Financial Sponsors

The term “financial sponsor” refers to traditional private equity (PE) firms, merchant banking divisions of investment banks, hedge funds, venture capital funds, and special purpose acquisition companies (SPACs), among other investment vehicles. PE firms, hedge funds, and venture capital funds raise the vast majority of their investment capital from third-party investors, which include public and corporate pension funds, insurance companies, endowments and foundations, sovereign wealth funds, and wealthy families/individuals. Sponsor partners and investment professionals may also invest their own money into the fund(s) or in specific investment opportunities.

Capital raised from third-party investors and the sponsor partners and investment professionals is organized into funds that are usually structured as limited partnerships. Limited partnerships are typically established as a finite-life investment vehicle with a specific total capital commitment, in which the general partner (GP, i.e., the sponsor) manages the fund on a day-to-day basis and the limited partners (LPs) serve as passive investors.⁴ LPs subscribe to fund a specific portion of the total fund's capital (“capital commitment”). These vehicles are considered “blind pools” in that the LPs subscribe to their capital commitment without specific knowledge of the investments that the sponsor plans to make.⁵ However, sponsors are often limited in the amount of the fund's capital that can be invested in any particular business, typically no more than 10% to 20%.

Sponsors vary greatly in terms of fund size, focus, and investment strategy. The size of a sponsor's fund(s), which can range from tens of millions to tens of billions of dollars (based on its ability to raise capital), helps dictate its investment parameters. Some firms specialize in specific sectors (such as industrials or media, for example) while others focus on specific situations (such as distressed companies/turnarounds, roll-ups, or corporate divestitures). Many firms are simply generalists that look at a broad spectrum of opportunities across multiple industries and investment strategies. PE firms are staffed with investment professionals that fit their strategy, many of whom are former investment bankers or management consultants. They also typically employ (or engage the services of) operational professionals and industry experts, such as former CEOs and other company executives, who consult and advise the sponsor on specific transactions.

In evaluating an investment opportunity, the sponsor performs detailed due diligence on the target, often through an organized M&A sale process (see Chapter 6). Due diligence is the process of learning as much as possible about all aspects of the target (e.g., business, industry, financial, accounting, tax, legal, regulatory, and environmental) to discover, confirm, or discredit information critical to the sponsor's investment thesis. Detailed information on the target is typically stored in an online data room, such as those provided by Intralinks. Sponsors use due diligence findings to develop a financial model and support purchase price assumptions (including a preferred financing structure), often hiring accountants, consultants, and industry and other functional experts to assist in the process. Sponsors typically engage operating experts, many of whom are former senior industry executives, to assist in the due diligence process and potentially join the management team or board of directors of the acquired companies.

Investment Banks

Investment banks play a key role in LBOs, both as a provider of financing and as a strategic M&A advisor. Sponsors rely heavily on investment banks to help develop and market an optimal financing structure. They may also engage investment banks as buy-side M&A advisors in return for sourcing deals and/or for their expertise, relationships, and in-house resources. On the sell-side, sponsors typically engage bankers as M&A advisors (and potentially as stapled financing providers⁶) to market their portfolio companies to prospective buyers through an organized sale process.

Investment banks perform thorough due diligence on LBO targets (usually alongside their sponsor clients) and go through an extensive internal credit process in order to validate the target's business plan and underwrite a debt financing for the target. They must gain comfort with the target's ability to service a highly leveraged capital structure and their ability to market the debt financing to the appropriate investors. Investment banks work closely with their sponsor clients to determine an appropriate financing structure for a particular transaction.⁷ Once the sponsor chooses the preferred financing structure for an LBO (often a compilation of the best terms from proposals solicited from several banks), the deal team presents it to the bank's internal credit committee(s) for final approval.

Following credit committee approval, the investment banks are able to provide a financing commitment to support the sponsor's bid.⁸ This commitment offers funding for the debt portion of the transaction under proposed terms and conditions (including worst case maximum interest rates (“caps”) and structural flex⁹) in exchange for various fees¹⁰ and roles.¹¹ The commitment letters are typically subject to specific conditions, including the sponsor's contribution of an acceptable level of cash equity and a minimum level of EBITDA for the target. This is also known as an underwritten financing, which traditionally has been required for LBOs due to the need to provide certainty of closing to the seller (including financing). These letters also typically provide for a marketing period during which the banks seek to syndicate their commitments to investors prior to the sponsor closing the transaction.

For the bank debt, each arranger¹² expects to hold a certain dollar amount of the revolving credit facility in its loan portfolio, while seeking to syndicate the remainder along with any term loan(s). As underwriters of the high yield bonds or mezzanine debt,¹³ the investment banks attempt to sell the entire offering to investors without committing to hold any securities on their balance sheets. However, in an underwritten financing, the investment banks commit to provide a bridge loan for these securities to provide assurance that sufficient funding will be available to finance and close the deal even if the banks cannot sell the entire debt offering to investors.

Bank and Institutional Lenders

Bank and institutional lenders are the capital providers for the bank debt in an LBO financing structure. Although there is often overlap between them, traditional bank lenders provide capital for revolvers and amortizing term loans, while institutional lenders provide capital for longer tenored, limited amortization term loans. Bank lenders typically consist of commercial banks, savings and loan institutions, finance companies, and the investment banks serving as arrangers. The institutional lender base is largely comprised of hedge funds, pension funds, mutual funds, insurance companies, and structured vehicles such as collateralized debt obligation funds (CDOs).¹⁴

Like investment banks, lenders perform due diligence and undergo an internal credit process before participating in an LBO financing. This involves analyzing the target's business and credit profile (with a focus on projected cash flow generation and credit statistics) to gain comfort that they will receive full future interest payments and principal repayment at maturity. Lenders also look to mitigate downside risk by requiring covenants and collateral coverage. Prior experience with a given company, sector, or financial sponsor is also factored into the decision to participate. To a great extent, however, lenders rely on the due diligence performed (and materials prepared) by the lead arrangers.

