For any business, finance is required to start, maintain, and expand. Debt/Leverage finance is a primary source of external growth for a corporation seeking to acquire another corporation. Thus the majority of commercial law firms seek to offer services in this area. This article will specifically explore an in-depth overview of the process of a leveraged finance deal and the role of a commercial solicitor within the debt finance team. This is of significant importance in the undertaking of a role as a banking and finance lawyer.
What is a Leveraged Finance Transaction?
Leveraged finance is a method used to obtain financing that utilises an above-normal level of debt. The finance raised is then used to acquire a target company or target asset.
The above-normal use of debt makes the borrower highly leveraged and, in turn, considered riskier in the view of the lender. To reflect the higher risk in a leveraged finance transaction, a borrower will charge a higher margin. This makes leveraged finance a more expensive option for borrowers. Thus borrowers primarily utilise leveraged financing to finance acquisitions, as opposed to raising generic corporate funding to bolster existing operations.
Due to leveraged finance involving lending to highly leveraged companies with large risks, the amount of debt available from lenders is sensitive to market dynamics and ultimately depends on whether we are in a borrower-friendly or lender-friendly market (which we are slowly transitioning to with the recent Bank of England interest rate hikes to 0.5% from 0.25%).
Example Process
Now that we have established a brief outline of what an LBO (Leveraged buyout) is, it is easier to understand the process of this through a fictitious scenario where ‘our’ legal team will represent a PE Fund through an auction process as they are seeking to acquire Company X.
Leveraged Finance Transactions - The Parties Involved
Within the selling of the Target, there is a far more complex process that goes behind the scenes before the final purchase agreement is signed.
The Target
The Target is the company chosen as an attractive merger or acquisition option by a potential acquirer. The Target’s financials will be published in a teaser document in order to attract potential investors. Once the Confidentiality Information Memorandum (CIM) and Non-Disclosure Agreement (NDA) are signed, the potential buyer is exposed to the industry overview, company profile, financial statements, revenue and employee profile, investment rationale and other elements of the Target. The seller’s M&A banker will aim to make the company look as appealing as possible and will develop its own operating model and a complete valuation of the business- this is not shared with anyone but used as a backup in case a question of valuation arises and aid understanding the range to which bids should be expected around.
The Seller
The seller is simply the party that sells the Target. It will work with bankers to prepare a teaser document, providing the major highlights of the Target, including all its financials, investment rationale and USP. However, it doesn’t disclose the identity of the target company (later revealed once the NDA and CIM are signed).
The Sponsor
A financial sponsor is a PE investment firm that will seek leveraged buyout transactions in order to create a future return when selling the firm later down the line. The background of the Sponsor (e.g. how long has it been established and the number of transactions it has completed) are very important for lenders and can be a crucial make-or-break factor in determining whether the lending can go ahead. The Sponsor will work with the legal debt finance team to tackle all the legal aspects of the acquisition- whether that be gathering and legally binding lender’s obligations or the legality of the transactions and negotiating procedural documents.
The Financing Process
As mentioned, the Target is the company chosen as an attractive merger or acquisition option by a potential acquirer.
The seller, will offer the Target to multiple bidders (one of which is the PE Fund that ‘our’ firm will represent) by way of a competitive auction (generally broad auctions with large pools of bidders). It must be noted that this is simply the most common form of process in which the Target is sold in a leveraged finance transaction, but not the only way: the seller’s bankers may reach out to certain buyers specifically (targeted solicitation) or limited auctions (smaller groups of interested buyers). Several of these bidders will approach the seller to express their interest. They will then enter into non-disclosure agreements (NDA) and receives copies of a short Information Memorandum- containing summary details of the Target business and its recent financial performance.
These potential bidders will then be given a deadline by which they must submit their bid (which will have to be accompanied by evidence that the purchaser has the funds to pay the purchase price).
