Financing the private equity boom

The past year has seen a record number of private equity transactions—they are highly complex, innovative and ground breaking for the Australian market. The Australian market has experienced many of the changes and trends that those in private equity have already encountered elsewhere in the world. This article highlights some of the more significant changes and trends and their impact on private equity sponsors and financiers.

Drivers of change

The drivers behind these changes are many and inter-related. They include:

• liquidity in private equity investment funds and a lack of attractive targets given the supply of this equity funding
• competition between financers (including growth in the number and breadth of the leveraged finance capability of banks arranging and underwriting Australian deals)
• growth in non-bank sources of debt finance (including hedge and superannuation funds)
• reduced pricing—lower interest rates and fees
• low default rates, and
• recent large deal sizes.

Bidding for the asset

These days vendors run very competitive auction processes for the sale of assets. Sponsors try to differentiate their bids from other bidders by focusing on two main areas of the bid which impact on their financing: the purchase price and certainty of funding.

The purchase price

The liquidity in private equity investment funds and a lack of attractive targets with robust earnings has increased competition for assets and in turn helped to raise the price paid for those assets. Sponsors selling assets previously acquired can realise better returns on their investment under these market conditions. Sponsors looking to acquire new assets will need to factor in this higher purchase price thereby making target IRRs harder to achieve.

Cheaper pricing of debt as compared to equity naturally means sponsors have put pressure on the arrangers of finance to increase the amount of debt funding and thereby reduce the equity otherwise required. The result is that leverage multiples have significantly increased to improve the IRR.

Increases in leverage have been achieved by various means. In larger transactions, an increase in the pool of financiers for the deals has been experienced. It is on these deals that there is great competition among the arrangers of the debt finance and the arrangers enjoying international networks are able to access many pools of debt providers and products which were not historically tapped in Australian deals. International banks have enjoyed this advantage over local banks and this has given them a competitive edge in large transactions. Senior bank debt is stretched and slowly becoming more widely syndicated domestically, in Asia, Europe and the US to both bank and nonbank financiers. New subordinated debt products are being offered. PIK products (including third ranking debt) are becoming more common. On larger transactions, high yield bonds have been used. Whilst those products have been a common feature or leveraged financing structures in the UK, Europe and the US for a number of years, they are only now gaining traction in Australia. The increase in the number of products and debt providers involved in financing is reshaping the financing terms of Australian deals.

Certainty of funding

Sponsors, trying to improve the attractiveness of their bid, have sought to ensure that the financing for their bid is as unconditional as possible. The rules in relation to the funding of public deals are relevant here.

A credit agreement usually provides that the financiers are only obliged to fund if certain conditions are met. There are two main categories of conditions. The first is that the documentary conditions precedent have been delivered. In order to reduce the operation of this condition, sponsors often deliver core documentation, including the sale and purchase agreement (SPA), to the financers and obtain their ‘sign-off’ before submitting the bid.

The second is that, on the utilisation date, the representations and warranties under the credit agreement are correct and not misleading and there is no potential or actual event of default. Sponsors have sought to ensure that these conditions do not apply to the financing for the acquisition, subject to certain agreed exceptions which usually include insolvency of the borrower, the satisfaction of the conditions to the SPA and illegality.

Terms of the financing

Historically, financers have enjoyed tight controls in leveraged finance transactions.

The risks faced by senior financiers were usually addressed with tight controls over the business operations and keeping value within the financed group. Significant information rights, tight financial covenants and other controls gave financiers early warning signs and the ability to step in where there was any significant underperformance.

With competition among the arrangers and underwriters of debt finance so high, sponsors now enjoy much greater power in negotiations. The level of competition is seen by the number of banks competing for the financing roles and the arrival of staple-on financings. Under a stapleon, the vendor’s financial advisor provides a financing package which is available to any potential bidder to finance their bid.

The level of competition has meant that from the sponsor’s perspective they have been able to improve the terms of the financing significantly over the past few years—increasing the operational flexibilities afforded to the group, reducing the ability of the banks to step in and improving the ability of the sponsors to obtain returns prior to a full exit. Sponsors have been able to import concepts from overseas markets into Australian transactions.

