One of the main trends in the leveraged acquisition finance
market in 2004 and 2005 has involved debt arrangers and their
lawyers creating inventive new instruments by which the overall
size of debt packages funding leveraged acquisitions can be
increased. There have been at least four main drivers behind this
process.
First, as more and ever larger private equity funds are set up
against a backdrop of reduced availability of larger leveraged
acquisition opportunities, competition among potential buyers in
the market has been more fierce than ever. Inevitably, this has
driven prices higher and higher. To fund these higher prices,
private equity sponsors have demanded greater leverage for their
deals from their finance providers than ever before. Whereas less
than two years ago, leverage (that is, total debt:Ebitda) of six
was seen as a limit, recently for deals involving reliably cash
generative targets, leverage of eight has been seen.
Secondly, private equity funds generally need to generate
returns from individual deal investments within three to five
years. The initial public offering market has essentially been
closed for the last year or so, and private equity houses have
looked to effect additional or releveraging debt transactions to
fund an equity return.
Thirdly, in parallel with the growth of private equity funds,
the availability of debt funding for leveraged acquisition
transactions has also increased greatly by the entry of new types
of participant debt providers (such as hedge funds, insurance
companies, mutual funds, CDOs, and CLOs). These new debt investors
are looking for a different type of debt instrument (higher margin
for a longer term) than that sought by traditional bank debt
providers in the market.
Lastly, the high-yield market has been alternately hot and cold
and seemingly unpredictable.
How has the leveraged acquisition debt package been
stretched?
Starting at the bottom of the risk/return spectrum, there has
been little scope to increase amounts provided under senior A
facilities - they are still the domain of traditional lending
banks looking for a standard amortizing instrument with an average
life of four and a half years or less. The non-amortizing B and C
facilities have, however, been attractive to the new types of
investors because they provide higher margins (2.75% to 3.25% over
Euribor/Libor) for longer periods - typically eight- and nine-year
bullet maturities where the debt holder has an option to reject
early prepayment if the A facility remains outstanding.
Consequently, in recent deals the B and C facilities have been
taking up a much larger portion of the overall debt package.
Traditionally the next instrument in the risk/return profile
after the B and C facilities has been the mezzanine facility or, in
larger deals if the market is open, a high-yield bond issue.
Mezzanine instruments, still generally structured as loans although
mezzanine notes have been seen recently, offer returns of 4% to 5%
cash pay margin and 4% to 5% rolled-up margin plus, in some cases,
warrants to share in any ultimate equity upside. These returns are
obviously attractive to the new funds investors (although some
might not be able to take the warrants due to their fund investment
criteria). As a result there has been a move in the market to
stretch the debt package through increased mezzanine facilities to
take advantage of the high liquidity in the market for this sort of
high-yielding instrument. Sometimes, the perceived demand for this
sort of paper has been so great that sponsors have negotiated
reverse flex arrangements, where the underwritten pricing for the
mezzanine piece of a transaction would be trimmed if demand was so
great that the underwriter could successfully syndicate at the
lower price.
Such high returns are earned on these instruments because their
guarantee and security credit support is much weaker than the
senior A, B and C pieces. Always contractually subordinated
pursuant to the intercreditor agreement, mezzanine instruments are
often structurally subordinated too. This can create a problem for
some of the fund investors, because their investment parameters
require them to buy only senior debt pieces and mezzanine loans and
notes are subordinated, not senior.
One solution to this issue, which has been transported recently
from the US to the European market, is the concept of a second lien
debt piece. This ranks as senior debt, in the sense that the debt
claim itself is pari passu with the senior A, B and C facilities
(often referred to simply as the D facility), but the security
support is subordinated to the security support provided for the A,
B and C facilities. However, these second lien instruments do
still, through the second ranking security, rank ahead of trade and
unsecured debt and any structurally subordinated debt (for example,
most high-yield bonds). Having senior ranking as regards the debt
claim also means that the second lien instruments will not cause an
issuer to fall foul of anti-layering provisions in any existing
high-yield bond issues, for instance in a refinancing equity return
transaction, because the second lien debt is not treated as a
separate tranche of debt for these provisions.