As part of their due diligence process, prospective lenders attend a group meeting known as a “bank meeting,” which is organized by the lead arrangers.¹⁵ In a bank meeting, the target's senior management team gives a detailed slideshow presentation about the company and its investment merits, followed by an overview of the debt offering by the lead arrangers and a Q&A session. At the bank meeting, prospective lenders receive a hard copy of the presentation, as well as a confidential information memorandum (CIM or “bank book”) prepared by management and the lead arrangers.¹⁶ As lenders go through their internal credit processes and make their final investment decisions, they conduct follow-up diligence that often involves requesting additional information and analysis from the company.

Bond Investors

Bond investors are the purchasers of the high yield bonds issued as part of the LBO financing structure. They are generally institutional investors, such as high yield mutual funds, hedge funds, pension funds, insurance companies, and CDOs.

As part of their investment assessment and decision-making process, bond investors attend one-on-one meetings, known as “roadshow presentations,” during which senior executives present the investment merits of the company and the proposed transaction. A roadshow is typically a three to five-day process (depending on the size and scope of the transaction), where bankers from the lead underwriting institution (and generally an individual from the sponsor team) accompany the target's management on meetings with potential investors. These meetings may also be conducted as breakfasts or luncheons with groups of investors. The typical U.S. roadshow includes stops in the larger financial centers such as New York, Boston, Los Angeles, and San Francisco, as well as smaller cities throughout the country.^17,18

Prior to the roadshow meeting, bond investors receive a preliminary offering memorandum (OM), which is a legal document containing much of the target's business, industry, and financial information found in the bank book. The preliminary OM, however, must satisfy a higher degree of legal scrutiny and disclosure (including risk factors¹⁹). Unlike bank debt, most bonds are eventually registered with the SEC (so they can be traded on an exchange) and are therefore subject to regulation under the Securities Act of 1933 and the Securities Exchange Act of 1934.²⁰ The preliminary OM also contains detailed information on the bonds, including a preliminary term sheet (excluding pricing) and a description of notes (DON).²¹ Once the roadshow concludes and the bonds have been priced, the final terms are inserted into the document, which is then distributed to bond investors as the final OM.

Target Management

Management plays a crucial role in the marketing of the target to potential buyers (see Chapter 6) and lenders alike, working closely with the bankers on the preparation of marketing materials and financial information. Management also serves as the primary face of the company and must articulate the investment merits of the transaction to these constituents. Consequently, in an LBO, a strong management team can create tangible value by driving favorable financing terms and pricing, as well as providing sponsors with comfort to stretch on valuation.

From a structuring perspective, management typically holds a meaningful equity interest in the post-LBO company through “rolling” its existing equity or investing in the business alongside the sponsor at closing. Several layers of management typically also have the opportunity to participate (on a post-closing basis) in a stock option-based compensation package, generally tied to an agreed upon set of financial targets for the company. This structure provides management with meaningful economic incentives to improve the company's performance as they share in the value created. As a result, the interests of management and sponsor are aligned in pursuing superior performance. The broad-based equity incentive program outlined above is often a key differentiating factor versus a public company ownership structure.

Strong Cash Flow Generation

The ability to generate strong, predictable cash flow is critical for LBO candidates given the highly leveraged capital structure. Debt investors require a business model that demonstrates the ability to support periodic interest payments and debt principal repayment over the life of the loans and securities. Business characteristics that support the predictability of robust cash flow increase a company's attractiveness as an LBO candidate. For example, many strong LBO candidates operate in a mature or niche business with stable customer demand and end markets. They often feature a strong brand name, established customer base, and/or long-term sales contracts, all of which serve to increase the predictability of cash flow. Prospective financial sponsors and financing providers seek to confirm a given LBO candidate's cash flow generation potential during due diligence to gain comfort with the target management's projections. Cash flow projections are usually stress-tested (sensitized) based on historical volatility and potential future business and economic conditions to ensure the ability to support the LBO financing structure under challenging circumstances.

Leading and Defensible Market Positions

Leading and defensible market positions generally reflect entrenched customer relationships, brand name recognition, superior products and services, a favorable cost structure, and scale advantages, among other attributes. These qualities create barriers to entry and increase the stability and predictability of a company's cash flow. Accordingly, the sponsor spends a great deal of time during due diligence seeking assurance that the target's market positions are secure (and can potentially be expanded). Depending on the sponsor's familiarity with the sector, consultants may be hired to perform independent studies analyzing market share and barriers to entry.

Growth Opportunities

Sponsors seek companies with growth potential, both organically and through potential future bolt-on acquisitions. Profitable top line growth at above-market rates helps drive outsized returns, generating greater cash available for debt repayment while also increasing EBITDA and enterprise value. Growth also enhances the speed and optionality for exit opportunities. For example, a strong growth profile is particularly important if the target is designated for an eventual IPO exit.

Companies with robust growth profiles have a greater likelihood of driving EBITDA “multiple expansion”²⁴ during the sponsor's investment horizon, which further enhances returns. Moreover, as discussed in Chapter 1, larger companies tend to benefit from their scale, market share, purchasing power, and lower risk profile, and are often rewarded with a premium valuation relative to smaller peers, all else being equal. In some cases, the sponsor opts not to maximize the amount of debt financing at purchase. This provides greater flexibility to pursue a growth strategy that may require future incremental debt to make acquisitions or build new facilities, for example.

Efficiency Enhancement Opportunities

While an ideal LBO candidate should have a strong fundamental business model, sponsors seek opportunities to improve operational efficiencies and generate cost savings. Traditional cost-saving measures include lowering corporate overhead, streamlining operations, introducing lean manufacturing and Six Sigma processes,²⁵ reducing headcount, rationalizing the supply chain, and implementing new management information systems. The sponsor may also seek to source new (or negotiate better) terms with existing suppliers and customers. These initiatives are a primary focus for the consultants and industry experts hired by the sponsor to assist with due diligence and assess the opportunity represented by establishing “best practices” at the target. Their successful implementation often represents substantial value creation that accrues to equity value at a multiple of each dollar saved (given an eventual exit).

