Introduction to acquisition finance
Financing the acquisition
Security in acquisition finance transactions
Transaction management
The term acquisition finance describes the debt element of the funding for the acquisition of a business. The term is particularly associated with leveraged businesses, ie private equity sponsored buy-outs of businesses using significant amounts of debt finance.
This guidance note describes what is meant by the term “acquisition finance”, the typical tiers of debt which comprise the debt element of an acquisition finance transaction and the advantages from a sponsor perspective of using debt.
See What is acquisition finance?
Key parties and documents in acquisition financeThe main parties to an acquisition finance transaction will usually include:
- •the sponsor, or, in some cases, sponsors — the sponsor will provide the equity often by way of ordinary shares and subordinated loans, into a special purpose holding entity (“Holdco”) and will normally acquire a controlling stake in the business;
- •management — management will normally subscribe for or be granted equity or equity rights in the group and will manage the business in accordance with the business plan;
- •finance parties — lenders and related parties such as the security trustee and facility agent which are the common roles of banks and other financial institutions. Lenders will provide the senior and, if applicable, mezzanine debt;
- •purchaser — the purchaser will normally be a special purpose vehicle (SPV) set up to purchase the target(s) and will often be the main borrower;
- •Holdco and other SPVs — the parent will typically be the SPV established above the purchaser where equity is invested and subordinated loans lent;
- •target and its subsidiaries (known as the target group) — the target group makes up the business (or group) that is being acquired; and
- •seller / vendor — the entity selling the target group.
The main documents for an acquisition finance fall into three categories:
- •acquisition documents — these govern the terms of the acquisition between the vendor and the purchaser. These documents may include the sale and purchase agreement and disclosure letter and will be negotiated between the sponsor and the vendor;
- •equity documents — these govern the terms of the equity investment (which may include shareholder subordinated debt) and the relationship between the investors. These documents may include a shareholders agreement/investment agreement, Holdco constitution and shareholder subordinated debt instrument and will be broadly determined by the controlling sponsor with some allowances for the views of participating management and the sponsor; and
- •finance documents — these govern the provision of the acquisition facilities and any related facilities (such as a revolving credit facility for working capital). These documents may include facilities agreements (senior and, if applicable, mezzanine), bond documentation, intercreditor agreements and security documentation and will be agreed to by the sponsor and relevant finance parties.
This guidance note further details each of the above key parties and documents and includes a structure diagram for a typical leveraged buy-out transaction.
See Key parties and documents in acquisition finance.
The leveraged buy-out transaction lifecycleA typical buy-out of the target business or group is often subject to a tender process which can be broadly divided into a number of stages. This guidance note outlines each of the following stages:
- •commencement of sale process — informal sounding out of potential buyer interest and preparation and circulation of an information memorandum by the vendor;
- •initial due diligence — the main purpose of due diligence is for the buyer/bidder to gather information about the target business to ascertain any problems (that may require a price adjustment or even determine whether the buyer wishes to proceed with the purchase). Due diligence reports usually include financial, tax and legal considerations;
- •choosing a purchaser and the tender process — the seller is likely to run a tender process in order to work out its preferred buyer. There will normally be several rounds;
- •selecting finance providers — while the seller is trying to select a preferred bidder, the sponsor will be running a process with, and leading to obtaining commitments to fund from, potential finance providers;
- •drafting and negotiation of equity, acquisition and finance documents — these documents may be prepared and negotiated prior to full exclusivity being granted by the seller to the preferred buyer. However, full documents often will not be put in place until after exclusivity is granted;
- •satisfying the conditions precedent — conditions precedent to signing are often documents and evidence that the borrower must provide to the agent (and lenders) before funding can occur. They are often included as a schedule in the facility agreement and are often copied into a separate table (known as a CP checklist). See Conditions precedent on acquisition finance transactions — documents table;
- •signing — signing occurs when the acquisition agreement is executed (which is often with the facility agreement so that the parties know when, and with a tolerable level of certainty that, the funds can be drawn down for the purchase);
- •completion — completion is when the conditions precedent is satisfied (or waived) and completion occurs eg ownership of the target is transferred to the purchaser;
- •syndication — syndication may occur within a few months of funding where other financial institutions take on loan commitments and become lenders under the finance documents. However, it may also occur prior to first funding; and
- •exit — the equity and debt providers will ultimately wish to realise their investments in the purchaser. For debt providers, this should mean repayment of the outstanding balance of their facilities. For equity providers, this means realising on their investment in whole or in part through a sale of the business or flotation on a stock exchange.
See The leveraged buy-out transaction lifecycle.
