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.
Legal
advisers to US targets and acquirers YTD |
Rank |
Attorney |
Value $
billion |
Number of
deals |
1 |
Skadden Arps Slate
Meagher & Flom |
390.7 |
165 |
2 |
Sullivan &
Cromwell |
358.2 |
97 |
3 |
Wachtell Lipton Rosen
& Katz |
326.5 |
52 |
4 |
Cravath Swaine &
Moore |
230.4 |
44 |
5 |
Latham &
Watkins |
221.4 |
169 |
6 |
Davis Polk &
Wardwell |
210.9 |
65 |
7 |
Fried Frank Harris
Shriver & Jacobson |
201.8 |
42 |
8 |
Shearman &
Sterling |
199.3 |
74 |
9 |
Cleary Gottlieb Steen
& Hamilton |
175.7 |
38 |
10 |
Weil Gotshal &
Manges |
121.2 |
103 |
Includes
work for financial advisers
Data processed November 14
Source: Dealogic |
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.
US M&A |
Recommended firms |
Tier 1 |
Cravath Swaine & Moore |
Davis Polk & Wardwell |
Simpson Thacher & Bartlett |
Skadden Arps Slate Meagher &
Flom |
Sullivan & Cromwell |
Wachtell Lipton Rosen & Katz |
Tier 2 |
Cleary Gottlieb Steen &
Hamilton |
Latham & Watkins |
Shearman & Sterling |
Tier 3 |
Cadwalader Wickersham & Taft |
Debevoise & Plimpton |
Fried Frank Harris Shriver &
Jacobson |
Gibson Dunn & Crutcher |
Weil Gotshal & Manges |
US private equity –
transactions |
Recommended firms |
Tier 1 |
Debevoise & Plimpton |
Kirkland & Ellis |
Simpson Thacher & Bartlett |
Tier 2 |
Davis Polk & Wardwell |
Latham & Watkins |
Skadden Arps Slate Meagher &
Flom |
Weil Gotshal & Manges |
Tier 3 |
Cleary Gottlieb Steen &
Hamilton |
Fried Frank Harris Shriver &
Jacobson |
Gibson Dunn & Crutcher |
Ropes & Gray |
Schulte Roth & Zabel |
Wachtell Lipton Rosen & Katz |
Willkie Farr & Gallagher |
US private equity –
fund formation |
Recommended firms |
Tier 1 |
Debevoise & Plimpton |
Simpson Thacher & Bartlett |
Tier 2 |
Kirkland & Ellis |
Ropes & Gray |
Weil Gotshal & Manges |
Tier 3 |
Akin Gump Strauss Hauer &
Feld |
Cleary Gottlieb Steen &
Hamilton |
Davis Polk & Wardwell |
Gibson Dunn & Crutcher |
Latham & Watkins |
Schulte Roth & Zabel |
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
Top 10
club deals in the US YTD |
Target |
Acquirer |
Target
Nationality |
Value $
million |
Target
adviser |
Acquirer
adviser |
HCA |
Bain Capital; Kohlberg
Kravis Roberts; Merrill Lynch Global Private Equity |
US |
32,675.0 |
Shearman & Sterling;
Bass Berry & Sims; Sullivan & Cromwell; Cravath
Swaine & Moore |
Simpson Thacher &
Bartlett |
Clear Channel
Communications (Bid No 2) |
Bain Capital; Thomas H
Lee Partners |
US |
26,535.8 |
Akin Gump Strauss Hauer
& Feld; Sidley Austin |
Ropes & Gray; Dow
Lohnes & Albertson |
Harrah's
Entertainment |
Apollo Management; Texas
Pacific Group |
US |
25,717.7 |
Latham &
Watkins |
Cleary Gottlieb Steen
& Hamilton; Wachtell Lipton Rosen & Katz |
Kinder Morgan |
GS Capital Partners; AIG
Global Asset Management Holdings; Carlyle Group;
Riverstone Holdings |
US |
21,558.2 |
Skadden Arps Slate
Meagher & Flom |
Weil Gotshal &
Manges; Davis Polk & Wardwell; Vinson & Elkins;
Wachtell Lipton Rosen & Katz |
Freescale Semiconductor
(Bid No 2) |
Blackstone Group;
Carlyle Group; Permira; Texas Pacific Group |
US |
17,600.0 |
Wilson Sonsini Goodrich
& Rosati |
Skadden Arps Slate
Meagher & Flom; Cleary Gottlieb Steen &
Hamilton |
Univision Communications
(Bid No 2) |
Madison Dearborn
Partners; Providence Equity Partners; Texas Pacific
Group; Thomas H Lee Partners; Saban Capital Group |
US |
13,632.9 |
Skadden Arps Slate
Meagher & Flom |
Weil Gotshal &
Manges; Hogan & Hartson; Cleary Gottlieb Steen &
Hamilton; Latham & Watkins |
VNU |
AlpInvest Partners;
Blackstone Group; Carlyle Group; Hellman & Friedman;
Thomas H Lee Partners; Kohlberg Kravis Roberts |
Netherlands |
10,998.0 |
Simpson Thacher &
Bartlett; De Brauw Blackstone Westbroek |
Clifford Chance; Latham
& Watkins |
Philips Semiconductors
(80.1%) |
Kohlberg Kravis Roberts;
Silver Lake Partners; AlpInvest Partners; Apax Partners;
Bain Capital Partners |
Netherlands |
9,479.9 |
Sullivan & Cromwell;
De Brauw Blackstone Westbroek |
Clifford Chance; Simpson
Thacher & Bartlett; Kirkland & Ellis |
Aramark |
Goldman Sachs Capital
Partners; JP Morgan Partners; Thomas H Lee Partners;
Warburg Pincus |
US |
8,300.3 |
Shearman & Sterling;
Skadden Arps Slate Meagher & Flom |
Sullivan & Cromwell;
Wachtell Lipton Rosen & Katz |
General Motors
Acceptance Corp - GMAC (51%) |
Cerberus Capital
Management; Citigroup Venture Capital Equity Partners;
Aozora Bank |
US |
7,400.0 |
Weil Gotshal &
Manges; Kirkland & Ellis |
Cleary Gottlieb Steen
& Hamilton; Debevoise & Plimpton; Schulte Roth
& Zabel; Freehills |