At the same time, sponsors must be careful not to jeopardize existing sales or attractive growth opportunities by starving the business of necessary capital. Extensive cuts in marketing, capex, or research & development, for example, may hurt customer retention, new product development, or other growth initiatives. Such moves could put the company at risk of deteriorating sales and profitability or loss of market position.

Low Capex Requirements

All else being equal, low capex requirements enhance a company's cash flow generation capabilities. As a result, the best LBO candidates tend to have limited capital investment needs. However, a company with substantial capex requirements may still represent an attractive investment opportunity if it has a strong growth profile, high profit margins, and the business strategy is validated during due diligence.

During due diligence, the sponsor and its advisors focus on differentiating those expenditures deemed necessary to continue operating the business (“maintenance capex”) from those that are discretionary (“growth capex”). Maintenance capex is capital required to sustain existing assets (typically PP&E) at their current output levels. Growth capex is used to purchase new assets, thereby expanding the existing asset base. In the event that economic conditions or operating performance decline, growth capex can potentially be reduced or eliminated.

Strong Asset Base

A strong asset base pledged as collateral against a loan benefits lenders by increasing the likelihood of principal recovery in the event of bankruptcy (and liquidation). This, in turn, increases their willingness to provide debt to the target. Strength is defined as size of the asset base (e.g., tangible assets as a percentage of total assets) as well as quality of the asset base. Accounts receivable and inventory are considered high quality assets given their liquidity. As opposed to long-term assets such as PP&E, they can be converted into cash easily and quickly.

The target's asset base is particularly important in the leveraged loan market, where the value of the assets helps dictate the amount of bank debt available (see “LBO Financing” sections for additional information). A strong asset base also tends to signify high barriers to entry because of the substantial capital investment required, which serves to deter new entrants in the target's markets. At the same time, a company with little or no assets can still be an attractive LBO candidate provided it generates sufficient cash flow.

Proven Management Team

A proven management team serves to increase the attractiveness (and value) of an LBO candidate. Talented management is critical in an LBO scenario given the need to operate under a highly leveraged capital structure with ambitious performance targets. Prior experience operating under such conditions, as well as success in integrating acquisitions or implementing restructuring initiatives, is highly regarded by sponsors.

For LBO candidates with strong management, the sponsor usually seeks to keep the existing team in place post-acquisition. It is customary for management to retain, invest, or be granted a meaningful equity stake so as to align their incentives under the new ownership structure with that of the sponsor. Alternatively, in those instances where the target's management is weak, sponsors seek to add value by making key changes to the existing team or installing a new team altogether to run the company. In either circumstance, a strong management team is crucial for driving company performance going forward and helping the sponsor meet its investment objectives.

Returns Analysis—Internal Rate of Return

Internal rate of return (IRR) is the primary metric by which sponsors gauge the attractiveness of a potential LBO, as well as the performance of their existing investments. IRR measures the total return on a sponsor's equity investment, including any additional equity contributions made, or dividends received, during the investment horizon. The IRR approach factors in the time value of money—for a given amount of cash proceeds at exit, a shorter exit timeline produces a higher IRR for the sponsor. In contrast, if the investment proceeds take longer to realize, the IRR will decrease.

IRR is defined as the discount rate that must be applied to the sponsor's cash outflows and inflows during the investment horizon in order to produce a net present value (NPV) of zero. Although the IRR calculation can be performed with a financial calculator or by using the IRR function in Microsoft Excel, it is important to understand the supporting math. Exhibit 4.4 displays the equation for calculating IRR, assuming a five-year investment horizon.

While multiple factors affect a sponsor's ultimate decision to pursue a potential acquisition, comfort with meeting acceptable IRR thresholds is critical. Sponsors typically target superior returns relative to alternative investments for their LPs, with a 20%+ threshold historically serving as a widely held “rule of thumb.” This threshold, however, may increase or decrease depending on market conditions, the perceived risk of an investment, and other factors specific to the situation.

The primary IRR drivers include the target's projected financial performance,²⁶ purchase price, and financing structure (particularly the size of the equity contribution), as well as the exit multiple and year. As would be expected, a sponsor seeks to minimize the price paid and equity contribution while gaining a strong degree of confidence in the target's future financial performance and the ability to exit at a sufficient valuation.

In Exhibit 4.5, we assume that a sponsor contributes $300 million of equity (cash outflow) at the end of Year 0 as part of the LBO financing structure and receives equity proceeds upon sale of $1 billion (cash inflow) at the end of Year 5. This scenario produces an IRR of 27.2%, as demonstrated by the NPV of zero.

Returns Analysis—Cash Return

In addition to IRR, sponsors also examine returns on the basis of a multiple of their cash investment (“cash return”). For example, assuming a sponsor contributes $300 million of equity and receives equity proceeds of $1 billion at the end of the investment horizon, the cash return is 3.3x (assuming no additional investments or dividends during the period). However, unlike IRR, the cash return approach does not factor in the time value of money.

How LBOs Generate Returns

LBOs generate returns through a combination of debt repayment and growth in enterprise value. Exhibit 4.6 depicts how each of these scenarios independently increases equity value, assuming a sponsor purchases a company for $1 billion, using $700 million of debt financing (70% of the purchase price) and an equity contribution of $300 million (30% of the purchase price). In each scenario, the returns are equivalent on both an IRR and cash return basis.

Scenario I

In Scenario I, we assume that the target generates cumulative free cash flow of $500 million, which is used to repay the principal amount of debt during the investment horizon. Debt repayment increases equity value on a dollar-for-dollar basis. Assuming the sponsor sells the target for $1 billion at exit, the value of the sponsor's equity investment increases from $300 million at purchase to $800 million even though there is no growth in the company's enterprise value. This scenario produces an IRR of 21.7% (assuming a five-year investment horizon) with a cash return of 2.7x.

