Key trends and drivers in European Leverage Acquisitions

Richard Sharples of Clifford Chance discusses recent developments in terms and structures for European leverage acquisition financing This is an exciting time to be a leverage acquisition finance lawyer in the European market. The market has grown in recent years and continues to do so, with strong structural factors driving change and resulting in rapid development of new products and new combinations of those products. This article will look at these changes and key drivers and at the resulting products, combinations and structures which have been seen recently, together with some of the linked changes in common financing terms and conditions. The growth in the market has been mainly driven by two factors: (i) The large funds now raised by private equity sponsors ($300 billion was raised globally in 2006 giving $1 trillion of funds for acquisitions when leveraged – of these amounts $100 billion ($350 billion) was raised for European funds), and (ii) Perhaps even more significantly, the size of the subordinated debt market has grown with CLOs, CDOs, hedge funds and other investors such as insurance companies and pension funds scrambling over each other to invest in certain of the higher yielding financing products (for example, active CLO managers in Europe doubled from 22 in 2005 to 52 in 2006 (Standard & Poor's)). The results of these drivers include the following: Private equity sponsors are under pressure to invest the much larger funds within the usual time frames. This has led to competition in auctions resulting in high purchase prices and target size increasing dramatically (TDC (€15 billion), BAA (£15 billion)). Increasing leverage on financing structures (Pages Jaunes was 9.6 times total debt to Ebitda). Multiple debt layer structures used to maximize the potential investor base. Margins falling and reverse flex common. Covenants terms weakening – so-called covenant lite products being introduced. Zero amortization products dominating. Thinly spread syndications with low allocations – some investors are now using the loan credit default swap market to achieve additional exposure. One of the key structural developments has been that, whilst European high yield issuances been strong (2006 being a record year with over €42 billion issued), leverage loans have seen much more significant growth (rising from €75 billion in 2002 to €200 billion in 2006) this has been driven partly by the benefits of leverage loans for private equity sponsor borrowers in contrast to high yield bonds, some of which we will look at below, and partly by the preference of new investors in the market, such as CLO funds, for loan products. Why have leveraged loans grown faster than high yield? The key reasons for this are as follows: Inflexible call protection of high yield (five year non-call). Length of high yield implementation process. Ongoing high yield disclosure obligations. Easier amendment flexibility with loans. Significant increase in investor liquidity for BCD and mezzanine loans. Funds raised in the last year or so for investing in leveraged transactions have often had their investment parameters widened so as to allow investments across a number of different leveraged instruments including B and C loans, second lien loans, mezzanine loans and PIK loans. Transactions have even been seen where funds have taken portions of A loans and revolving working capital facilities. It is expected that this trend for institutional lending dominating structures will continue. For instance, institutional lending in European LBOs is not yet anywhere near the current US levels where B loans count on average for over 60% of structures (as opposed to just over 20% in Europe). In parallel, second lien loan volumes have also increased and become commonplace with second lien pieces developing from stretched senior seen in some recapitalizations to be standard tranches in most primary LBOs and almost all recaps. Until recently, it has been accepted that, in order to successfully syndicate a second lien piece, a subordinated instrument ranking behind the second lien would be required (mezzanine or high yield). However, very recent deals have the subordinated piece missed out or replaced with PIK/Holdco notes. These PIK/Holdco notes have traditionally been used to boost the equity portion of financing structures. But it appears that they now may perform the role of the main subordinated debt instrument behind senior and second lien tranches. Obviously, one of the key attractions of PIK (Payment In Kind) notes is that they are just that. They do not require any cash outflow, as there is no amortization and interest is rolled up into additional principal. Additionally, these notes do not benefit from any upstream guarantees or security but simply a share pledge over their issuer and security over the loan by which the PIK note proceeds are lent into the group structure below the issuer. As the sponsors increasingly grasp opportunities to refinance debt structures very soon after acquisition, by taking advantage of the current UK market liquidities, the attractions of instruments which minimize cash outflow receive considerable focus. One result of this has been the introduction of so-called toggle notes into the market. These notes allow the issuer, for a period of time, to toggle back and forth between cash and PIK interest. As an example, for the first five years of a 10-year bond or loan, an issuer/borrower will be able to pay interest: all cash; all PIK (by issuing new toggle notes); or say 50% cash and 50% PIK. Another recent development has seen the call protection inflexibility in fixed rate high yield bonds drive an increase