I overview of typical acquisition and leveraged
finance debt products
A range of debt products has traditionally been used in acquisition and leveraged finance. As always, a combination of cost, the features of the debt product in question and availability has driven what is used for a given project.
We are operating in interesting times, because the credit crisis that started in mid-2007 has triggered an evolutionary process that has not yet ended – because the US leveraged finance market goes from strength to strength in relative terms, debt products that are more readily available in the US leveraged finance market have been turned to in parts of the world that would not have considered them in the past, such as US first lien and second lien financings for European or, to a lesser degree, Asian acquisitions and groups (and the market continues to grapple with whether to tinker with those products to eliminate differences arising from the fact that one cannot count on US Chapter 11 applying for a European or Asian target or group), and investors in certain debt products such as European mezzanine required changes to those products because of losses that exceeded expectations during the downturn, although that product is currently in something like hibernation because of a mismatch between lender and borrower pricing expectations.
In addition, the buoyant US loan market has been continuing to compete with the US high-yield market through its enthusiastic adoption of covenant lite loans; and because the US loan market has shown itself to be available for international financings even where there are minimal US revenues in the group or acquisition being financed, this in turn is pressuring the European market to adopt less restrictive terms for loans and since the beginning of 2014 there has now been a reasonable number of European placement covenant-lite loans, in addition to the relatively numerous and earlier US placement covenant-lite loans for European acquisitions or groups.
The principal debt products normally turned to for acquisition and leveraged finance are:
- a bonds and notes, usually referred to as high yield (or, less flatteringly, junk) bonds;
- b senior secured loans;
- c super-senior revolving credit facilities (super senior RCFs) or asset-backed borrowing base revolvers (ABL revolvers), usually made available alongside bonds or unitranche loans (in the case of super senior RCFs) or senior secured term loans (in the case of ABL revolvers);
- d second lien loans or bonds;
- e mezzanine loans;
- f unitranche loans; and
- g payment in kind (PIK) loans or bonds.
The following discussion gives an overview of the principal features of these products.
Bonds have been a staple of leveraged and acquisition finance since the early 1980s. In contrast to the type of bonds issued by investment grade issuers, which have relatively few covenants (undertakings) beyond a limited negative pledge, investors in below investment grade debt typically require a covenant package that allows the issuer to conduct business in the ordinary course without restriction, but requires it to pass financial ratio testing before undertaking certain actions that are perceived to potentially alter credit quality and are beyond certain pre-agreed limits or ‘baskets’. Examples of these kinds of actions include making minority investments, paying dividends, incurring debt and granting security. These types of covenant packages are known as ‘incurrence covenants’ because the ratio tests only apply if the action in question is actually taken – the key point being that the issuer does not involuntarily go into default until it runs out of cash, even if its business is deteriorating and it could no longer pass those ratio tests.
Initially, high-yield bonds were contractually subordinated by their terms (i.e., ‘senior subordinated notes’) but never featured standstill provisions, largely because they were developed first in the United States as a publicly registered security,2 and a standstill period upon an event of default violates the US Trust Indenture Act, which, inter alia, specifies certain required characteristics for public debt securities.
Over time, more and more US-issued high-yield bonds were issued without being contractually subordinated, even where they were intended to be junior to senior loans, because the lenders of the senior loans were and are comfortable relying on the relatively comprehensive guarantee and security packages that are available in the US. In addition, contractual standstill periods on default are largely superfluous where Chapter 11 applies with its automatic stay – effectively a standstill for everyone other than the limited categories of creditors who are exempted from that stay.
The high-yield market outside the US followed the US lead, although with a several-decade lag before becoming a volume market albeit still dwarfed by the size of the US market. However, the European market focused on the fact that, depending on the jurisdiction outside the US, the consequence of accelerating debt usually is to cause an insolvency of the issuer with the initiation of a bankruptcy regime that, again outside the US, can be value-destroying compared with a consensual workout or Chapter 11. It was therefore for many years the norm in Europe to structurally subordinate the high-yield issuer (that is to say, to make the high-yield issuer a parent of the borrower of the more senior debt in the debt capital structure) so as to reduce senior debt holders’ concern about the lack of a standstill feature in the bonds. The structural subordination was also helpful – from the viewpoint of the more senior debt – in enabling the operating businesses to be sold in a security enforcement, leaving behind the claims of the high yield in a way that often could not otherwise be achieved absent seeking Chapter 11 protection.
