The credit crunch has left many banks with large amounts of debt on their balance sheets. The traditional investor pool of banks, hedge funds and CDO and CLO funds has resisted inducements to syndicate credits – original issue discount, upfront fees, Libor floors, increased pricing, retranching debt and changing currencies (to sell into overseas markets). Secondary trading opportunities for these traditional investors, direct and indirect pressures to preserve capital, and a collapse in the securitisation market have depleted the pool for new syndicated credits and these hangover credits. So banks are looking for alternative exit strategies from existing credits. One possibility is allowing private equity funds and equity sponsors to purchase debt, in a departure from conventional practice.
Above the threshold
Private equity funds are taking advantage of the steep discount, pricing increases and other incentives being offered to purchase large positions in 2007's multi-billion dollar acquisition financings. These busted deals have proven intractable even for the best syndication desks. The twist is that in many cases, the selling lead arrangers are providing seller financing to the private equity funds. The amount of seller financing varies from deal to deal, but banks are frequently providing up to 75% of the funds necessary to purchase the loans, with equity contributed by the private equity fund making up the balance.
These deals are in essence a leveraged warehouse facility within a leveraged buyout. Primarily because of failures in the securitisation market for CDOs (whether syndicated loans or mortgage-backed securities), lead arrangers have been forced to step in to provide the necessary credit support to finance the purchase of the loans. Given that the private equity funds have taken the last-out equity position on the purchase of loans, there is a transfer of risk from the balance sheet of the bank to the new buyer.
This deal structure is attractive to both sides. Private equity has the prospect of attractive internal rates of return (IRRs) at a time when equity sponsors are struggling to raise enough debt at attractive rates to fund new acquisitions or sell existing portfolio companies. Banks, of course, can use these deals to reduce their balance sheet exposure, although incrementally, at a time when they face pressures to maximise capital.
The balance sheets of banks have faced, and will continue to face, a variety of pressures from the loan market. First, there has been an increase in the number of borrowers that have drawn down pre-emptively on their standby revolving credit facilities, apparently driven by declining free cashflow and concerns over possible deteriorations in the bank's balance sheet, which would limit its ability to fund future draws. Second, hundreds of billions of credit facilities are reaching maturity and will need to be refinanced or renewed. Third, banks need to get back to a position where they can make loans to new clients to develop their leveraged finance groups, which, before the recent market turmoil, were key drivers of profit.
Another reason these deals are attractive is that some banks have bargained for the inclusion of contingent interest provisions in their deals. Under these provisions, if the private equity fund achieves an IRR over a period of time above a certain negotiated threshold, the bank will share in the upside above that threshold.
Share the pain
In executing these equity fund sell-down transactions, the underlying credit documentation must be carefully reviewed. In some cases, the borrower has approval rights over the identity of assignees. In our experience, obtaining these consents has not been problematic, particularly in deals where the lead arrangers have not fully exercised their market flex. In deals where the borrower has approval rights and declines to approve the proposed assignment, it may be possible to structure around this by styling the seller financing as a participation in, rather than an assignment of, the seller's loans.
This is because many credit agreements do not give the borrower approval rights over the identity of participants. In an assignment, the assignee becomes a lender with all the rights and obligations of a lender. In a participation, by contrast, the participating bank remains a lender, and retains a lender's rights and obligations.
Buying a participation is a less attractive option for private equity for several reasons. A participant tends to have limited voting rights that are tied to a handful of fundamental economic provisions in the credit agreement, whereas an assignee gets the benefit of all of the voting provisions in the credit agreement. A participant does not have a right to attend lenders' meetings, and is forced to rely on the participating bank reporting back to the participant, which may leave the participant in a more passive and reactive position. If a participant incurs increased costs, Libor-breakage costs or tax liabilities, it can only recover those amounts from the borrower to the extent that the participating bank would be entitled to those amounts. Another variant is to structure the transaction through credit derivatives, although such structures often suffer from the same negative considerations as the participation structure above. In each of these variations, accounting and tax considerations will also need to be factored into the deal.
If a deal has multiple joint arrangers in a number of transactions, it is common practice shortly before closing for these arrangers to enter into an agreement that requires any sell-down or syndication of the debt to be done on a pro rata basis among the arrangers, based on the principal amount of their outstanding loans and unfunded commitments. These arrangements are intended to cause the arrangers to reduce their exposure in an orderly manner and, in effect, to share the pain equitably. If this type of agreement exists, either (i) the arranger seeking to sell its position in a credit will need to obtain a waiver from the other arrangers or (ii) the other lead arrangers will need to sign on to the deal struck with the selling arranger or negotiate that deal.
Protecting the henhouse
Lenders are also tapping another source of capital in sponsor acquisition financings, subject to certain restrictions: the sponsor and its affiliates.
In recent years, top-tier private equity sponsors have been able, in many (but not all) acquisition financing credit facilities, to include provisions that allow them and/or an affiliate to purchase a portion of the loans made or to be made under those facilities. From a lender's perspective, these provisions conflict with traditional expectations that loan parties and owners of the equity in loan parties (or their affiliates) will not acquire interests in senior loans and that such purchases should not be permitted as they violate expectations of pro rata pay-downs among lenders before any recovery by equity holders.