Scenario II

In Scenario II, we assume that the target does not repay any debt during the investment horizon. Rather, all cash generated by the target (after the payment of interest expense) is reinvested into the business, and the sponsor realizes 50% growth in enterprise value by selling the target for $1.5 billion after five years. This enterprise value growth can be achieved through EBITDA growth (e.g., organic growth, acquisitions, or streamlining operations) and/or achieving EBITDA multiple expansion.

As the debt represents a fixed claim on the business, the incremental $500 million of enterprise value accrues entirely to equity value. As in Scenario I, the value of the sponsor's equity investment increases from $300 million to $800 million, but this time without any debt repayment. Consequently, Scenario II produces an IRR and cash return equivalent to those in Scenario I (i.e., 21.7% and 2.7x, respectively).

How Leverage Is Used to Enhance Returns

The concept of using leverage to enhance returns is fundamental to understanding LBOs. Assuming a fixed enterprise value at exit, using a higher percentage of debt in the financing structure (and a correspondingly smaller equity contribution) generates higher returns. Exhibit 4.7 illustrates this principle by analyzing comparative returns of an LBO financed with 30% debt versus an LBO financed with 70% debt. A higher level of debt provides the additional benefit of greater tax savings realized due to the tax deductibility of a higher amount of interest expense.

While increased leverage may be used to generate enhanced returns, there are certain clear trade-offs. As discussed in Chapter 3, higher leverage increases the company's risk profile (and probability of financial distress), limiting financial flexibility and making the company more susceptible to business or economic downturns.

^(a) In practice, the higher leverage in Scenario IV would require a higher blended cost of debt by investors versus Scenario III. For simplicity, we assume a constant cost of debt in this example.

^(b) Reduced FCF in Scenario IV versus Scenario III reflects the incremental interest expense associated with the additional $400 million of debt, which results in less cash available for debt repayment.

Scenario III

In Scenario III, we assume a sponsor purchases the target for $1 billion using $300 million of debt (30% of the purchase price) and contributing $700 million of equity (70% of the purchase price). After five years, the target is sold for $1.5 billion, thereby resulting in a $500 million increase in enterprise value ($1.5 billion sale price – $1 billion purchase price).

During the five-year investment horizon, we assume that the target generates annual free cash flow after the payment of interest expense of $60 million ($300 million on a cumulative basis), which is used for debt repayment. As shown in the timeline in Exhibit 4.8, the target completely repays the $300 million of debt by the end of Year 5.

By the end of the five-year investment horizon, the sponsor's original $700 million equity contribution is worth $1.5 billion as there is no debt remaining in the capital structure. This scenario generates an IRR of 16.5% and a cash return of approximately 2.1x after five years.

^(a) Annual free cash flow is after interest expense on the $300 million of debt. Also known as levered free cash flow or cash available for debt repayment (see Chapter 5).

Scenario IV

In Scenario IV, we assume that a sponsor buys the same target for $1 billion, but uses $700 million of debt (70% of the purchase price) and contributes $300 million of equity (30% of the purchase price). As in Scenario III, we assume the target is sold for $1.5 billion at the end of Year 5. However, annual free cash flow is reduced due to the incremental interest expense on the $400 million of additional debt.

As shown in Exhibit 4.9, under Scenario IV, the additional $400 million of debt ($700 million – $300 million) creates incremental interest expense of $32 million ($19.2 million after-tax) in Year 1. The after-tax incremental interest expense of $19.2 million is calculated as the $400 million difference multiplied by an 8% assumed cost of debt and then tax-effected at a 40% assumed marginal tax rate. For each year of the projection period, we calculate incremental interest expense as the difference between total debt (beginning balance) in Scenario III versus Scenario IV multiplied by 8% (4.8% after tax).

By the end of Year 5, the sponsor's original $300 million equity contribution is worth $994.3 million ($1.5 billion sale price – $505.7 million of debt remaining in the capital structure). This scenario generates an IRR of 27.1% and a cash return of approximately 3.3x after five years.

^(a) Post-debt service on the $300 million of debt in Scenario III.

^(b) Employs a beginning year as opposed to an average debt balance approach to calculating interest expense (see Chapter 5).

Sale of Business

Traditionally, sponsors have sought to sell portfolio companies to strategic buyers, which typically represent the most attractive potential bidders due to their ability to realize synergies from the target and, therefore, pay a higher price. Strategic buyers may also benefit from a lower cost of capital and a lower return threshold. The proliferation of private equity funds, however, has made exits via a sale to another sponsor increasingly commonplace. Moreover, during robust debt financing markets, sponsors may be able to use high leverage levels and generous debt terms to support purchase prices competitive with (or even in excess of) those offered by strategic buyers.

Initial Public Offering

In an IPO exit, the sponsor sells a portion of its shares in the target to the public. Post-IPO, the sponsor typically retains the largest single equity stake in the target with the understanding that a full exit will come through future follow-on equity offerings or an eventual sale of the company. Therefore, as opposed to an outright majority sale for control, an IPO generally affords the sponsor only a partial monetization of its investment. At the same time, the IPO provides the sponsor with a liquid market for its remaining equity investment while also preserving the opportunity to share in any future upside potential. Furthermore, depending on equity capital market conditions, an IPO may offer a compelling valuation premium to an outright sale.

Dividend Recapitalization

While not a true “exit strategy,” a dividend recapitalization (“dividend recap”) provides the sponsor with a viable option for monetizing a sizeable portion of its investment prior to exit. In a dividend recap, the target raises proceeds through the issuance of additional debt to pay shareholders a dividend. The incremental indebtedness may be issued in the form of an “add-on” to the target's existing credit facilities and/or bonds, a new security at the HoldCo level,²⁸ or as part of a complete refinancing of the existing capital structure. A dividend recap provides the sponsor with the added benefit of retaining 100% of its existing ownership position in the target, thus preserving the ability to share in any future upside potential and the option to pursue a sale or IPO at a future date. Depending on the size and number of dividends, the sponsor may be able to recoup all of (or more than) its initial equity investment.