These structures, particularly in Europe, led to certain workouts during the 2001–2005 period in which European bondholder recoveries were unexpectedly poor compared with the historical US experience. As a result of pressure from investors who perceived the poor recoveries to have been due to the structural subordination rather than the quasi-venture-capital nature of some of the European issuers that had been funded in this way prior to that period, high-yield bonds continued to be structurally subordinated but, for the first time with the Brakes Brothers issue in 2004, received upstream senior subordinated guarantees that would only be released in a senior security enforcement scenario if certain ‘fair value’ requirements were met. These have been standard in high-yield bonds in Europe ever since.
In a development that, at least outside the US, began in 2005 with the Cablecom high-yield issue, high-yield bonds started to be issued to occupy the position of what had formerly been the senior secured term loans in a debt capital structure, and enjoyed security alongside the first super senior RCF with covenants that largely tracked the bonds (but in addition had one maintenance financial covenant – see below for an explanation of what a maintenance financial covenant is). In 2009, Virgin Media issued the first senior secured bond that was pari passu with senior secured term loan debt – the senior term loan lenders initially agreeing to that structure largely because the proceeds were used to part prepay them and therefore reduce their overall lending exposure (this was a period when banks held many assets on their books below par and were seeking liquidity).
This new market further developed in 2010 with CVC’s acquisition of the Swiss telecoms company Sunrise. In that case the acquisition was financed not only with senior secured term loans but also with the first issue of senior secured bonds that were both pari passu with those term loans and formed part of the initial acquisition finance structure.
Senior secured bonds, whether the main term debt in a structure and sitting alongside a super senior RCF or truly pari passu with other senior secured term loan debt, have matured and become a normal feature in cross-border acquisition finance in just a few years.
Where bonds are intended to finance an acquisition, there usually is a need to show the vendor (or, in a take-private transaction in many jurisdictions, a regulatory body although, interestingly, this is not required in the US) that the funding will be forthcoming. This is normally achieved through underwriting banks committing to provide a bridge loan, with the acceptable degree of conditionality depending on vendor requirements or, in take private transactions with these kinds of requirements, regulatory requirements for ‘certain funds’. Bridge lenders prefer to be refinanced as soon as possible and structure bridge loan pricing and certain other features to encourage this, so the acquirer may issue bonds in escrow, pending closing of the acquisition, and it is not uncommon for the target to agree to cooperate in helping the acquirer issue the bonds as this requires substantial diligence and disclosure regarding the target.
Bonds normally pay a fixed rate of interest (although floating rate notes, bearing a floating rate of interest, are also seen, depending on the market) and also normally have a limited initial period where they cannot be prepaid or involuntarily redeemed, or can be prepaid at an expensive make-whole rate.
ii Senior secured loans
Loans come in all kinds of sizes, shapes, currencies and governing laws. While they can be bilateral (i.e., one lender extending credit to one borrower), in acquisition and leveraged financings these normally take the form of a credit or loan facility under which a group of lenders (known as a syndicate) makes available loans or other extensions of credit, or both, to one or more borrowers, with one or more initial members of the syndicate appointed as the administrative or facility agent, security agent or the documentation agent for administrative purposes.
Larger credit or loan facilities are normally arranged by one or more arranging banks and, given the need for certainty of funding of an acquisition, these banks normally also underwrite the facility, with a subsequent syndication to bring in additional lenders in due course. Refinancings may be done on an underwritten basis, but also are often done on a ‘best efforts’ basis where one or more arranging bank syndicates the facility but does not agree to provide the funding should the syndication fail to attract sufficient investor interest.
The Loan Market Association in London has published syndicated loan agreement forms that are widely adopted in Europe as a starting point for English law (and certain other law) loans, with trade bodies in some other jurisdictions following their lead and making similar efforts. The much larger US leveraged loan market has never succeeded in adopting a common form for loans or credit agreements, but the Loan Syndications and Trading Association has published forms for a variety of boilerplate provisions and ancillary documents, and market forces and the need to reflect market practice do ensure that there is a large degree of commonality in US law syndicated loan financings.
