Sources of finance for leveraged buy-outs

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.

Equity

The 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.

Debt

The 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 structure

Taking 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 transactions

The 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 letters

A 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 differences

Leveraged 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 agreement

Senior 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 agreement

Mezzanine 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 finance

This 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 finance

The 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 finance

A 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 finance

Borrowers 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.

See Hedging in acquisition finance.