For the borrower, the benefits of including a second lien layer
are that it will carry a lower coupon than unsecured or
subordinated debt and will provide access to a broader debt market.
Also, whereas a typical 10-year high-yield bond would usually have
a five-year no-call clause, which would require a make-whole
payment for any earlier redemption, second lien debt can usually be
redeemed from day one for a specified and much lower premium.
Recent deals in which European second lien financing has been
used include Brenntag, Invensys, Waterford Wedgewood, Aker
Kvaerner, Ashtead, KAP Springer, TUMI and Cognis.
So what is a second lien financing instrument?
Well, it can either be a second lien loan or a second lien bond
and, perhaps strangely, its terms will often be dictated by its
nature. So second lien loans will often be documented as a simple
facility D in the same credit agreement as the senior A, B and C
facilities, and will benefit from the usual senior control
provisions (representations, undertakings and defaults).
Conversely, if structured as a second lien bond, the instrument
will probably have bond terms and conditions that follow the
incurrence-based approach found in high-yield bond indentures. In
both cases however, the second lien loan or note will have the same
borrowers, the same guarantors and the same security package as the
senior A, B and C facilities - though, of course, the security
claims will be subordinated.
The Cognis transaction had both second lien loans and second
lien notes, and the covenant package for both of these followed the
covenant package on the Cognis high-yield issue. Also, the Cognis
subordination arrangements included a payment blockage period,
showing that European second lien arrangements might differ from
the approach found in equivalent issues in the US.
In the US, second lien instruments will generally place their
holder ahead of trade creditors of the relevant group. The same
will be true in the UK, where robust upstream guarantees from
operating companies are usually obtained. However, in the context
of a European group security package, the strength of upstream
guarantees can be fairly low in jurisdictions where financial
assistance and corporate benefit laws are particularly strict (such
as France and Italy).
Second lien investors need to be aware of the complex nature of
European security packages and claims to fully assess the value
they receive from a second ranking security package. As with many
senior facility participants, a brief analysis of the legal
technicalities underpinning the European guarantee and security
package could quickly lead to the conclusion that by far the most
likely enforcement is simply a sale of shares fairly high up the
group structure, leaving trade creditors to be kept whole as
opposed to an enforcement at the asset level. Of course, any share
pledge enforcement would usually be directed and controlled by the
senior lenders holding the A, B and C paper. The second lien
holders will only recover anything from this security enforcement
to the extent that proceeds recovered by the senior lenders exceed
the amounts owed to them; the senior lenders do of course have a
duty to obtain the best price reasonably available. As with
traditional mezzanine, second lien holders will generally have the
right to buy out the senior lenders at par as a protection against
any enforcement sale not recovering full value.
The other typical protection given to mezzanine investors is
through the enforcement standstill periods, which limit the time
for which senior lenders can procrastinate and avoid enforcing
security. Holders of second lien loans will generally enjoy
equivalent rights to those traditionally provided to mezzanine
lenders - that is, if senior banks do not take enforcement action
within the standstill period (usually 90 days for payment default,
120 days for financial ratio default and 180 days for any other
default), the second lien security holder can enforce
themselves.
Typical second lien security subordination provisions will
usually include undertakings from the second lien lenders:
- not to take enforcement action while senior secured debt is
outstanding (permanently or for a limited period);
- not to challenge enforcement actions of senior security
holders;
- not to challenge the validity or priority of senior
security;
- to waive or limit (usually for a specified time) other
typical secured creditors rights with regards to the senior
security holders. For example, whether and when to exercise
remedies against the secured assets, the order in which to
foreclose on which secured assets, the type of sale in which to
sell secured assets, and the appropriate price for, and buyers
of, secured assets; and/or
- automatic release of second lien security rights over any
collateral upon a sale of that collateral pursuant to a senior
security enforcement.
As the subordination of second lien debt relates only to
security and not to the debt claim itself, payment blockage
provisions (whereby the interest payments are blocked for a period
while a senior default exists) typically found in other
subordinated debt instruments such as mezzanine loans, are
absent.
These subordination provisions result in second lien debt being
referred to as silent (where the provisions bite permanently until
the senior secured debt is repaid in full) or quiet (where the
provisions only bite for limited standstill periods). Second lien
bonds generally tend to be silent and second lien loans tend to be
quiet.
