Acquisition Finance Sources: Debt

By: Linda Curtis and Andrew Cheng, Gibson, Dunn & Crutcher LLP.

THE FINANCING SOURCES FOR BUSINESS ACQUISITIONS are as varied as the structure and motivations for the acquisitions themselves. The most efficient source depends on several factors, including the cost of raising capital, prevailing interest rates, flexibility desired, and any anticipated need for future financing. Potential sources of financing generally can be divided into equity financing and debt financing. Seller financing, defined as financing provided by the seller or sellers of the business being acquired— either structured as debt or equity—raises special issues and is discussed later in this article under Acquisition Finance Sources: Equity and Seller Financing.

The financing for many substantial business acquisitions includes a debt component, sometimes in multiple tranches. Companies generally elect to include debt in their capital structure in part because interest on debt is usually tax deductible whereas dividends are usually not. In addition, in the acquisition context, the inclusion of debt financing as well as equity financing helps to diversify the potential sources of financing. Debt is a particularly attractive source of financing for private equity sponsors. It is rare for lenders to have recourse to the private equity sponsor if the financed business fails to meet its obligations to the lenders. Therefore, by using leverage, the private equity sponsor loses less if the company fails, with minimal risk to its own assets (except for its investment in the company), and gains more (proportionately) if it succeeds. The ability of debt financing to magnify private equity returns is of course further accelerated when interest rates are low.

Senior Secured Credit Facilities

A senior secured credit facility is the prototypical type of debt financing for an acquisition. In an unsecured credit facility, the lender has a general claim on the assets of the borrower in the event of nonpayment. The lender may share this claim with numerous other unsecured creditors. However, in a secured credit facility, in addition to the general unsecured claim (unless the facility is non-recourse), the lender has a specific claim on the assets of the borrower that constitute collateral.

Outside of bankruptcy, the secured lender has the right in a default to foreclose on its collateral. In a bankruptcy scenario, the secured lender (assuming its lien is perfected and unavoidable) has a preferential right to the assets constituting collateral up to the value of such assets. It is important to note that a secured acquisition facility is usually secured both by the assets of the acquirer and the target. See Secured and Unsecured Credit Facilities, Mezzanine Facilities and Subordinated Loans. See also Perfecting Security Interests– Possession, Filing and Control and Establishing Priority of the Secured Creditor’s Lien for more information regarding perfection and priority under the Uniform Commercial Code.

A secured loan facility may include multiple tranches of term loans and revolving loans. Term loans, unlike revolving loans, are typically not subject to successive repayment and reborrowing. Many acquisition facilities include term loans with both a Term Loan B and Term Loan A tranche, with the payment terms of the Term Loan B comparable to those of high-yield bonds. A Term Loan B has minimal amortization (usually 1% per annum) and a longer maturity date than a Term Loan A.

Given these differences, the Term Loan A often has lower pricing than the Term Loan B, and there is often significant overlap between the Term Loan A lenders and the revolver lenders. Term Loan A lenders tend to be commercial banks or other similar financial institutions, while Term Loan B lenders include a greater variety of types of lenders (including hedge funds, collateralized loan obligations (CLOs), or other types of investment funds that are comfortable with investing in instruments with bond-like features). The revolver may have subfacilities for swingline borrowings (typically available on shorter notice than regular revolver draws) and letters of credit.

If a senior secured debt facility is being used to fund an acquisition, such facility usually provides most of the debt financing used to fund the purchase price of the acquisition. Term loans (both Term Loan A and Term Loan B) are typically drawn in a single draw at the closing of the acquisition to fund the payment of the purchase price. One exception is if the target company has outstanding public debt that requires an irrevocable notice of redemption. To address this issue, some term loans may have a delayed draw component. Revolving loans may be drawn in part at the closing of the acquisition to help fund the payment of the purchase price, but they are primarily used (along with any swingline or letter of credit subfacilities) for ongoing working capital needs of the acquired company.

The key feature of a senior secured credit facility is that all of these different tranches and types of obligations are usually included in a single credit agreement and secured on a pro rata basis by the same pool of collateral. From the lender’s perspective, the presence of security helps reduce the risk of the financing (as compared to an unsecured credit facility) and accordingly helps to reduce the borrower’s cost of funds.

If feasible from a business and tax perspective, many secured lenders in acquisition financings like to structure the acquisition with a holding company component. With a holding company structure, the sole asset of the holding company is the stock of the main operating company (which itself may directly or indirectly own the stock of numerous subsidiaries). The lenders take a perfected first priority lien on the stock of the main operating company. In a default situation, the lenders have the option of foreclosing on the stock of the operating company, thereby realizing the going concern value of the business as a whole. This may be a cleaner, quicker, and more efficient remedy for a default rather than attempting to foreclose on the assets of the main operating company and any downstream subsidiaries on a piecemeal basis. See Collateral Security and Intercreditor Issues — Holding Company Structures.