Loan agreements historically imposed financial ratio tests under which the borrowing group is required to maintain certain minimum levels either at all times or at periodic testing dates (usually quarterly). These are known as ‘maintenance financial covenants’, and the traditional suite of these consisted of an interest cover ratio test, fixed charge cover ratio test, leverage ratio test and a limitation on the permitted amount of capital expenditures. Starting in the mid-2000s, many larger loans omitted all but a leverage ratio test and were referred to as ‘covenant loose’ and a number of covenant-lite loans, omitting these tests entirely, were made on both sides of the Atlantic before the credit crisis disrupted the loan markets for a period. In recent times there has been a resurgence of covenant-lite loans-first, enthusiastically, in the US, and from 2014 also regularly in Europe albeit not available for every borrower.
A typical traditional European acquisition financing facility may provide for up to three term loan facilities, each with different features to appeal to different investor types but almost always providing for a floating rate of interest:
- a an amortising term loan facility, where the investors are often banks;
- b one or two term loan facilities, usually with no or minimal amortisation and maturing after the amortising term loan facility (and bearing a higher interest rate), designed to appeal to institutional investors and usually referred to in the market as a term loan B; and
- c an RCF to provide liquidity for working capital and sometimes other needs.
In recent times, it has been common to omit the amortising term loan facility in many European facilities, albeit not as commonly as in the United States.
The RCF can often be drawn in the form of fronted letters of credit (LCs) or bank guarantees, where one bank (the issuing bank) issues the LC or bank guarantee but is backstopped by the syndicate participating in the RCF. Basel III costs to the fronting bank in relation to the indemnities it receives from the other lenders have resulted in most banks being unwilling to act as fronting bank at the moment, so the future of these kinds of arrangements is currently uncertain, and the market occasionally experiments with syndicated LCs (one piece of paper signed by an agent on behalf of the lenders, but representing several credit exposures of the individual lenders, so potentially presenting a collection challenge for the beneficiary in the event that any of those lenders default) and other bilateral LC issuances out of an RCF as an alternative.
European RCFs also often allow a lender to carve out some or all of its commitment so the lender can make it available bilaterally for whatever local use the borrower might need, while still benefiting from the guarantee and security package of the main facility. These are referred to as ‘ancillary facilities’, and are the way many European groups obtain local overdrafts, custom clearance facilities, trade LC facilities and the like. At the moment, this is the most common way to replace the LC facilities while no bank in the syndicate is willing to act as a fronting issuing bank for an LC issued directly under the RCF.
A typical US acquisition financing facility would provide for a term loan facility and a cash flow revolving facility secured on a pari passu basis with the term loans. Revolving facilities in the US market may be provided on such a cash flow basis as part of the same credit agreement documentation for the term loans financing the acquisition. Additionally, as discussed in detail below, revolving facilities may be provided as part of an ‘asset-backed’ facility (ABL facility) that is documented separately from the acquisition term loans. Unlike the cash flow revolving facilities, the ABL facilities are senior to the term loans with respect to certain highly liquid types of collateral (typically inventory and receivables). The lenders to the revolving facilities are typically banks (most typically the arranging banks), whereas the investors for the term loan facilities are typically institutional investors. As noted above, amortising term loans are rare in the US acquisition finance market although there is typically nominal (1 per cent per annum) amortisation in the US term loan B market. LCs are also available under these cash flow revolving facilities or ABL facilities.
US market revolving facilities will also often allow one lender to make bilateral ‘swing line’ loans under the credit agreement on shorter notice, to be refinanced later with drawing under the revolving facility. These are seen in Europe, too, but curiously only for investment grade borrowers.
