrictions is clear at all times.
Depending on the circumstances of the deal, a degree of
flexibility might need to be built into the structure by way of
limited carve outs from the above restrictions. The greater the
level of flexibility, the greater the syndication risk for the OpCo
lenders as a result of blurred lines of demarcation between the
OpCo and PropCo financings.
The PropCo lenders' perspective
Provided that the risks inherent in the deal have been allocated
appropriately among the investors, the expectations of property
financiers in terms of reward will not be as lofty as those of the
OpCo lenders. PropCo lenders will need to be sure that PropCo has
enough resources to enable it to meet its ongoing obligations
(taxes, costs, other expenses and debt servicing) and that the
extent of those ongoing obligations is clearly defined. To maximize
debt quantum, the full amount of PropCo debt will probably need to
be hedged.
If properties are held by separate PropCos, the PropCo lenders
are likely to require that the loan be made to a holdco, with each
of the PropCos providing upstream guarantees and security in
respect of the holdco's obligations as borrower. The PropCo lenders
will seek ringfencing provisions as follows:
- to ensure that PropCo is insulated from OpCo performance
risk, the only circumstance in which a PropCo default will
arise as a result of an event in OpCo will be non-payment of
all or part of the lease rentals. A default under the OpCo
financing will not cross-default the PropCo financing but the
Propco lenders will seek to ensure that default for non-payment
under one lease will cross-default the other leases to prevent
OpCo from cherry-picking viable sites and defaulting on
others;
- no amendments to the terms of the PropCo leases without the
consent of the PropCo lenders;
- if the long term property financing has been bridged,
during the bridge period the disposal proceeds from the bridged
properties will be applied first by way of mandatory prepayment
of the property bridge and only then against the OpCo
bridge;
- during the bridge period, the property bridge lenders will
have priority over the OpCo bridge lenders in respect of the
proceeds of enforcement of security over the bridged properties
and related insurance proceeds; and
- covering each of the issues raised above in the context of
the restrictions imposed by the OpCo lenders, but protecting
the PropCo lenders' interests and ensuring no value leakage
from the PropCo group into the OpCo group.
The PropCo lenders will push for debt service from the rental
stream to be on a pre-tax basis - using the rentals to service the
financing might give rise to a tax mismatch in PropCo. The
financial model for the PropCo financing will be based on certain
assumptions (factoring in, for example, capital allowances
permitted to be transferred from OpCo to PropCo) and on current law
and practice. Even if the model shows no (or limited) tax exposure
in PropCo, there is no guarantee that PropCo will not become tax
paying in the future. Assuming no or minimal support from OpCo, the
only option at the time would be for the sponsors to put the PropCo
in funds to make any tax payments.
Timing issues
The debt quantum attributable to the property financing will
initially be provided by way of a bridge facility to a long-term
property financing solution (sale and leaseback, securitization,
commercial mortgage facility or straight disposals). The bridge
period is necessary because:
- the target group will probably need to be reorganized to
split the initial bridged credit into two separate and distinct
OpCo and PropCo credits;
- moving property interests (and the associated bridge debt
that financed their acquisition) to above the target group and
giving upstream guarantees and security will constitute
unlawful financial assistance that will need to be whitewashed
under the procedures set out at sections 155 to 158 of the
Companies Act 1985; and
- the sponsors will wish to undertake a period of operational
assessment on a property-by-property basis.
The reorganization can take three to six months to effect and
will require careful planning and execution, particularly if it is
to be achieved in a tax efficient manner. Even if the lenders have
granted a lengthy bridge period, they will insist on swift
implementation of the reorganization during the bridge period to
create two distinct credits before the longer term refinancing is
carried out. Additional timing hurdles will arise if the deal is a
public-to-private or if the reorganization requires prior tax
clearance.
Property aspects
The lease from PropCo to OpCo is usually long term (25 to 30
years, although the banking (as opposed to securitization) market
may accept a shorter term) with no breaks or rent-free periods.
Rentals will be subject to annual indexation and possibly also
scheduled open market rent reviews. As lessee, OpCo will have full
responsibility for repairing and insuring the properties. The
PropCo lenders might prefer a single master lease in respect of the
portfolio, but the sponsors will push for the flexibility of a
single lease per property to preserve marketability.
In addition, although the sponsors might agree to non-payment of
the lease rentals defaulting the PropCo loan, they will be
reluctant to agree to default (other than for non-payment of the
rental) under a single lease cross-defaulting all the other
leases.
If the portfolio contains leasehold property interests, careful
consideration should be given to alienation covenants in the leases
prohibiting assignment or underletting without landlords'
consent.
When negotiating the terms of the internal lease, OpCo and
PropCo should aim to achieve a fair balance between the interests
of the landlord and the tenant. There is an inevitable tension
between the flexibility desired by OpCo and anticipating the
demands of third-party landlords. One aspect of this balancing is
that the sponsor may seek a right to buy the portfolio back upon
exiting its OpCo investment, because not owning the property
portfolio might impact on its ability to exit.