Secured loans may be categorized as either first lien loans or second lien loans, or even third or fourth lien loans, depending on their priority with respect to the collateral pledged to secure the loan. Second lien lenders hold a second priority security interest on the assets of the borrower, meaning that first lien lenders will be paid in full before any payments are made to second lien lenders from proceeds of the shared collateral. First and second lien lenders will often enter into an intercreditor agreement that defines their rights with respect to one another as such rights relate to the collateral. Because of the greater risks associated with second lien loans, their interest rates tend to be higher than those applicable to first lien loans but lower than for unsecured debt such as mezzanine facilities.

Mezzanine Facilities

So-called mezzanine facilities are typically employed in acquisition financings when the purchase price in the acquisition requires more debt financing than can be obtained on a senior secured basis. The term mezzanine is a bit imprecise, as it can encompass a variety of types of debt that are subordinated to the senior secured acquisition credit facility, either by way of structural or contractual subordination or both.

Structural subordination occurs when the loan is made to a holding company and is not guaranteed by the operating subsidiaries. In such a case the lender will not have access to the assets of the operating subsidiaries until after all of the subsidiaries’ lenders and other creditors have been paid and the remaining assets have been distributed up to the holding company as an equity holder. Contractual subordination occurs when the senior and subordinated lenders enter into an intercreditor agreement setting forth the terms and conditions for the senior lender’s priority in payment relative to the subordinated lender. Mezzanine facilities are typically unsecured and, because they are riskier for the lenders than a senior secured facility, usually represent a higher cost than the senior secured loan. For more information on the structure of mezzanine debt, see Understanding the Structure of Mezzanine Debt Generally. See also Exploring Subordinated Debt + PIK Interest, and Subordinated Debt + Warrants and Examining Subordinated Debt + Profit Participation and Convertible Loans for more information regarding equity and debt aspects of this type of financing.

The typical tenor of a mezzanine loan is often pegged at a fixed time period (such as one year) after the maturity date of the senior secured facility. Although mezzanine loans share many (if not all) of the same covenants as those of the senior secured facility, the financial covenants are generally looser. Also, many of the baskets in the negative covenants are larger in the mezzanine facility than in the corresponding senior secured facility. In addition, in a customary mezzanine loan, a borrower pays interest during the life of the loan without amortization. Principal is then repaid in full at maturity.

Mezzanine debt typically accounts for a much lower proportion of the total debt financing for the acquisition than senior secured debt. The borrower and its equity holders clearly have an incentive to maximize the size of the senior secured debt financing given its lower cost. In addition, rather than being provided by banks, lenders providing mezzanine debt are principally institutional investors such as funds set up for the purpose of making such investments and specialist mezzanine houses. In this way, mezzanine debt investors bear some similarity to the investors in Term B loans.

Tax considerations are critical in determining the terms of any mezzanine or subordinated debt. Although interest on debt is typically deductible (whereas dividends on equity are typically not), the line between debt and equity can become blurred, and there are tax rules that limit the deductibility of interest on certain equity-like debt instruments. For federal tax purposes, there are limitations that apply to “applicable high yield discount obligations” (AHYDO). For more information, see Certain Tax and Regulatory Considerations in Acquisition Financings — AHYDO Issues.

Unitranche Facilities

Unitranche facilities, which have recently become quite popular (especially in the middle market), combine what otherwise would be separate first and second lien facilities into a single senior secured loan. The intercreditor arrangements between lenders are documented in a separate agreement among lenders to which the borrower is typically not a party. Because unitranche facilities are typically not widely syndicated and have streamlined documentation requirements (at least from the borrower’s point of view), they have become common funding structures for middle market acquisition financings. To understand more about these types of facilities and the agreement among lenders, see Unitranche Facilities and The Agreement Among Lenders (AAL).

Public Securities (Investment Grade and High Yield)

Investment grade debt securities may be used by well-capitalized strategic buyers for acquisition financings. Whether or not a security qualifies as investment grade is determined by the formal ratings assigned to it by Moody’s Investors Service, Standard & Poor’s, Fitch Ratings, or another ratings agency. As a practical matter, it is not common for debt securities issued in LBOs to receive an investment grade rating.

High yield bonds, also known as junk bonds or speculative grade bonds, are corporate securities that either carry a speculative-grade rating from one of the established credit rating agencies or go unrated altogether. High yield bonds are issued in the debt capital markets in the same way as investment grade bonds but usually carry yields that are high relative to the yields of investment-grade bonds of comparable maturity to compensate for their higher risk of default. High yield bondholders tend to be institutional investors such as pension funds, insurance companies, and investment funds established for the purpose of investing in high yield debt products. High yield bonds are generally unsecured obligations of the issuer that rank below senior secured credit facilities and other secured debt to the extent of the value of the collateral securing such debt.

High yield bonds are a good complement to a senior secured credit facility for the funding of a large leveraged acquisition. The high yield market offers the opportunity to do relatively large financings (minimum deal size is $150 to $200 million or so), with longer tenors and typically more forgiving covenants than a customary senior secured credit facility. In particular, so-called maintenance financial covenants in high yield debt offerings are rare. See Covenants: High Yield vs. Investment Grade. See also Overview — Conducting a Rule 144A/Regulation S Offering and Covenants: High Yield vs. Investment Grade for additional information on the high yield market.