Almost inevitably, over time these clauses have crept into a number of middle market deals. The clauses should be distinguished from the deal structure described in the preceding paragraphs in which the investing private equity fund tends to be unaffiliated with the sponsor, having no equity stake in the underlying transaction, rather than the deal sponsor. This is an important distinction: in the structure described above, the interests of the unaffiliated equity fund purchasing the debt tend to be closely aligned with the interests of other lenders (unless the fund holds a direct or indirect equity position in the borrower, other members of the credit group or any of their parent entities, in which case the arranger should consider whether to include the provisions described below).
If written correctly (from the perspective of the senior lenders), these clauses provide another option for banks to sell down their positions, at little if any incremental risk of allowing the proverbial fox (the affiliated private equity sponsor) into the henhouse (the senior lender group). There is surprisingly little uniformity in the way that banks draft these provisions. The key issues relate to the ability of the affiliated private equity sponsor to vote the debt it acquires, and the scope (if any) of the limitations placed on the rights enjoyed by other lenders.
Votes
A number of different drafting permutations tend to be included in loan documents. Restrictions are placed on which sponsor-related entity or entities can purchase the debt – often it will be limited to debt funds managed by the sponsor, which will be walled off from the sponsor entity that oversees and administers the credit and, potentially, is in possession of material non-public information about the credit not known to other lenders.
A cap may be placed on the amount of debt that the sponsor entity and its affiliates can purchase.
There may be a requirement that the sponsor entity purchase the debt either within a specified period or before the commencement of the syndication process, particularly in the rare instance where the fee letter provides that the sponsor will not pay a commitment fee (or will pay a reduced fee) on any debt purchased by the permitted sponsor entity. Without this provision, the lead arranger's syndications desk has to assume that the sponsor entity will not buy the debt; the desk will be forced to engage in a full-scale syndications effort, for which it will not be compensated (or fully compensated) by the borrower.
An outright prohibition or cap on the amount of debt that the sponsor entity can vote may be introduced. If the sponsor entity is allowed to vote, from the syndicate's perspective, the sponsor entity should not be able to acquire a sufficient stake in the debt to hold a blocking position on lender votes. Although credit agreements generally contain yank-a-bank provisions that permit a holdout lender to be removed from the syndicate, it is only the borrower (and not the lenders) that can exercise that provision.
A provision in the credit agreement may also be included, coupled with a requirement that the sponsor entity sign a waiver addressed to the other lenders. It may unconditionally waive any present or future right to require any agent appointed under the credit facility or any lender to take any action (or refrain from taking any action) with respect to the credit facilities or any of the definitive loan documentation; attend any meeting, in its capacity as a lender, with any agent or lender or receive any documents or information, reports or notices from any such agent or lender; or make or bring any claim, in its capacity as a lender, under or in respect of the credit agreement or any of the other definitive loan documentation, against any agent or lender with respect to the duties and obligations of those agents and lenders under the definitive loan documentation.
The middle man
Many of these provisions are often excluded from the initial draft of a credit agreement allowing a sponsor entity to purchase bank debt. Banks that choose not to include these restrictions do so at their peril. The banks that do include this type of language are rarely willing to remove or substantively change these clauses, based on a recognition of their importance if the credit becomes troubled; the lenders need to decide how to proceed out of earshot of the sponsor and the loan parties.
Historically, lead arrangers have often pushed back strongly on a sponsor's request to purchase bank debt, because of (i) the sponsor's predictable request (which typically is met with strong and successful resistance from the bank) that it not be charged a commitment fee on capital that it, or one of its affiliates, provides; (ii) a concern that the sponsor and, probably, the borrower, will gain access to information about the other lenders' positions on, and strategies to resolve, problems with the credit; and (iii) until the last year or so, a belief that the lead arrangers, will be able to successfully syndicate the debt with relative ease, either with or without invoking market flex, and without the need for capital provided by the sponsor or its affiliates.
If the arranger includes the provisions discussed above in the loan documentation, it can adequately mitigate lenders' concerns relating to the sponsor's and the borrower's access to sensitive and possibly privileged information during credit workouts, credit-related litigation, and loan-party insolvency proceedings. Banks generally insist on being paid their full commitment fee, particularly in the current environment in which rich incentives are being offered to potential syndicate members (including the lending sponsor entity). Many of the costs of these incentives, such as original issue discount and upfront fees, are borne directly by the arranger, although provisions in some credit agreements now require the arranger to be made whole for these types of losses.
As the supply of syndicated debt continues to exceed demand among the traditional investor base, we may see more arrangers agreeing to allow sponsor entities to purchase debt, turning traditional convention in the banking markets on its head. Perhaps more interestingly, when the credit crunch ends, lead arrangers may face competition for the lead arranger role from the debt funds set up by private equity firms. In the past, many of those funds have been content to be syndicate members. However, the more sizeable funds have the resources and capital to originate deals. This is far more lucrative than being a mere syndicate member, because it cuts out the middle man, namely, the banks that have historically held the arranger role.