Covenant-lite term loans will frequently be made alongside a RCF that is pari passu and documented under the same facility agreement, so the RCF benefits from all the same covenants as the term loans. However, the RCF will also normally benefit from one maintenance financial covenant that the term lenders don’t benefit from unless the RCF lenders accelerate on the basis of its breach, and it is also entirely within the RCF lenders’ gift whether to amend, waive, etc. that maintenance financial covenant. This kind of maintenance financial covenant is typically tested quarterly but only if RCF usage is in excess of some level ranging from 15 to 35 per cent at quarter end or, albeit less frequently these days, RCF usage over the quarter exceeds an average amount threshold, and this kind of covenant is known in the market as a ‘springing covenant’.
iii ABLs and super senior RCFs
As noted above, in the US market an ABL facility is typically used alongside senior secured term loans or senior secured bonds where the borrower has an asset base that makes an ABL facility a cheaper and more flexible form of financing for the borrower’s working capital needs. The ABL facilities take a first lien (first priority security interest) on the most liquid forms of collateral, typically receivables and inventory, and then advance funds based on a ‘borrowing base’ formula that is designed such that the amount of credit extended does not exceed the discounted value that the lenders expect to receive upon the quick sale of that liquid collateral. ABL facilities have been around in the US market for a very long time, but have only more recently been used in large-cap financial sponsor-led leveraged transactions alongside term loans or senior secured bonds.
There are many factors that make ABL facilities attractive to borrowers, including an all-in lower cost and an absence of leverage covenants (typically only a fixed charge coverage maintenance covenant, although springing; i.e., not tested if outstandings under the ABL revolver are below a negotiated level). From the lender perspective, a well-managed ABL facility may represent a better compensation-to-risk ratio than a cash flow revolver (which is pari passu with the term loans) for the same credit.
The documentation typically allows the ABL lenders to freely liquidate ABL first lien collateral without interference from any other secured lender. This gives the ABL lender a high degree of control not available to pari passu cash flow revolvers that form part of the main term loan credit agreement.
The super senior RCF developed out of the increasing popularity of the senior secured notes discussed above, albeit mostly outside the US; while they appear from time to time in the US, they are relatively rare there. Starting in 2005, but with a noticeable acceleration in frequency since 2009, senior secured notes in Europe have often been used to provide the term loan debt in debt capital structures, leaving the borrower with a continuing need for the liquidity and other features of an RCF (unless the notes provide overfunding). This is often dealt with in Europe by the underwriters arranging a super senior RCF.
A fine balance exists between the interests of the holders of the senior secured notes and the super senior RCF lenders (who receive only 30 to 40 per cent of the margin while commitments are undrawn, so arguably are undercompensated for the inherent credit risk if one assumes that the RCF will be fully drawn before defaults occur and if one disregards the other fees being paid). In these structures, the notes are typically not subordinated in any way to the super senior RCF, but all security enforcement proceeds and distressed disposals of collateral (and sometimes certain other amounts) are applied under a waterfall where the super senior RCF lenders are paid first.
There is also a finely negotiated arrangement as to who controls security enforcement in the event there is no agreement as to the best course of action. Broadly speaking, there usually is a six-month period where the note holders can take control, but if no enforcement action is taken within a specified initial period (often three months), or the super senior RCF has not been repaid in cash in full within six months, control shifts back to the RCF lenders.
Again, broadly speaking, a typical European super senior RCF:
- a has the same negative covenants (usually ‘interpreted’ under New York law, even though the facility is governed by English or another law) as the associated senior secured notes, modified to reflect structural differences and to back out the effect of equity cures on various baskets that otherwise increase in size for equity injections;
- b has loan agreement style representations and affirmative housekeeping covenants;
- c may have a maintenance financial covenant (very infrequently, two), usually set at around 30 to 40 (and sometimes even 50) per cent above the model; this maintenance financial covenant may also have a springing feature along the lines discussed above or, in some super senior RCFs as negotiated, may only act as a draw stop rather than a breach if exceeded;
- d usually has some kind of ‘note purchase covenant’ requiring the facility to be reduced in size if the other debt in the structure is reduced to an extent where the super senior RCF has become a disproportionately large part of the group’s debt capital structure (this is heavily negotiated);
- e may have certain additional undertakings dealing with issues that loan lenders are concerned with but that the senior secured bond covenants do not normally address, such as acquisitions of targets doing business in sanctioned countries; and
- f may have term loan agreement style events of default, or the same events of default as the associated senior secured notes with a few technical changes, such as the addition of a misrepresentation event of default (high-yield note indentures do not have representations and warranties, and consequently do not have a misrepresentation event of default).