Key areas of law relevant to acquisition financeAcquisition finance transactions may typically include many areas of law such as:
- •contract law;
- •security, property and intellectual property law;
- •regulatory issues;
- •corporate law — particularly the operations of the Corporations Act 2001 (Cth) in Australia;
- •tax law;
- •insolvency law;
- •legal issues on cross-border transactions;
- •trust law; and
- •competition law.
The key areas may differ depending on the nature of each transaction. This guidance note describes how each of the above areas of law may become relevant in an acquisition finance transaction.
Leveraged buy-outs are commonly funded using a mixture of sponsor equity and external debt. This guidance note outlines these two main sources of funding and the typical purposes to which such funding is applied.
See Sources of finance for leveraged buy-outs.
EquityThe equity contribution as a proportion of the whole will depend on prevailing market conditions. It will also depend on how much equity the sponsor is able or willing to deploy, sponsor IRR targets, the strength and desirability of the target business and the cash flows it is expected to generate. This guidance note describes the following typical types of equity contribution (assuming, for present purposes, that Holdco or Topco is a company, not eg a unit trust):
- •true equity in the form of ordinary share capital; and
- •quasi-equity in the form of subordinated shareholder loans or, less frequently, some other form of capital investments such as, eg redeemable preference shares.
See Equity.
DebtThe external debt for financing an acquisition will typically be provided by banks and institutional investors that invest in leveraged loans. This guidance note outlines the following types of external debt used:
- •senior debt;
- •mezzanine debt; and
- •vendor finance.
See Debt.
Determining the funding structureTaking into account transaction costs and expenses (which may include stamp duty and other transaction taxes) as well as the likely purchase price (and any required expansion or working capital), the sponsor will consider how best in the current environment to finance the purchase. This guidance note highlights the various factors which will be considered including sponsor preferences, appetite from various debt providers for the business sector and the proposed type of the transaction, ease of amendments, negotiation, flexibility etc.
See Determining the funding structure.
Term sheets in acquisition finance transactionsThe terms of a leveraged buy-out financing will typically be extensively negotiated and clearly documented in a reasonably detailed term sheet (and accompanying commitment letter) prior to any formal finance documentation being drafted. The term sheet sets out key terms to be included in the finance documents; primarily the facilities agreement(s) and the intercreditor agreement.
The level of detail in an acquisition finance term sheet is typically higher than general purpose loans partly reflecting the need for certainty in a bidding environment, partly reflecting the high leverage context and the focus and intensity that private equity typically brings to negotiations.
For facilities which are intended to be syndicated, term sheets are generally agreed by the sponsor and main lead banks (often referred to as the ”mandated lead arrangers” or ”MLAs”). This guidance note outlines the key terms and commonly negotiated provisions of a term sheet for acquisition finance.
See Term sheets in acquisition finance transactions.
Commitment letters and mandate lettersA commitment letter (noting that in Australia mandate letters are usually termed ”commitment letters” where there is no separate syndication process) is normally drafted alongside the term sheet (and when finalised has the term sheet attached). It, or a mandate letter (where there is still a separate syndication to be run), appoints the mandated lead arrangers or the “MLAs”.
Commitment letters are viewed as an indicator of a buyer’s ability to obtain funding and complete the acquisition. This guidance note outlines the key terms of a mandate letter for acquisition finance.
See Commitment letters and mandate letters.
Leveraged vs investment grade facility agreement — similarities and differencesLeveraged finance syndicated facility agreements typically follow (if one adopts a helicopter view) the same basic structure as a corporate syndicated facility agreement. However, there are key differences to better reflect:
- •the essentially limited recourse nature of the facilities;
- •the higher risk profile of leveraged facilities (reflected in the inclusion of provisions to monitor and control activities of the group and mandatorily reduce debt (and therefore the refinancing risk for the lender given the group's amount of debt)); and
- •the security and guarantees and undertakings that material companies in the group, especially the target group, will be required to provide.
This guidance note highlights the main similarities and differences when comparing leveraged and investment grade facility agreements.
See Leveraged vs. investment grade facility agreement — similarities and differences.
The senior facility agreementSenior debt facilities may be provided by banks or institutional investors. Senior facilities often comprise two main components:
- •term facilities (which will be applied towards the purchase); and
- •a revolving working capital facility (for general corporate purposes).
Other possible senior facilities include:
- •a capex facility, which may be provided to help the group fund its growth capital expenditure plans; or
- •a further acquisition facility, which may be provided where the business intends to grow by making acquisitions (a well-known approach where an industry is ripe for consolidation or the business needs to achieve critical mass and/or market share to facilitate an exit strategy, is to follow a “roll up” strategy where similar businesses are acquired and ”rolled up” into the whole).