A mitigating protection usually given by senior secured lenders
in favour of second lien lenders is to agree a limit on the
principal amount of debt that can benefit from the senior ranking
security.
A concern which many participants in the European asset debt
financing markets have is that, because second liens are new to the
market, the effective implementation of the security subordination
provisions and the intercreditor approach of typical second lien
investors have not yet been tested in restructuring/workout
scenarios.
Sometimes, second lien security will be documented separately,
so the possibility arises of a situation where enforcement of the
senior security documents encounters difficulties that do not
hinder the second lien enforcement. Typically, senior secured
lenders are protected in this instance by turnover provisions in
the subordination agreement, obliging the second lien holders to
turn over receipts to the senior secured lenders insofar as
necessary to leave them both in the position they would have been
in had the senior secured security documents not encountered such
difficulties.
The end result for second lien holders can vary depending on the
security enforcement scenario encountered. For instance, if the
senior secured lenders enforce at a time when the secured group can
be sold on a going concern basis to third party purchasers, the
senior secured lenders will most likely enforce by way of a share
sale at the top of the group. Second lien holders will be obliged
to release their security and their debt claims and seek recovery
to the proceeds recovered from the sale by the senior secured
lenders, who are obliged to use reasonable endeavours to obtain the
best possible price. If the secured group cannot be sold on a going
concern basis (so the senior secured lenders look to enforcement
against asset security), although the second lien holders will be
obliged to release their security claim over any assets sold, and
look to any excess in recoveries made by the senior secured
lenders, they will not be obliged to release their debt claims,
which will remain, after full asset security enforcement, as
unsecured claims ranking pari passu with the debt claims of the
senior secured lenders.
Higher up the risk/return spectrum, another recent (but less
common) way of stretching the debt package (again largely brought
to Europe from the US) is the insertion of a payment-in-kind (PIK)
note issue between the mezzanine/high-yield bond debt layer and the
subordinated loans invested by the private equity investors. The
term payment in kind reflects the defining aspect of this
instrument, being that interest is a high fixed interest rate (14%
to 16%, often about 5% above the mezzanine/high-yield coupon) which
is payable, at the option of the issuer, through the issuance of
additional PIK notes (that is, rolled up) or in cash. Reflecting
their position in the risk/return spectrum, the PIK notes will
mature six months after the maturity date for the
mezzanine/high-yield bond (that is, usually 10 years and six months
from issue). The PIK notes will have a customized non-call
arrangement, often being non-call in the first two years and then
callable at 102% of par in the third year and 101% of par in the
fourth year. The PIK notes will be issued by a topco company, which
will sit in the corporate structure above the issuer of the
mezzanine/high-yield bonds. The PIK notes will therefore be
structurally subordinated to the instruments (as well as to any
senior and second lien debt). PIK notes will usually be unsecured
with an incurrence-based covenant package reflective of typical
high-yield bond terms and conditions, although they are often less
extensive than those found in a high-yield bond issue.
Growing ambition
Debt packages in the European acquisition debt financing markets
are being stretched to fund ever more ambitious purchase prices
and, where timely exits are not available, interim equity returns.
This is being done both through stretching the traditional debt
pieces (senior B & C loans, mezzanine and, if the market is
open, high-yield issues) and through squeezing new instruments into
the risk/return spectrum of each deal through second lien loans or
bonds and, less frequently, PIK notes.
Author
biography
Richard
Sharples
Clifford Chance
LLP
Richard Sharples is a partner in the general banking and
acquisition/structured finance group of Clifford Chance LLP in
London. He specializes in the debt finance side of UK and
multi-jurisdictional leveraged acquisitions acting for both
investment bank arrangers and private equity sponsors. He also
advises on other event-driven debt financings and, recently,
restructuring/workout transactions. Recent transactions involved
advising the mandated lead arrangers on Cemex's acquisition of RMC
and on Charterhouse's acquisition of Autobar, and advising Candover
on financing its acquisition of ABB's Oil and Gas division. Born in
Bolton, he studied law at Brasenose College, Oxford, qualified with
Clifford Chance in 1992 and became a partner in 2000.
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