Below Par Debt Repurchase

Many private equity firms have the flexibility to purchase the bank debt and high yield securities of their portfolio companies in the pursuit of acceptable risk-adjusted returns, either directly or through the issuer. As sponsors typically own a majority stake in the company and serve on the board of directors, they are well-positioned to evaluate the future prospects of the business, including its ability to service and eventually repay its indebtedness. This strategy is particularly attractive when the debt can be bought at distressed levels, which was relatively commonplace during the credit crisis of 2008 and 2009. In these instances, financial sponsors found opportunities to purchase debt instruments of their portfolio companies at significant discounts to par value. As market conditions improved and the financial performance of these companies rebounded, the debt instruments increased in price commensurately. This distressed debt strategy provides sponsors with an additional tool for generating returns from existing portfolio companies while still preserving future monetization opportunities via a refinancing, dividend, sale, or IPO.

Bank Debt

Bank debt is an integral part of the LBO financing structure, consistently serving as a substantial source of capital (as shown in Exhibit 4.12). Also referred to as “senior secured credit facilities,” it is typically comprised of a revolving credit facility (which may be borrowed, repaid, and reborrowed) and one or more term loan tranches (which may not be reborrowed once repaid). The revolving credit facility may take the form of a traditional “cash flow” revolver²⁹ or an asset-based lending (ABL) facility.³⁰ Bank debt is issued in the private market and is therefore not subject to SEC regulations and disclosure requirements.³¹ However, it has restrictive covenants that require the borrower to comply with certain provisions and financial tests throughout the life of the facility (see Exhibit 4.24).

Bank debt typically bears interest (payable on a quarterly basis) at a given benchmark rate, usually LIBOR or the Base Rate,³² plus an applicable margin (“spread”) based on the creditworthiness of the borrower (or quality of the asset base in the case of ABL facilities). This type of debt is often referred to as floating rate due to the fact that the borrowing cost varies in accordance with changes to the underlying benchmark rate. In addition, the spread may be adjusted downward (or upward) if it is tied to a performance-based grid based on the borrower's leverage ratio or credit ratings.

Revolving Credit Facility

A traditional cash flow revolving credit facility (“revolver”) is a line of credit extended by a bank or group of banks that permits the borrower to draw varying amounts up to a specified aggregate limit for a specified period of time. It is unique in that amounts borrowed can be freely repaid and reborrowed during the term of the facility, subject to agreed-upon conditions set forth in a credit agreement³³ (see Exhibit 4.24). The majority of companies utilize a revolver or equivalent lending arrangement to provide ongoing liquidity for seasonal working capital needs, capital expenditures, letters of credit (LC),³⁴ and other general corporate purposes. A revolver may also be used to fund a portion of the purchase price in an LBO, although it is usually undrawn at close.

Revolvers are typically arranged by one or more investment banks and then syndicated to a group of commercial banks and finance companies. To compensate lenders for making this credit line available to the borrower (which may or may not be drawn upon and offers a less attractive return when unfunded), a nominal annual commitment fee is charged on the undrawn portion of the facility.³⁵

The revolver is generally the least expensive form of capital in the LBO financing structure, typically priced at, or slightly below, the term loan's spread. In return for the revolver's low cost, the borrower must sacrifice some flexibility. For example, lenders generally require a first priority security interest (“lien”) on certain assets³⁶ of the borrower³⁷ (shared with the term loan facilities) and compliance with various covenants. The first lien provides lenders greater comfort by granting their debt claims a higher priority in the event of bankruptcy relative to obligations owed to second priority secured and unsecured creditors (see “Security”). The historical market standard for LBO revolvers has been a term (“tenor”) of five to six years, with no scheduled reduction to the committed amount of such facilities prior to maturity.

Asset-Based Lending Facility

An ABL facility is a type of revolving credit facility that is available to current asset-intensive companies. ABL facilities are secured by a first priority lien on all current assets (typically accounts receivable and inventory) of the borrower and may include a second priority lien on all other assets (typically PP&E). They are more commonly used by companies with sizeable accounts receivable and inventory and variable working capital needs that operate in seasonal or asset-intensive businesses. For example, ABL facilities are used by retailers, selected commodity producers and distributors (e.g., chemicals, forest products, and steel), manufacturers, and rental equipment businesses.

ABL facilities are subject to a borrowing base formula that limits availability based on “eligible” accounts receivable, inventory, and, in certain circumstances, fixed assets, real estate, or other more specialized assets of the borrower, all of which are pledged as collateral. The maximum amount available for borrowing under an ABL facility is capped by the size of the borrowing base at a given point in time or the committed amount of the facility, whichever is less. While the borrowing base formula varies depending on the individual borrower, a common example is shown in Exhibit 4.16.

ABL facilities provide lenders with certain additional protections not found in traditional cash flow revolvers, such as periodic collateral reporting requirements and appraisals. In addition, the assets securing ABLs (such as accounts receivable and inventory) are typically easier to monetize and turn into cash in the event of bankruptcy. As such, the interest rate spread on an ABL facility is lower than that of a cash flow revolver for the same credit. Given their reliance upon a borrowing base as collateral, ABL facilities traditionally have only one “springing” financial covenant.³⁸ Traditional bank debt, by contrast, has multiple financial maintenance covenants restricting the borrower. The typical tenor of an ABL revolver is five years.

Term Loan Facilities

A term loan (“leveraged loan,” when non-investment grade) is a loan with a specified maturity that requires principal repayment (“amortization”) according to a defined schedule, typically on a quarterly basis. Like a revolver, a traditional term loan for an LBO financing is structured as a first lien debt obligation³⁹ and requires the borrower to maintain a certain credit profile through compliance with financial maintenance covenants contained in the credit agreement. Unlike a revolver, however, a term loan is fully funded on the date of closing and once principal is repaid, it cannot be reborrowed. Term loans are classified by an identifying letter such as “A,” “B,” “C,” etc. in accordance with their lender base, amortization schedule, maturity date, and other terms.