Highly leveraged companies are more vulnerable to any decline in the credit cycle and any deviation from the business plan. They are also more vulnerable to refinancing risk. Put simply, high leverage magnifies returns and risk. As a consequence, sponsors have negotiated with significant success to try to minimise the impact of these risks—thereby improving their ability to take remedial action in the event of any underperformance. Financial covenants have been an area of focus for sponsors to try to minimise these risks.

Financial covenants and ‘covenant-lite’

In the US and Europe, sponsors have sought to protect themselves against any future downturn in the credit cycle by borrowing on a ‘covenant-lite’ basis. In 2006, some US$24 billion of loans were covenant-lite in the US.

‘Covenant-lite’ loans do not include traditional financial covenants. Rather, financers rely on a covenant not to incur additional indebtedness. Covenant-lite strips from the financiers the rights they would have otherwise had to track performance and accelerate in the event of the breach of those financial covenants.

‘Covenant-lite’ transactions have not yet become common in Australia though it has been widely reported that the facility used by the bidder for Qantas is on such terms. However, pressure is being exerted on these controls. Sponsors are negotiating for greater headroom in setting the financial covenants and equity cure rights. The terms of cure rights can be the subject of much negotiation.

Amortisation

Debt amortisation and excess cashflow sweeps have been used by senior financiers to reduce leverage quickly in the initial years.

These are now the focus of sponsors who in increasing leverage need to reduce the repayments of principal. There are now a number of deals in the market which do not contain any amortising debt. This obviously increases the risks to the financiers.

The amount of the excess cashflow sweeps is also being reduced, and the threshold amount before the sweep operates is being increased, as sponsors look to retain cash in the business to fund growth.

Yank the bank

Most major transactions now include what is commonly know as ‘yank the bank’. The ‘yank the bank’ clause allows the sponsor to buy out or replace a lender with a willing replacement lender where the outgoing lender will not agree to an amendment or waiver requested by the company. This may assist a sponsor where amendments or waivers are needed and can be viewed as helping to mitigate the risks associated with highly leveraged deals. A restructure with consenting banks is made that bit easier. Often the threat of the sponsor evoking such right will draw out the necessary consent from the financiers.

Pricing pressure

Sponsors have been successful in reducing margin levels, fees and the amount of market flex on transaction—thereby making the ultimate pricing of the deal more certain. Market flex refers to the right of the arrangers to change structure, terms or pricing of the debt in order to achieve successful syndication of the debt. Reverse flex is also being included on many deals. This entails reducing the margin levels if there is sufficient interest in taking the debt on syndication, which enables the margin to be reduced.

Clean up period

The concept of a clean up period has also now been incorporated in many transactions. Like certain funds, this concept has been imported from public takeover bids. In public takeovers there is often far less due diligence performed on the target than in a private bid. As a result, acquirers seek to have a period of time during which the financiers’ right to accelerate are suspended and the company can remedy breaches of the financing terms.

It is arguable that the greater competition for assets in private auctions can result in a lower level of due diligence being completed and necessitate the provision. In any event, a clean up period is useful to mitigate the risk of there being circumstances in relation to the target about which the sponsor is not aware.

Distributions

Historically, acquired companies were prohibited by financing terms from making any distribution to the sponsors. This has changed. Sponsors have successfully negotiated for equity distributions to be permitted at a certain level of leverage and the market level is on the decrease.

Conclusion

There are many drivers which are changing the financing of acquisitions, including the competition between competing sponsors and the great liquidity in the markets. Leveraged finance transactions are arguably more highly negotiated than ever before. This must invariably be the result when competition and risk are heightened. Changes in financing terms focus on pricing, certainty of funding, operational flexibility, reducing financiers’ ability to step in and increasing the rights of the sponsors to realise some returns and take remedial action.

This article was written by John Schembri, Partner and Hayley Neilson, Senior Associate.

For more information please contact

Name : Hayley Neilson
Title : Partner
Office : Sydney
Phone : +61 2 9322 4376
Fax : +61 2 9322 4000
Email : hayley.neilson@freehills.com