In order to submit a bid for the target, the Sponsor must have a binding commitment from lenders to make loans covering the portion of the purchase price that will be funded by debt. Evidence of this commitment to make loans will need to be submitted alongside to the bid to the Seller. Of course, often the period to submit a bit may not be enough time to agree on a full form loan documentation- therefore, a Commitment Letter (where lenders contractually commit to making the loans) and a Term Sheet (setting out all of the key terms of the financing e.g. interest rate, loan amount etc.) will need to be drafted and sent to the Seller accompanying the bid.
Similar to the Seller, who will seek multiple bids to get the best deal, the potential Sponsor will also seek to contact multiple banks in order to get the best financing terms (e.g. highest amount/lowest interest rate etc.).
In order to finance a large transaction (generally where the Sponsor requires £1,000,000 or more), the amount of debt would often be too large for a single bank to provide or the loan is outside the scope of the lender’s risk tolerance. In such cases, a ‘syndicated’ facility will be required, where a group of banks each lend part of the debt under a single loan agreement. Within this, the Sponsor will be required to appoint a few (generally two or three) banks as Mandated Lead Arrangers (MLAs). These banks arrange syndication in the loan market (i.e. gather several banks/funds/other financial institutions to lend the full amount of debt collectively). Of course, this will come as extra work for the banks. As such, MLAs will usually be paid a fee (often around 1-2% of the amount of the debt). Obviously, banking institutions tend to offer hefty bonuses and therefore fee earner banker teams generally want to be an MLA.
Working alongside the Sponsor, the debt finance team at the law firm will draft a Commitment Letter and Term Sheet, which will be sent to all the banks. The banks will then send back their comments on that proposal. The best offering deal from the banks will generally have the best chance of being appointed as an MLA.
Financing Terms:
Amount:
To no surprise, this will be the amount of the loan that the Sponsor is given by each financial institution/bank.
Interest Rate:
Usually, the interest rate is a floating rate for the loan, with the interest rate varying from underlying indexes (such as EURIBOR- the base rate for borrowing in Euros calculated by the interbank interest rate which EU banks are willing to lend to one another; LIBOR- the average interbank interest rate which London banks are prepared to lend to one another (currently being phased out); SOFR- a benchmark interest rate for dollar-dominated derivatives and loans that replaces US LIBOR), plus a margin/price (representing the banks’ profit). However, the interest rate from each underlying index ultimately depends on the specific transaction and debt obligation. Generally, this can be influenced by the location of the lenders and the currency they lend with. Obviously, the Sponsor will want to keep this rate as low as physically possible to keep the costs of the acquisition down. But, it must be high enough that it won’t deter the lenders from participating in the deal.
It is noteworthy to mention that these interest rates are determined by macroeconomic factors such as rising inflation. As we have seen, the Bank of England has had to increase interest rates to tackle rapid inflation and rising prices.
Financial Testing:
As leveraged loans are relatively high risk, lenders may insist on the Target’s financial performance being tested every quarter. If the Target fails this test, it will be a default under the loan documents that the lenders have the right to accelerate their debt (however, in reality, they will usually force the Sponsor to renegotiate the debt on less favourable terms).
A key financial test for private equity deals is the leverage ratio, which means how much debt there is compared to the Target’s EBITDA (earnings before tax, interest, depreciation and amortisation- a rough proxy for the amount of cash profit the Target can generate annually).
There are generally two ways that a company can improve/lower its leverage ratio. It can either increase its EBITDA or reduce the amount of its debt.
Example: If the EBITDA is £100m and the Debt is £300m, the debt is effectively 3x EBITDA. Conversely, if Debt is £200m, then it is 2x EBITDA.
In other words, the debt borrowed is 2/3 times the EBITDA (money generated by the Target) annually. Usually, firms may offer 4x or 5x- however, this is entirely based on the situation. That said, the higher the leverage ratio (e.g. 6/7x, the better it is for the Sponsor)- but this can only really be achieved in a borrower-friendly market (due to higher bargaining power).