Amortizing Term Loans

“A” term loans (“Term Loan A” or “TLA”) are commonly referred to as “amortizing term loans” because they typically require substantial principal repayment throughout the life of the loan.⁴⁰ Term loans with significant, annual required amortization are perceived by lenders as less risky than those with de minimis required principal repayments during the life of the loan due to their shorter average life. Consequently, TLAs are often the lowest priced term loans in the capital structure. TLAs are syndicated to commercial banks and finance companies together with the revolver and are often referred to as “pro rata” tranches because lenders typically commit to equal (“ratable”) percentages of the revolver and TLA during syndication. TLAs in LBO financing structures typically have a term that ends simultaneously (“co-terminus”) with the revolver.

Institutional Term Loans

“B” term loans (“Term Loan B” or “TLB”), which are commonly referred to as “institutional term loans,” are more prevalent than TLAs in LBO financings. They are typically larger in size than TLAs and sold to institutional investors (often the same investors who buy high yield bonds) rather than banks. The institutional investor class prefers non-amortizing loans with longer maturities and higher coupons. As a result, TLBs generally amortize at a nominal rate (e.g., 1% per annum) with a bullet payment at maturity.⁴¹ TLBs are typically structured to have a longer term than the revolver and any TLA as bank lenders prefer to have their debt mature before the TLB. Hence, a tenor for TLBs of up to seven (or sometimes seven and one-half years) has historically been market standard for LBOs.

Second Lien Term Loans

The prevalence of second lien term loans⁴² to finance LBOs is generally a sign of a strong debt market, such as during the credit boom of the mid-2000s. A second lien term loan is a floating rate loan that is secured by a second priority security interest in the assets of the borrower. It ranks junior to the first priority security interest in the assets of the borrower benefiting a revolver, TLA, and TLB. In the event of bankruptcy (and liquidation), second lien lenders are entitled to repayment from the proceeds of collateral sales after such proceeds have first been applied to the claims of first lien lenders, but prior to any application to unsecured claims.⁴³ Unlike first lien term loans, second lien term loans generally do not amortize. Second lien term loans are typically structured to have a longer term than the first lien term loans as first lien lenders prefer to have their debt mature before the second lien term loan.

For borrowers, second lien term loans offer an alternative to more traditional junior debt instruments, such as high yield bonds and mezzanine debt. As compared to traditional high yield bonds, for example, second lien term loans provide borrowers with superior prepayment optionality and no ongoing public disclosure requirements. They can also be issued in a smaller size than high yield bonds, which usually have a minimum issuance amount of $150+ million due to investors' desire for trading liquidity. Depending on the borrower and market conditions, second lien term loans may also provide a lower cost-of-capital. However, they typically carry the burden of financial covenants, albeit moderately less restrictive than first lien debt. For investors, which typically include hedge funds and CDOs, second lien term loans offer less risk (due to the secured status) than traditional unsecured high yield bonds while paying a higher coupon than first lien debt.

High Yield Bonds

High yield bonds are non-investment grade debt securities that obligate the issuer to make interest payments to bondholders at regularly defined intervals (typically on a semiannual basis) and repay principal at a stated maturity date, usually seven to ten years after issuance. As opposed to term loans, high yield bonds are non-amortizing with the entire principal due as a bullet payment at maturity. Due to their junior, typically unsecured position in the capital structure, longer maturities, and less restrictive incurrence covenants as set forth in an indenture (see Exhibit 4.25),⁴⁴ high yield bonds feature a higher coupon than bank debt to compensate investors for the greater risk.

High yield bonds typically pay interest at a fixed rate, which is priced at issuance on the basis of a spread to a benchmark Treasury. As its name suggests, a fixed rate means that the interest rate is constant over the entire maturity. While high yield bonds may be structured with a floating rate coupon, this is not common for LBO financings. High yield bonds are typically structured as senior unsecured, senior subordinated, or, in certain circumstances, senior secured (first lien, second lien, or even third lien).

Traditionally, high yield bonds have been a mainstay in LBO financings. Used in conjunction with bank debt, high yield bonds enable sponsors to substantially increase leverage levels beyond those available in the leveraged loan market alone. This permits sponsors to pay a higher purchase price and/or reduce the equity contribution. Furthermore, high yield bonds afford issuers greater flexibility than bank debt due to their less restrictive incurrence covenants (and absence of maintenance covenants), longer maturities, and lack of mandatory amortization. One offsetting factor, however, is that high yield bonds have non-call features (see Exhibit 4.23) that can negatively impact a sponsor's exit strategy.

Typically, high yield bonds are initially sold to qualified institutional buyers (QIBs)⁴⁵ through a private placement under Rule 144A of the Securities Act of 1933. They are then registered with the SEC within one year of issuance so that they can be traded on an open market. The private sale to QIBs expedites the initial sale of the bonds because SEC registration, which involves review of the registration statement by the SEC, can take several weeks or months. Once the SEC review of the documentation is complete, the issuer conducts an exchange offer pursuant to which investors exchange the unregistered bonds for registered securities. Post-registration, the issuer is subject to SEC disclosure requirements (e.g., the filing of 10-Ks, 10-Qs, 8-Ks, etc).

During robust credit markets, companies have been able to issue bonds with atypical “issuer-friendly” provisions, such as a payment-in-kind (PIK) toggle. The PIK toggle allows an issuer to choose whether to pay interest “in-kind” (i.e., in the form of additional notes) or in cash. This optionality provides the issuer with the ability to preserve cash in times of challenging business or economic conditions, especially during the early years of the investment period when leverage is highest. If the issuer elects to pay PIK interest in lieu of cash, the coupon typically increases by 75 bps.