However, one disadvantage of high yield bonds in the acquisition financing context is that the debt capital markets are notoriously fickle and unpredictable. In the case of an acquisition agreement that does not have a financing condition to the buyer’s obligation to close—and it is very common in the current market for there to be no such condition—the buyer may find itself in a difficult position if the debt capital markets are unfavorable at a time when it is able to satisfy the other closing conditions. In this instance, the buyer may be required to close its high yield transaction with unfavorable pricing based on market conditions (assuming that market conditions have not deteriorated to such an extent that debt capital markets have temporarily ceased to function).

One common solution to this issue is the bridge facility, as described later in this article. Another potential solution to this issue is for the parties to take advantage of favorable pricing and market conditions by closing a high yield component of an acquisition financing into escrow before the closing of the acquisition itself. A recent example is the $1.6 billion in principal amount of high yield bonds issued by AECOM Technology Corporation to fund in part its acquisition of URS Corporation. The bonds were issued into escrow on October 6, 2014 and the acquisition closed on October 17, 2014. See https://www.sec.gov/Archives/edgar/ data/868857/000110465914070777/a14-22108_18k.htm.

Another recent example is the issuance by Frontier Communications Corporation of $6.6 billion in principal amount of high yield bonds into escrow in September 2015 to fund in part its potential (still pending) approximately $10 billion acquisition of the wireline properties of Verizon Communications Inc. in California, Florida, and Texas. See https://www.sec.gov/Archives/edgar/ data/20520/000119312515330969/d84004d8k.htm. The escrow approach has advantages for both the buyer and the bondholders:

• The buyer eliminates any risk of an execution failure (due to market failure or otherwise) at the time of the acquisition and also obtains certainty of pricing.
• The bondholders are able to accrue and even be paid interest during the interim period and have little practical risk—the proceeds usually are held by the indenture trustee in escrow pending closing of the acquisition and in certain cases may be subject to a lien during the interim period. Usually if the acquisition does not close by an agreed date the proceeds are required to be returned to the holders through a mandatory redemption.

Bridge Facilities

Bridge loans are temporary loans that bridge all or part of the buyer’s need for financing until the buyer has the time and opportunity to obtain permanent financing. For acquisition financings with a senior secured and a high yield component, the banks providing the committed senior financing often provide a bridge loan commitment to backstop the high yield offering in case the debt capital markets are unfavorable when the acquisition closes. Indeed, the seller may even require a bridge commitment to be part of the buyer’s financing package, to minimize the risk of a portion of the financing required to close the acquisition being unavailable at closing.

Because of the mutual interest of the buyer and the seller to have a bridge loan commitment, such commitments are relatively common in the marketplace when high yield bonds are part of the contemplated acquisition financing package. Although bridge loan commitments are common, the frequency with which bridge loans are actually drawn is quite low. Bridge loans are expensive, with high initial interest rates that typically increase over time. The initial interest rate tends to be higher than the corresponding initial interest rate on the senior secured debt financing, and increases may be as often as quarterly (often, however, subject to a total cap).

With a maturity of one year or less, bridge loans do not represent a viable long-term source of financing. Instead, they are merely a backstop until the borrower can find a better long-term substitute. Many bridge loans convert into long term debt at the end of their term, but at a steep price in terms of both interest rate (usually higher than the initial bridge interest rate) and fees.

When structuring bridge facility provisions, the parties should be aware of the constraints imposed by the bank anti-tying rules. These rules, which are set forth in the Bank Holding Company Act (12 U.S.C. 1972(1)), are intended to prevent banks from tying the accessibility of loans to requirements that the borrower purchase other services from the banks. The rules are complex, but essentially the concern in a bank/bridge loan context is to make sure that the bank is not improperly conditioning any of its proposed loan financing (including the bridge loan) on the retention of the bank or an affiliate of the bank as an underwriter for any securities (such as high yield bonds) to be issued as part of the acquisition financing. For a further discussion of anti-tying rules, see Lending Limits and Restrictions — Anti-Tying.

One common approach in a bank/bridge context is for the bank to provide a commitment for both the bank and the bridge financing, pursuant to which an underwriter acceptable to the bank is required to be engaged to underwrite the high yield bonds that are anticipated to refinance the bridge. Although the bank does have a consent right to the identity of the underwriter (as it has a legitimate business interest in the borrower hiring a reputable and capable underwriter), the bank does not require the borrower to hire it or its affiliate as an underwriter. As a practical matter, due to these antitying rules, there is no requirement for the borrower to hire the bank as its underwriter for the high yield bond component of the deal, but there is no prohibition against it if the borrower wishes to do so.

The economics of bridge loans give the borrower the incentive to refinance as soon as practical. In addition, the bridge lenders often will negotiate for a securities demand under which, at the option of some or all of such bridge lenders, the borrower will be required to refinance the bridge loan with permanent securities. The securities demand provisions are among the most highly negotiated provisions in the bridge loan commitment papers. For a sample securities demand provision, see Section 3 of the form Fee Letter. This form can be found in the Finance Module of Lexis Practice Advisor under Commitment Papers and Syndicated Lending > Forms > The Fee Letter.

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