Advancements: From Bidding to Signing
Exclusivity
After negotiations have taken place, the MLAs are selected, Commitment Letter and Term Sheet are negotiated and signed, the Sponsor will then submit its bid.
In the case that the Seller informs the Sponsor that their bid is the highest and they will offer a period of exclusivity, this effectively means that the Seller will suspend discussions with the other bidders and negotiate only with the Sponsor until a certain date. Providing they can reach a deal by that date, the Sponsor will buy the Target.
This effectively means that the debt finance team will have a set period of time to go from a simply Commitment Letter and Term Sheet to a fully documented financing.
Secured Cross-Border Financings
As for the debt finance team, generally most of the work so far in the process is carried out by partners or senior associates- these individuals will have experience in negotiating the key commercial terms for leveraged financings. However, once they have been completed, the drafting and negotiation of security documents, particularly, will be a task for junior associates and trainees.
Due to leveraged finance, as previously mentioned, being a high-risk of debt (sub-investment grade) the lenders will always take security over some or all of the Target’s assets. This security (i.e. in the form of mortgages or other forms of collateral) gives the lenders an interest in the Target’s property which means that they rank ahead of the Target’s other creditors and should recover more of their money should the Target business become liquidated (effectively goes bust).
Although the lenders seek as much security as they can get, the Sponsor will want to run the Target business without undue interference from the lenders, so they will negotiate the extent of the security provided. Similarly to the initial full loan agreement time constraints, it would be too time pressing to sign all of the security documents before the deadline, but the debt finance team will negotiate with the lender’s legal team on a set of ‘Agreed Security Principles’ that will be scheduled to the signed loan agreement.
In the case where the Target has assets and operations within multiple countries, the giving of security will involve property rights (a matter of local law) and therefore local lawyers, in each jurisdiction where security will be taken, are required. Junior lawyers will co-ordinate the work of local lawyers, seeking their advice on the practical implications of taking security in their jurisdiction and making sure that the Agreed Security Principles do not require the giving of any security which will interfere with the running of the Target business.
Advancements: From Signing to Closing
Signed Deal:
Once everything has been taken care of, at the end of the exclusivity period (if offered)/ sale period, the Seller and Sponsor will enter into a Sale and Purchase Agreement, under which the Sponsor agrees to buy the Target. At the same time as this, the Sponsor will enter into a full form loan documentation, under which the lenders commit to providing the debt finance portion of the deal.
However, the Sponsor does not yet own the Target: it has not yet paid the purchase price and the lenders have not yet actually lent any money. Depending entirely on the complexity of the transaction, it can take weeks/months to move from signing to closing.
The Conditions Precedent:
Whilst, at this stage, it seems that everything is completed. This is only for the commercial negotiations and so the partners will have little interference in the day-to-day involvement in the deal. That said, there is still plenty of work for the rest of the debt finance team.
The banks’ commitment to lend under the signed documents will be conditional upon the delivery of various documentary, and other items, the so-called conditions precedent (CPs). Before the deal can close, the debt finance team must help the sponsor deliver the necessary documents to satisfy all of the CPs. This will include getting the security documents agreed upon and signed, ensuring that the directors of the Target and all of its subsidiary companies have formally approved the financing, collecting, and delivering hundreds of other documents, ranging from insurance policies to share certificates to environmental reports. In the case of multiple countries involved, the debt finance team will have to coordinate this process across every country in which the Target operates.
The debt finance team will aim to satisfy all the CPs and ensure that the banks are ready to lend come closing day. Trainees and Junior associates will be responsible that this process runs smoothly. They will be involved in the drafting, negotiating, chasing, coordinating, and delivering of the CP documents. On the other side of the deal, associates and trainees at the firm representing the lenders will have to review the documents and check that they satisfy the relevant conditions.
By Max Davies
Penultimate Year Law Student
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