As bank debt and high yield bonds are the primary debt instruments used in an LBO financing, a comparison of the primary terms is shown in Exhibit 4.19.

Bridge Loans

A bridge loan facility (“bridge”) is interim, committed financing provided to the borrower to “bridge” to the issuance of permanent capital, most often high yield bonds (the “take-out” securities). In an LBO, investment banks typically commit to provide funding for the bank debt and a bridge loan facility. The bridge usually takes the form of an unsecured term loan, which is only funded if the take-out securities cannot be issued and sold by the closing of the LBO.

Bridge loans are particularly important for LBO financings due to the sponsor's need to provide certainty of funding to the seller. The bridge financing gives comfort that the purchase consideration will be funded even in the event that market conditions for the take-out securities deteriorate between signing and closing of the transaction (subject to any conditions precedent to closing enumerated in the definitive agreement (see Chapter 6, Exhibit 6.9) or the commitment letter). If funded, the bridge loan can be replaced with the take-out securities at a future date, markets permitting.

In practice, however, the bridge loan is rarely intended to be funded, serving only as a financing of last resort. From the sponsor's perspective, the bridge loan is a potentially costly funding alternative due to the additional fees required to be paid to the arrangers.⁴⁶ The interest rate on a bridge loan also typically increases periodically the longer it is outstanding until it hits the caps (maximum interest rate). The investment banks providing the bridge loan also hope that the bridge remains unfunded as it ties up capital and increases exposure to the borrower's credit. To mitigate the risk of funding a bridge, the lead arrangers often seek to syndicate all or a portion of the bridge loan commitment prior to the closing of the transaction.

Mezzanine Debt

As its name suggests, mezzanine debt refers to a layer of capital that lies between traditional debt and equity. Mezzanine debt is a highly negotiated instrument between the issuer and investors that is tailored to meet the financing needs of the specific transaction and required investor returns. As such, mezzanine debt allows great flexibility in structuring terms conducive to issuer and investor alike.

For sponsors, mezzanine debt provides incremental capital at a cost below that of equity, which enables them to attain higher leverage levels and purchase price when alternative capital sources are inaccessible. For example, mezzanine debt may serve to substitute for, or supplement, high yield financing when markets are unfavorable or even inaccessible (e.g., for smaller companies whose size needs are below high yield bond market minimum thresholds). In the United States, it is particularly prevalent in middle market transactions.⁴⁷

Typical investors include dedicated mezzanine funds, insurance companies, business development companies (BDCs), and hedge funds. For the investor, mezzanine debt offers a higher rate of return than traditional high yield bonds and can be structured to offer equity upside potential in the form of purchased equity or detachable warrants that are exchangeable into common stock of the issuer. The interest rate on mezzanine debt typically includes a combination of cash and non-cash PIK payments. Depending on available financing alternatives and market conditions, mezzanine investors typically target a “blended” return (including cash and non-cash components) in the low-to-mid teens (or higher) depending on market conditions. Maturities and terms for mezzanine debt may vary substantially, but tend to be similar to those for high yield bonds.⁴⁸

Equity Contribution

The remaining portion of LBO funding comes in the form of an equity contribution by the financial sponsor and rolled/contributed equity by the target's management. The equity contribution percentage typically ranges from approximately 30% to 40% of the LBO financing structure, although this may vary depending on debt market conditions, the type of company, and the purchase multiple paid.⁴⁹ For large LBOs, several sponsors may team up to create a consortium of buyers, thereby reducing the amount of each individual sponsor's equity contribution (known as a “club deal”).

The equity contribution provides a cushion for lenders and bondholders in the event that the company's enterprise value deteriorates as equity value is eliminated before debt holders lose recovery value. For example, if a sponsor contributes 30% equity to a given deal, lenders gain comfort that the value of the business would have to decline by more than 30% from the purchase price before their principal is jeopardized. Sponsors may also choose to “over-equitize” certain LBOs, such as when they plan to issue incremental debt at a future date to fund acquisitions or fund growth initiatives for the company.

Rollover/contributed equity by existing company management and/or key shareholders varies according to the situation, but often ranges from approximately 2% to 5% (or more) of the overall equity portion. Management equity rollover/contribution is usually encouraged by the sponsor in order to align incentives.

Security

Security refers to the pledge of, or lien on, collateral that is granted by the borrower to the holders of a given debt instrument. Collateral represents assets, property, and/or securities pledged by a borrower to secure a loan or other debt obligation, which is subject to seizure and/or liquidation in the event of a default.⁵⁰ It can include accounts receivable, inventory, PP&E, intellectual property, and securities such as the common stock of the borrower/issuer and its subsidiaries. Depending upon the volatility of the target's cash flow, creditors may require higher levels of collateral coverage as protection.

Seniority

Seniority refers to the priority status of a creditor's claims against the borrower/issuer relative to those of other creditors. Generally, seniority is achieved through either contractual or structural subordination.

Contractual Subordination

Contractual subordination refers to the priority status of debt instruments at the same legal entity. It is established through subordination provisions, which stipulate that the claims of senior creditors must be satisfied in full before those of junior creditors (generally “senior” status is limited to bank lenders or similar creditors, not trade creditors⁵¹). In the case of subordinated bonds, the indenture contains the subordination provisions that are relied upon by the senior creditors as “third-party” beneficiaries.⁵² Exhibit 4.21 provides an illustrative diagram showing the contractual seniority of multiple debt instruments.

While both senior secured debt and senior unsecured debt have contractually equal debt claims (pari passu), senior secured debt may be considered “effectively” senior to the extent of the value of the collateral securing such debt.