By contributing editor Neil Cummings of Proskauer Rose and Joshua W Thompson of Jefferies Finance
On January 1 2009 some changes to the German Foreign Trade and Payments Act (Außenwirtschaftsgesetz, AWG) will come into effect that are likely to have a significant impact on foreign investors wishing to invest in German target companies. Under the new regime, any such acquisition by foreign investors may trigger the right of the German Federal Ministry of Economics to investigate and even prohibit the transaction.
The reform
Who is affected?
Under the Foreign Trade and Payments Act, investors from non-EC countries that do not belong to the European Free Trade Association (EC plus Switzerland, Norway, Iceland and Liechtenstein) and that acquire shares representing 25% or more of the voting stock of a German company may have their acquisition investigated by the Federal Ministry of Economics. Shares held by companies controlled by the acquirer (by holding at least 25% of the voting stock) are treated as if they were held by the acquirer itself. Shares that are subject to voting agreements are also assigned to the acquirer.
If the Ministry comes to the conclusion that Germany's public order or national security are threatened by a transaction, it may prohibit the acquisition. Unfortunately, the Act does not contain any definition of public order or national security, so the Act brings a certain degree of uncertainty about which transactions fall within its scope. If the Ministry decides that a transaction falls within the scope of the Act, it may order that the acquisition (which may already be consummated) be reversed. The Ministry may also choose only to prohibit the exertion of voting rights of shares held by the foreign investor, thus restricting the investor's influence on the German target.
How long does it take to reach a decision?
Foreign investors are under no obligation to file their transaction with the Federal Ministry of Economics. However, they may do so after signing and will, in that case, receive a final decision on whether the transaction will be prohibited within one month. If the transaction is not filed with the Ministry, it may start an investigation on its own account within three months after the consummation of the transaction, with the effect that the transaction is put under the condition precedent of the Ministry's approval. The Ministry will immediately inform the investor of its decision to investigate the acquisition, which triggers the acquirer's obligation to provide the Ministry with data. The acquirer will be informed about the specific data required by the Ministry through an announcement in the Federal Gazette (Bundesanzeiger). The investigation must be completed within two months of receipt of the transaction data.
Aims and criticism
The reform seeks to protect sensitive branches of German industry such as the energy, telecom and military sectors. Potential threats are perceived to come from state-controlled funds (in particular from China, the Emirates and Russia) that may be used to influence German politics via investments in German key enterprises. State-controlled foreign corporations have also been classified as potentially dangerous.
The reforms have attracted much criticism. For example, the new powers granted to the Ministry of Economics are suspected of infringing the freedom of capital movement as guaranteed by Article 56 of the EC Treaty. The European Commission is planning to examine the Act for its reconcilability with Article 56 and the freedom of establishment (Article 49). Also, the scope of the Act is considered to be unreasonable because it not only restricts investment from foreign countries, state-owned funds or state-controlled corporations but foreign investors in general. Any private equity investor wishing to invest in Germany may find his transaction being investigated by the Federal Ministry of Economics.
The problem for foreign investors
The main problem is the legal uncertainty for foreign investors. If an investor has successfully completed a transaction, it may still be subject to investigation for a period of three months after the closing date. A further two months may pass until the Ministry has completed its investigation. The result may be that the transaction is prohibited and the acquisition must be reversed. This uncertainty is unacceptable for the seller, buyer, target, financing banks and employees of the target company.
Recommended course of action
Foreign investors wishing to acquire 25% or more of the voting stock of a German company should therefore adhere to the following guidelines.
Informal enquiry before signing
A foreign investor can contact the Federal Ministry of Economics before he signs a share purchase agreement on a confidential and informal basis in order to find out if the Ministry will investigate the transaction. A similar approach is generally taken if a bidder wishes to know the position of the German Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin) on a takeover process. There are no guidelines on how such an informal approach should be made, though any informal contact bears the risk that information may be leaked. A seller is therefore unlikely to agree to such contact.
Filing for investigation after signing
Therefore, a foreign investor should voluntarily file the transaction with the Federal Ministry of Economics immediately after signing a share purchase agreement. He should refrain from filing only if he and the seller are in no doubt that the transaction does not qualify for an investigation by the Ministry. If the investor intends to file the transaction, the share purchase agreement should contain a clause that makes the clearance of the acquisition by the Ministry a condition precedent for the obligation of the parties to consummate the transaction. After the Ministry has received all relevant data, it has one month to decide whether it will prohibit the consummation. In order to speed up the process, the investor should agree with the Ministry on which information it needs in order to come to a decision as quickly as possible. It appears likely that an investor will, in most cases, be able to get a decision before the German Federal Cartel Authority (Bundeskartellamt) has cleared the transaction. Therefore, the filing of the acquisition should not lead to delay in most cases.
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