iv Second-lien loans or notes
The US has a long-established second lien market, with the second lien taking the form of either notes (i.e., high-yield bonds) or loans. The main distinguishing feature of second lien in the United States is that as a payment obligation (both for the primary obligor and any guarantees) it is an ordinary senior claim with no subordination features of any kind, and therefore is pari passu in every way with the first-lien debt. It is also given the benefit of second ranking security over the same assets over which the first-lien debt has security, typically (in the US) under a separate set of security documents with a different security agent. The practice is different in many other jurisdictions where there may be a common security agent or trustee holding one set of security for the two different classes of secured creditor, but as noted this security (however documented) ranks second to the first-lien security.
When the second lien takes the form of notes, the second-lien debt’s ability to enforce security is often ‘silent’ (i.e., it cannot enforce the security separately from the first lien, so it is just piggyback security). Otherwise, the second lien often has a security enforcement standstill period, which varies in length as negotiated but is often 120 days, after which the second lien can initiate a security enforcement.
This dichotomy between the senior claim and the second ranking security position is one of the important features of US-style second lien and why it is turned to in certain financings – its incurrence does not breach the terms of the typical ‘limitation on layering’ covenant that one finds in senior subordinated and certain other high-yield bonds, due to the fact that the second lien is not contractually subordinated to other senior debt.
It should be noted that even where the second lien features a standstill period (or in the case of the silent second lien version, a quasi-permanent security enforcement standstill), the second-lien debt can still immediately accelerate and take other unsecured enforcement action even during the standstill period because as noted the standstill period only applies to the security enforcement. As an acceleration or other enforcement action will usually tip the borrower into a Chapter 11 process in the United States, and in that process the second-lien holders will get the benefit of their security, even the indefinite standstill feature in the US is not as draconian as it might at first seem. In other jurisdictions, this avenue for second lien holders being comfortable with a silent second lien may not exist.
There is much more variation as to what ‘second lien’ means in the European market, driven in part because of different investor expectations and different senior lender requirements, but also because European insolvency laws work differently from the US where second lien first evolved and because guarantee and security packages in many European jurisdictions are not at all comprehensive, unlike the relatively comprehensive US guarantee and security packages where any limitations (such as under US fraudulent conveyance or transfer law) generally affect the first-lien and second-lien debt equally and are unlikely to result in a pari passu recovery for the second-lien debt.
Prior to 2008, very few European second liens followed the US model exactly, and most of those that did follow that model had German issuers. More typically, European second lien in that period was an extra tranche of debt under the main senior credit agreement (often referred to as Tranche D), which for most things voted as one class together with the rest of the debt under the senior credit agreement and therefore could normally be outvoted (i.e., this form of second lien did not control its own debt instrument, in contrast with the US model).
Tranche D normally only had a separate vote in limited circumstances, such as a Tranche D payment default or an insolvency. It was also contractually subordinated on a quasi-European mezzanine basis (see below), with both subordination of the debt claim and the security, plus a standstill period layered on top (normally 60 days following notice to the other lenders).
Between 2007 and November 2013, there were no European second-lien issuances at all as far as we are aware. Since then, there have been a few Tranche D second-lien issuances; there has also been a wave of a new European form of second lien, where the second lien is made available under a separate facility agreement that, from a form and legal status and security point of view, largely follows the model of European mezzanine debt (discussed below) or, occasionally, European mezzanine intercreditor terms but otherwise following the model of US mezzanine debt (discussed below). More and more of these, while having European mezzanine-style payment blocks and standstills, do however allow unsecured recoveries to be applied pari passu.