Structural Subordination

Structural subordination refers to the priority status of debt instruments at different legal entities within a company. For example, debt obligations at OpCo, where the company's assets are located, are structurally senior to debt obligations at HoldCo⁵³ so long as such HoldCo obligations do not benefit from a guarantee (credit support)⁵⁴ from OpCo. In the event of bankruptcy at OpCo, its obligations must be satisfied in full before a distribution or dividend can be made to its sole shareholder (i.e., HoldCo). Exhibit 4.22 provides an illustrative diagram showing the structural seniority of debt instruments at two legal entities.

Maturity

The maturity (“tenor” or “term”) of a debt obligation refers to the length of time the instrument remains outstanding until the full principal amount must be repaid. Shorter tenor debt is deemed less risky than debt with a longer maturity as it is required to be repaid earlier. Therefore, all else being equal, shorter tenor debt carries a lower cost of capital than longer tenor debt of the same credit.

In an LBO, various debt instruments with different maturities are issued to finance the debt portion of the transaction. Bank debt tends to have shorter maturities, often five to six years for revolvers and seven (or sometimes seven and one-half years) for institutional term loans. Historically, high yield bonds have had a maturity of seven to ten years. In an LBO financing structure comprising several debt instruments (e.g., a revolver, institutional term loans, and bonds), the revolver will mature before the institutional term loans, which, in turn, will mature before the bonds.

Coupon

Coupon refers to the annual interest rate (“pricing”) paid on a debt obligation's principal amount outstanding. It can be based on either a floating rate (typical for bank debt) or a fixed rate (typical for bonds). Bank debt generally pays interest on a quarterly basis, while bonds generally pay interest on a semiannual basis. The bank debt coupon is typically based on a given benchmark rate, usually LIBOR or the Base Rate, plus a spread based on the credit of the borrower.⁵⁵ A high yield bond coupon, however, is generally priced at issuance on the basis of a spread to a benchmark Treasury.

There are a number of factors that affect a debt obligation's coupon, including the type of debt (and its investor class), ratings, security, seniority, maturity, covenants, and prevailing market conditions. In a traditional LBO financing structure, bank debt tends to be the lowest cost of capital debt instrument because it has a higher credit rating, first lien security, higher seniority, a shorter maturity, and more restrictive covenants than high yield bonds.

Call Protection

Call protection refers to certain restrictions on voluntary prepayments (of bank debt) or redemptions (of bonds) during a defined time period within a given debt instrument's term. These restrictions may prohibit voluntary prepayments or redemptions outright or require payment of a substantial fee (“call premium”) in connection with any voluntary prepayment or redemption. Call premiums protect investors from having debt with an attractive yield refinanced long before maturity, thereby mitigating reinvestment risk in the event market interest rates decline.

Call protection periods are standard for high yield bonds. They are typically set at four years (“Non call-4” or “NC-4”) for a seven/eight-year fixed rate bond and five years (“NC-5”) for a ten-year fixed rate bond. The redemption of bonds prior to maturity requires the issuer to pay a premium in accordance with a defined call schedule as set forth in an indenture, which dictates call prices for set dates.⁵⁶

A bond's call schedule and call prices depend on its term and coupon. Exhibit 4.23 displays a standard call schedule for: a) 8-year bond with an 8% coupon, and b) 10-year bond with a 10% coupon, both issued in 2012.⁵⁷

Traditional first lien bank debt has no call protection, meaning that the borrower can repay principal at any time without penalty. Other types of term loans, however, such as those secured by a second lien, may have call protection periods, although terms vary depending on the loan.⁵⁸

Covenants

Covenants are provisions in credit agreements and indentures intended to protect debt investors against the deterioration of the borrower/issuer's credit quality. They govern specific actions that may or may not be taken during the term of the debt obligation. Failure to comply with a covenant may trigger an event of default, which allows investors to accelerate the maturity of their debt unless amended or waived. There are three primary classifications of covenants: affirmative, negative, and financial.

While many of the covenants in credit agreements and indentures are similar in nature, a key difference is that traditional bank debt features financial maintenance covenants while high yield bonds have less restrictive incurrence covenants. As detailed in Exhibit 4.24, financial maintenance covenants require the borrower to “maintain” a certain credit profile at all times through compliance with certain financial ratios or tests on a quarterly basis. Financial maintenance covenants are also designed to limit the borrower's ability to take certain actions that may be adverse to lenders (e.g., making capital expenditures beyond a set amount), which allows the lender group to limit the financial risks taken by the borrower. Covenants are also designed to provide lenders with an early indication of financial distress.

Bank Debt Covenants

Exhibit 4.24 displays typical covenants found in a credit agreement. With respect to financial maintenance covenants, the typical credit agreement contains two to three of these covenants. The required maintenance leverage ratios typically decrease (“step down”) throughout the term of the loan. Similarly, the coverage ratios typically increase over time. This requires the borrower to improve its credit profile by repaying debt and/or growing cash flow in accordance with the financial projections it presents to lenders during syndication. “Covenant-lite” loans are a leveraged loan market convention that is prevalent during strong credit markets. As the name suggests, covenant-lite loans have covenant packages similar to those of high yield bonds, typically featuring incurrence covenants as opposed to quarterly financial maintenance covenants.

High Yield Bond Covenants

Many of the covenants found in a high yield bond indenture are similar to those found in a bank debt credit agreement (see Exhibit 4.25). A key difference, however, is that the indenture contains incurrence covenants as opposed to maintenance covenants. Incurrence covenants prevent the issuer from taking specific actions (e.g., incurring additional debt, making certain investments, paying dividends) only in the event it is not in pro forma compliance with a “Ratio Test,” or does not have certain “baskets” available to it at the time such action is taken. The Ratio Test is often a coverage test (e.g., a fixed charge coverage ratio), although it may also be structured as a leverage test (e.g., total debt-to-EBITDA) as is common for telecommunications/media companies.

Term Sheets

The key terms for the debt securities comprising an LBO financing structure are typically summarized in a one-page format, such as that shown in Exhibit 4.26 (bank debt) and Exhibit 4.28 (high yield bonds). Exhibits 4.27 and 4.29 provide explanations for the term sheet items.