in floating rate high yield bond issues. Many of the investors in these instruments are the same investors that have driven the increasing B (and to a lesser extent C) tranche domination of recent structures and recapitalizations. In 2006, almost 50% of European high yield bond issues were floating rate (less than 10% in 2004). These FRN structures have usually been accompanied only by a revolving credit working capital facility. Another attraction of the FRN option has been the avoidance of loan style maintenance covenants in preference for bond style incurrence covenants. Revolving credit facilities included in these packages have adopted the incurrence covenants from the related FRN issues. It seems that it will only be a matter of time before the factors which have recently influenced sponsor preference for loan structures as opposed to bond structures (see above) will be put together with recent sponsor successes in achieving finance packages based solely on incurrence covenant provisions, to result in incurrence-based loan facilities. Recent FRN/RCF financings have included Cablecom (€825 million), Tim Hellas (€925 million), Impress (€800 million), NXP (€5 million), Grohe (€800 million), and Lecta (€750 million). Another recent trend has been the drift of infrastructure-style financing packages into acquisitions within the mainstream LBO arena. Infrastructure facilities are structured quite differently from traditional LBO facilities. They are based on cash sweeps rather than amortization, they have lower pricing and allow dividends out where lock-up ratios are satisfied and they include project finance concepts such as maintenance of debt service reserve deposit accounts. Historically, these structures have been used to finance the acquisition of true infrastructure targets (utilities, airports, toll roads, car parks, ports and other long-term concessions and monopolies). On the basis of the certain cash flows of these businesses, leverage for these transactions has been greater than in traditional LBOs; generally over 10 times and sometimes approaching 20 times Ebitda. We have recently seen these structures used in financing packages for targets which are not truly infrastructure, for example for use in short-term concessions such as bus routes. Against the backdrop of the potential move to incurrence-based loan agreements, it is perhaps worth looking briefly at some of the recent changes in terms in traditional maintenance-based leveraged loan agreements which have been achieved by sponsors taking advantage of the current highly liquid investor base. These have included the following: Back loaded amortization schedules. Restrictions on prepayment requirements (for example 18/24 month reinvestment periods with no holding accounts, no cash sweeps, no clean-downs on RCFs). Transferable facilities – non-repayment on change of control (provided sale is to one of an agreed list of purchasers and sometimes if a small change of control fee is paid to the syndicate). Yank the bank clause is now generally set at majority bank level (66%). Material adverse effect definitions now refer to payment obligations only as standard. So-called mulligans recently introduced whereby certain financial ratio breaches only result in an event of default if repeated. Borrower consents required for lender transfers is now common. Guarantor/security coverage now set at 80% (Ebitda/gross assets) as standard. Target guarantees and security generally not required until 90 days after closing. Generally reduced asset security due to high costs of taking and maintaining European asset security packages (legal, notarial and registration costs). Increased flexibility for permitted acquisitions (for example, limited due diligence, ability to increase leverage up to closing leverage, proforma anticipated synergies accepted). Prepayment fees on junior debt restricted – often now 2% (nine months), 1% (18 months), and sometimes just 1% (12 months). Increasing inclusion of QIPO (qualifying initial public offering) provisions whereby many undertakings fall away in the event of a QIPO and/or a commensurate reduction in leverage. Equity cure provisions now commonplace and increasingly flexible. Financial ratio headroom up from 20% to more than 25%. Baskets often larger than seen historically and with up to 100% carry forward and carry back. Facility change permissions now common and extensive (whereby changes to pricing or repayment terms for particular facilities require only majority banks and affected banks consent). Finally, it is also worth noting that many transactions are now done with only a commitment letter, term sheet and interim facility agreement in place. One or two transactions have even funded off the interim facility agreement. This trend is driven by the perceived need for fully documented, certain funds-based financing to be put in place very quickly in order to maximize the attractiveness of auction bids. These short term loan agreements, which were initially only used to enable a bidder to satisfy the certain funds requirements of a public takeover bid or for the benefit of the vendor in a private leveraged acquisition, and are now being used to put certain funds financing in place quickly for the purposes of auction bids which need to be made in time periods which do not allow a complex permanent financing arrangement to be finalized. Maturity for these loans is now stretched to 60-90 days, many typically include working capital and capex facilities alongside the acquisition term with the term loan carrying a blended floating rate which may ratchet up over the short loan period. Security is generally limited to a share pledge over the target and an assignment of SPA rights.