This guidance note outlines the senior facilities mentioned above.
See The senior facility agreement.
The mezzanine facility agreementMezzanine debt is a form of debt finance that ranks after the senior facilities.
Typically, mezzanine debt:
- •is provided by institutional investors (such as funds) and specialist mezzanine houses rather than banks;
- •accounts for a lower proportion of the total debt finance than senior debt;
- •has a considerably higher margin than senior debt (to reflect the greater risk); and
- •will either be structurally subordinated (by being provided at the Holdco level) or, often, when provided at the Borrower level, have the same security and guarantee package as senior debt but be contractually subordinated to the senior debt under an intercreditor agreement.
This guidance note examines the key features of a mezzanine facility agreement and describes how the priority and subordination of the mezzanine lenders to the senior lenders will typically be documented.
See The mezzanine facility agreement.
Representations, covenants and events of default in acquisition financeThis guidance note discusses:
- •the purpose of and typical representations in a leveraged senior facilities agreement and how these differ from those in an investment grade facility agreement;
- •common ways for the sponsor to attempt to limit the scope of the representations;
- •when representations are typically given;
- •the purpose of and typical information undertakings in a leveraged senior facilities agreement;
- •the purpose of typical general undertakings in a leveraged senior facilities agreement;
- •the use of “baskets” to provide flexibility under the general undertakings; and
- •the purpose of and typical events of default.
See Representations, covenants and events of default in acquisition finance.
Financial covenants in acquisition financeThe financial covenants contained in a leveraged finance facility agreement commonly include:
- •finance debt or senior debt to EBITDA ratio (leverage/senior leverage covenant);
- •CFADS (cashflow available for debt service to debt service ratio (debt service cover covenant or ”DSCR”);
- •EBITDA to interest/senior interest ratio (interest cover ratio ”ICR”); and
- •limit on capital expenditure.
This guidance note describes these financial covenants and outlines the consequences of breach including the sponsor’s typical equity cure rights.
See Financial covenants in acquisition finance.
Mandatory prepayment clauses in acquisition financeA leveraged finance facilities agreement will normally contain a more extensive list of mandatory prepayment events than an investment grade loan agreement. The list will commonly comprise:
- •exit by the sponsor from the business;
- •receipt by the group of disposal proceeds, proceeds of insurance claims and proceeds of claims under acquisition documents; and
- •receipt of excess cashflow by the obligor group.
This guidance note discusses each of these mandatory prepayment events, how proceeds are commonly applied against the facilities, and mandatory prepayment and holding accounts.
See Mandatory prepayment clauses in acquisition finance.
Hedging in acquisition financeBorrowers often hedge (or are required to hedge by senior lenders) against the following risks in the context of a lending transaction:
- •interest rate risk by entering into an interest rate swap or other derivative transaction of similar effect;
- •exchange rate risk by entering into a currency swap or other derivative transaction of similar effect; and
- •where relevant commodity price risk by entering into a commodity swap or other derivative transaction of similar effect.
This guidance note explains the key documentation issues to consider when hedging risks in a lending context.
Acquisition finance transactions often have a broadly similar structure, are relatively high risk and are normally financed on the basis of the current and projected cashflow of the group rather than the value of particular assets. For this reason, lenders will often expect the group to provide a comprehensive security and guarantee package giving priority to:
- •full security and guarantees from material members of the group to reflect the higher risk;
- •share security from holding companies to facilitate ease of enforcement if necessary; and
- •ensuring that the different tranches of debt have the package appropriate to their level of subordination, see Security on deals with different structures.
Security is generally held on behalf of the lenders and other beneficiaries by a security trustee or security agent.
This guidance note covers:
- •the aims when taking security and guarantees on an acquisition finance transaction;
- •the common structure of the security and guarantee package for senior and mezzanine lenders in acquisition finance transactions;
- •issues relating to guarantees such as the guarantor coverage test;
- •security package on transactions with different structures; and
- •issues that arise when negotiating the security and guarantee package.
For more information, see Typical security and guarantee arrangements in acquisition finance.
Intercreditor agreements in acquisition financeSubordination may be used in certain finance transactions as a way of changing the priority of claims against a debtor often to ensure that repayments of any intra-group loans rank behind repayments of debt provided by external creditors and to govern the relationship between a range of external creditors providing debt to the same debtor. This guidance details the two main ways of achieving subordination in commercial transactions are by “contractual subordination” and “structural subordination”.