The form of lease might need to be changed if PropCo is sold to
a third party with the benefit of the lease to OpCo. OpCo might
have to suffer a little to get the best price for the properties,
which might benefit the group as a whole, so the sponsors will push
for flexibility to permit changes to the lease terms. The OpCo
lenders will wish to ensure that the changes are not materially
prejudicial to the interests of the OpCo lenders or do not impose
more onerous obligations as a whole than those under the initial
lease.
The PropCo lenders might seek to prevent OpCo assigning the
lease, if not for the full term then perhaps for the first 10 years
of the lease. The sponsors will be keen to resist this, but might
agree to a requirement that any new occupational tenant must be of
an equivalent credit quality to that of OpCo.
In May 2004, the government issued a paper consulting on the
options for deterring or outlawing the use of upwards-only rent
review clauses in commercial property leases. Because longer leases
with steadily increasing rentals enable greater leverage to be
introduced into deals, regulation in this area might impact debt
quantums, although it might have a greater impact on securitization
take-outs (requiring longer lease terms) than bank financed
OpCo/PropCo take-outs.
Tax aspects
The sponsors will wish to structure the reorganization (and the
planning for any subsequent property disposals) as tax efficiently
as possible. The main tax issues relate to potential CGT and SDLT
arising on the transfer of the properties to PropCo and their
subsequent sale, although interest relief and value-added tax (VAT)
are also relevant.
On the basis that each PropCo will be incorporated as a member
of the overall capital gains tax group, the transfer of properties
to PropCo should be an intra-group no gain/no loss transfer
pursuant to section 171 of the Taxation of Chargeable Gains Act
1992 (TCGA). PropCo would inherit the transferor's historic base
cost in the property and the transferor would be deemed to have
disposed of the property for an amount of consideration that gives
rise to neither a gain nor a loss.
If a PropCo were to be sold within six years of the intra-group
transfer, a section 179 TCGA degrouping charge would be triggered.
Another approach, which would also achieve no gain/no loss
transfers of properties but without exposure to a subsequent CGT
degrouping charge, is a reconstruction involving transfers to a
company deliberately excluded from the CGT group. But confidence as
to application of the reconstruction relief would depend on a
Revenue clearance, and more recent experience indicates that the
tax clearance might not be forthcoming.
Where the substantial shareholdings exemption (SSE) applies to a
disposal, any gain that arises is not a chargeable gain. One of the
requirements of the SSE is that PropCo be a trading company or the
holding company of a trading group or a trading sub-group for 12
months before the disposal and immediately after it. Satisfying the
trading requirement might be difficult if the lenders to OpCo and
PropCo require ringfenced OpCo and PropCo credit groups. In such
circumstances, flexible structuring of the intra-group debt by
reference to any enhanced market value of the properties might
assist in reducing CGT liabilities.
If stamp duty (land tax) (SDLT) group relief is granted and a
sale of the PropCo takes place within three years of the transfer,
there will be clawback of the relief from SDLT, although it might
be possible to minimize clawback risk in the right
circumstances.
The sponsors will wish to create internal leases before the
reconstruction, which will remain in place for SDLT purposes and
will survive any external sale and leaseback. In doing so, they
will avoid a SDLT hit that would arise on the grant of new leases.
It is important to ensure that the term and demise of the lease do
not change later - although from an SDLT viewpoint, the other
provisions could be changed without much, if any, SDLT cost but
variations to the rent may result in such a cost.
Any consideration payable for the shares will attract stamp duty
or stamp duty reserve tax at 0.5%. The sale of shares in a company
not incorporated in the UK (which may nonetheless be UK tax
resident by virtue of management and control) need not give rise to
UK stamp duty. A common feature of schemes involving a
restructuring with a view to an on-sale of the portfolio portfolio
is the anticipation of a future share sale of PropCo rather than a
sale of the properties.
Pending any sale, PropCo will remain within the overall group.
The OpCo lenders will need to be comfortable with the risk of OpCo
entities potentially incurring secondary tax liabilities as a
result of unpaid taxes in PropCo. The same risk arises for PropCo
lenders in respect of unpaid OpCo taxes.
OpCo/PropCo versus securitization
The rigorous approach taken to default risk (and the additional
structural features imposed as a result) mean that a higher LTV
could be achieved on the portfolio by means of a securitization
than by an OpCo/PropCo structure. The downside is the inflexibility
of the securitization structure - unscheduled prepayments might be
prohibitively expensive.
Balance
Liquidity in the property finance market might not be as deep as
in the LBO senior debt market, but the number of OpCo/PropCo
proposals is increasing. Provided that the chosen structure
achieves a balance between the interests of the sponsors and the
different syndication risks to which the OpCo and PropCo lenders
are subject, bringing these investors together at the structuring
stage can increase the chances of winning the deal in the first
place, while also lowering the overall cost of capital.
Author
biography
Simon Johnson
Freshfields Bruckhaus
Deringer
Simon Johnson is a partner in the banking team at Freshfields
Bruckhaus Deringer. Simon specializes in banking, particularly
acquisition, leveraged and property financing for commercial and
investment banks, but also for corporate and private equity
borrowers.
Freshfields Bruckhaus Deringer
65 Fleet Street
London EC4Y 1HS
Tel: +44 20 7936 4000
Fax: +44 20 7832 7001