There is also a further line of European second lien that follows the US model with one important difference – while the debt claim against the issuer or borrower is senior and not subordinated or subject to standstills and is consistent with the US model in those respects, the claims against guarantors are run through the security enforcement waterfall but not otherwise subordinated or subject to standstills. The net effect of this is to quasi-subordinate the second lien claims against the guarantors, because the first lien gets the proceeds first.
v Mezzanine debt
Mezzanine can mean different things to different people. In Europe, for leveraged and acquisition financings,3 it normally means a contractually subordinated bullet maturity floating rate term loan that, while in a separate loan agreement and maturing after the senior debt in the same structure, is largely a photocopy of the senior loan facility agreement in substance, other than that the financial covenants are typically rolled back approximately 10 per cent. It is also normally secured on a second-ranking basis to the senior debt, with standstill periods and payment blocks applying as negotiated, and there has been significant movement in the intercreditor terms negotiated between senior and mezzanine lenders in European financings over the past few years.
In the US market, mezzanine finance is typically provided under a private high-yield instrument, with bond-like terms, although this kind of mezzanine is also increasingly seen in Europe, albeit usually as a high-yield bond replacement. It is also most often unsecured (in the United States).
There are only isolated examples of mezzanine debt in the same capital structure as high-yield bonds, in part because European mezzanine debt normally contains maintenance financial covenants unlike bonds, so there would be the oddity – particularly if the bonds are senior secured – of a junior part of the debt structure having tighter covenants than the more senior debt.
Mezzanine lenders can from time to time require warrants as an ‘equity kicker’, but this is rare in larger deals.
The mezzanine product, in contrast to second lien, has become very rare in the European market over the past two years owing largely to the target returns of the mezzanine lenders being considered too high by borrowers in the current low interest rate environment.
Unitranche (or sometimes ‘stretch senior’) loans are increasingly being seen, and noticeably the amount of debt that can be obtained under a loan taking this form is increasing in size so the product is migrating into the mid-cap market. In form, these are usually senior loan facility agreements that in all respects except the pricing (interest and margin, fees, sometimes warrants and board observer rights and the like) are the same as an ordinary senior loan, except that the aggregate amount being lent is normally greater than senior lenders would typically be comfortable with. In other words, unitranche covers some of the same debt funding territory as mezzanine or other subordinated debt would have covered, in addition to the senior debt, albeit all in one blended term loan tranche or facility agreement.
This product has been growing in popularity for mid-market and smaller financings over the past few years; it has the attraction of simplicity, since there is no need to document a complex intercreditor relationship as between the senior and mezzanine or other subordinated debt encompassed by the one unitranche instrument.
Investors in unitranche instruments may, however, wish to allocate losses and return between themselves in a way reflecting relative senior and subordinated positions, so there can be complexities in the behind-the-scenes funding of unitranche loans.
Unitranche loans are often put in place alongside either a stand-alone ABL or super senior RCF.
vii PIK loans or bonds
While any debt instrument can feature PIK interest (i.e., the interest is rolled into principal, or otherwise compounded), what the market normally refers to as PIK is usually a holding company issue of notes or loans, issued above the restricted group under the covenants of the debt applying to the more structurally senior debt of the group, where the terms of the PIK largely track the terms of the structurally more senior debt but, in addition, further limit payment of dividends (by the PIK issuer or borrower). There is also a great deal of variation in what other debt or activities the PIK issuer or borrower can have and on certain other terms.
Originally, PIK debt permitted but did not require payment of cash interest (referred to as ‘pay if you want’). In the past few years, there have increasingly been PIK financings that require payment of cash interest to the extent there is sufficient available cash that is able to be upstreamed to the PIK issuer or borrower from its subsidiaries, under the terms of the covenants imposed by the more senior debt in the relevant debt capital structure (this is referred to as ‘pay if you can’ but also sometimes ‘PIK toggle’, although that term’s original meaning encompassed a more limited concept of the ability to elect, usually only a few times, to switch from cash pay to PIK).
PIK debt is sometimes used as part of an overall acquisition structure, but more often is put in place to finance a dividend (i.e., to release some equity value to shareholders).
As noted above, debt products are continuing to evolve as a result of market forces, regulatory changes and other factors. It is likely that the discussion in this chapter will need to be supplemented in only a few years’ time.
1 Melissa Alwang and Christopher Kandel are partners at Latham & Watkins LLP.
2 Technically, these were usually initially placed in a private placement without US Securities and Exchange Commission (SEC) registration, but were almost always subsequently exchanged for an SEC-registered security.
3 A discussion of the very different mezzanine structures in real estate finance lies outside the scope of this survey.