The prevailing wisdom since the 2008 crisis has been that financial institutions, given the choice, would always prefer to purchase securities at closing rather than fund the bridge loan, even if it means taking those securities onto their own balance sheets. But recently, institutions have questioned (and in some cases upended) those expectations.
They’ve been electing, in consultation with the borrower, to fund the bridge loan rather than demand and purchase securities. Factors they’ll weigh when making this determination include:
- Liquidity: The high-yield bond market has historically been thought to be more liquid than the (bridge) loan market, and therefore securities have been easier to distribute than bridge loans. The growth in the syndicated loan market and the increased appetite and flexibility of private credit lenders have challenged this proposition. More importantly, as described above, post-closing distribution of securities by underwriters requires issuer cooperation -- including the production of an offering memorandum, updated financial information, diligence and auditor comfort. In circumstances where the issuer is unable or unwilling to provide prompt cooperation when a market opportunity presents itself, the underwriters will be unable to effect a distribution, so the expected liquidity may be limited. In contrast, the lower amount of cooperation and information required from the borrower to syndicate loans is less likely to be a roadblock.
-Flexibility: Where there is insufficient market for an issuer’s securities and it is unclear what the most efficient permanent capital structure will be, funding a bridge loan (without “call protection”) may offer all parties greater and lower cost flexibility (e.g. to pursue a term loan B refinancing or other structured solution) than issuing call-protected securities.
- Limits on post-closing demand rights: If arrangers are concerned about the ability to effectively exercise demand rights after closing, they may feel compelled to issue a securities demand at closing, at which time certain demand conditions will either not apply (e.g. the adverse tax consequences condition) or will already have been satisfied (e.g. delivery of offering memoranda and related financial information).
- Underwriter group dynamics: While the decision to issue a securities demand is typically controlled by a bridge arranger majority, it is important to note that no individual arranger can be forced to participate in the purchase of those securities. Some arrangers – particularly private credit and other non-traditional bridge parties – prefer loans, because of internal structure or investment policy, the higher cost of holding securities (rather than loans) and internal accounting policies that may produce different results depending on the instrument and the entity acquiring it. Even arrangers willing to take securities in a demand cannot be forced to participate in the distribution of the securities in accordance with the majority arranger’s expectations. Where some underwriters propose to hold – rather than distribute – the securities, that may need to be disclosed, and may result in market “overhang” (as the market anticipates additional supply becoming available just as prices recover). Such differing views within the arranger group as to whether to hold or sell securities will influence the majority arrangers’ decision over pursuing a securities demand.
- Economics: Funded bridge loans accrue interest at a floating rate equal to SOFR plus an agreed margin, which increases by 50 basis points every 90 days until the rate hits the total cap. If arrangers issue a securities demand and there is a demand failure event, the interest rate on the bridge will immediately increase to a fixed rate equal to the total cap. Securities, on the other hand, will have fixed rate of interest, and in a distressed market, that rate may be up to the total cap. This creates an incentive for the arrangers to issue a securities demand so that, one way or another, they are holding an instrument accruing interest at the total cap. As demonstrated in several recent transactions, however, in a rising rate environment, it is possible that, due to an increase in SOFR or another market dislocation, the bridge loan may at closing already be accruing interest at or near the total cap. In that case, at least from a yield perspective, arrangers may be indifferent toward the choice between funding the bridge or purchasing securities. If the yield outcome is neutral, the arrangers may be motivated to fund the bridge loan (and receive the corresponding funding fee, which could be used to offset losses) rather than securities (which do not attract a similar fee).
- Borrower dynamics: Arrangers demanding securities in the face of a borrower’s reluctance or inability to issue them may create friction in the ongoing business relationship with the borrower (and related sponsor, if applicable). It is also often the case that the arrangers rely on the borrower to provide accommodations or other concessions that go beyond the strict terms of the financing commitment in order to syndicate the overall financing package (or at least mitigate losses). Issuing a securities demand contrary to the wishes of a borrower may dampen its enthusiasm for such cooperation.
Where does this leave us?
Modern bridge financings have been predicated on two underlying assumptions: that arrangers always prefer to hold securities at closing, and that they can force (or effectively incentivize) borrowers to issue securities at closing through securities demand rights. Recent experience has challenged both these assumptions. The lessons for arrangers of a bridge facility are (at least) twofold. First, demands of securities and demand failure remedies should be closely scrutinized to ensure they properly balance the competing interests of the borrower and the arrangers, and that the rights and remedies of each party are fully understood.
This may include revisiting (and limiting) some of the conditions to the securities demand, expanding demand rights to include loan demands (with less onerous disclosure requirements) and reassessing and, where appropriate, reinforcing demand failure consequences. Second, as bridge facilities are more likely to be (involuntarily) funded in a distressed market, more attention may need to be paid to the terms of the bridge facility itself, such as including more specificity as to the more restrictive covenants that apply during the bridge period and ensuring bridge pricing (and its intended incentives) properly reflects the expectation of the parties, particularly in a rising interest rate environment.
Jason Kyrwood is partner and co-head of global finance practice at Davis Polk.
For part 1 of this series on bridge loan facilities is available here.