This guidance also outlines the key purpose and commonly negotiated provisions of an intercreditor agreement in acquisition finance transactions.
See Intercreditor agreements in acquisition finance.
Financial assistanceSection 260A of the Corporations Act 2001 (Cth) provides that a company registered in Australia can only provide financial assistance to a person to purchase shares in the company, or the shares of the company's holding company (even if that holding company is incorporated outside of Australia), if:
- •that assistance does not materially prejudice the company or its shareholders, or the company's ability to pay its creditors; or
- •that assistance is approved by shareholders of the company (known as a “whitewash”).
This guidance note explains what constitutes financial assistance, the rationale behind prohibiting companies from giving financial assistance and what is involved in the whitewash process.
See Financial assistance.
Reviewing foreign law security documentsGenerally, counsel acting both for the borrower(s) and lenders will want to review foreign law security documents.
This can occur where a group company in another jurisdiction grants security over its assets or where an Australian company owns assets located in another jurisdiction.
This guidance note examines the key issues for counsel acting for the sponsor/group when reviewing foreign law security documents, including:
- •compliance with the agreed security principles (if applicable);
- •covenants and costs obligations (to ensure they are not too unduly onerous); and
- •that representations are in line with those in the facilities agreement,
and the key issues for counsel acting for the lenders, including:
- •compliance with agreed security principles (if applicable); and
- •that the drafting of the security document(s) is correct, in particular:
- ◦that the correct assets are secured;
- ◦that the correct parties benefit from the security; and
- ◦that all relevant loans are secured.
Lenders' counsel will also ensure that they are fully aware of any laws in the relevant jurisdiction that might impact on the value of the security or make it hard to enforce, eg signing and perfection issues.
In addition to negotiating the finance documentation and coordinating their interplay with the other elements of the transaction, the role of the law firms in an acquisition finance transaction will include managing the process of satisfying the conditions precedent.
This guidance note addresses the following in the context of acquisition finance transactions:
- •the purpose of conditions precedent;
- •key types of conditions precedent; and
- •the process of satisfying conditions precedent.
See Conditions precedent on acquisition finance transactions — general considerations.
Conditions precedent on acquisition finance transactions — documents tableThis guidance note contains specific information on conditions precedent in an acquisition finance transaction along with some more general information on conditions precedent.
The following conditions precedent (“CPs”) will normally be included as a minimum:
- •constitutional documents of each obligor;
- •corporate resolutions of each obligor;
- •a certificate containing various confirmations from (usually two) directors;
- •legal opinions (typically issued by the financiers' counsel in Australia);
- •executed finance documents including the facilities agreement(s) itself, the intercreditor agreement, security documents, fee letters, hedging letter or hedging agreements;
- •acquisition documents, such as the acquisition agreement;
- •equity documents, such as the shareholders' agreement, constitution of Topco and loan note documents (if applicable);
- •ancillary matters relating to security;
- •due diligence reports;
- •funds flow statement and confirmations as to the equity finance being in place; and
- •confirmations there are no unsatisfied conditions to the acquisition agreement.
See Conditions precedent on acquisition finance transactions — documents table.
Reviewing acquisition documentsThis guidance note addresses some points of interest for lawyers for the lenders when reviewing specific acquisition documents. In more general terms, lawyers at this stage will check that:
- •the companies and/or assets being acquired accord with what the lenders are expecting;
- •the acquisition documents contain sufficient or typical contractual protections to protect the target group against unforeseen financial burdens; and
- •the acquisition documents deal with any key issues arising from disclosure and the due diligence process.
See Reviewing acquisition documents.
Reviewing equity documentsThe equity documents on an acquisition finance transaction will normally be negotiated between the sponsor, any other equity investor and the management team, with the lawyers for the lenders having the right to review and comment on the drafts.
This guidance note discusses the key considerations for lenders’ counsel when reviewing the main equity documents in an acquisition finance transaction, including:
- •the constitution of the top company in the group structure (Topco);
- •the shareholders' agreement, also known as the investment agreement or subscription agreement;
- •service contracts and bonus scheme documents;
- •shareholder subordinated loan agreement(s); and
- •downstream loan agreement(s).
See Reviewing equity documents.
Instructing and managing foreign counselGiven the cross-border nature of many acquisition finance transactions, it is common for the principal legal advisors for lenders and borrowers to need to instruct foreign lawyers to provide advice on foreign law.
This guidance note gives practical advice on instructing and managing foreign counsel and covers:
- •the role of foreign counsel;
- •instructing foreign counsel as principal legal advisers for the lender or borrower; and
- •the role of the principal legal advisers in managing foreign counsel.
