New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

Going-private transactions sponsored by private equity firms are facing increased resistance from public shareholders.  The resistance takes many forms, all designed to improve the price.  Like any seller these days, the opportunities to leverage competing bids typically bear fruit. 

A sponsor that faces stiff public stockholder resistance, and that wants to keep pricing within reason, has a few strategic alternatives:

• Stub Equity - “Stub equity” has been included as a feature in several recent transactions, including Harman, Clear Channel and Aeroflex in the United States. Stub equity gives public stockholders the option to choose either cash or stock in the company post-leveraged buyout. Stub equity is intended to deflect concerns that the going concern value of the target is worth more than the sponsor takeout price by offering the public stockholders the ability to choose, at least in part, to roll its investment going forward (possibly on a tax deferred basis). The amount of stock that may be issued to public stockholders is typically capped by the sponsors. Generally, caps have been in the 20% to 30% range of the company’s equity post-leveraged buyout, although in at least one transaction, Countryside, the cap was set at 55%. Stub equity has a number of disadvantages to sponsors, such as the requirement to register with the Securities and Exchange Commission the shares to be issued to the public stockholders and the requirement that the target remain a public company and file Securities and Exchange Commission reports for some period of time after the closing. This structure also has certain drawbacks for public stock-holders, particularly retail investors, as the sponsors may not be required to maintain a NYSE or NASDAQ listing for the stub equity so there may be very limited liquidity. 

• Contingent Value Rights - Similar to earn-out rights in a private company transaction, contingent value rights provide a mechanism to bridge a perceived value gap, and thereby help mitigate public stockholder opposition. Contingent value rights give public stockholders additional value if future hurdles are met and, as an example, can be tied to future financial targets or the sales price in the event of a divestiture of a division or key assets. However, unlike stub equity, contingent value rights customarily give public stock-holders limited upside potential and don’t carry any downside risk. A variation of contingent value rights was recently part of a stockholder derivative settlement in the Sabre Holdings going private transaction. The sponsors agreed to pay the public stockholders a percentage of any profits above a certain benchmark price if the sponsors flipped the company or divested certain crown jewel assets within a six month period following closing. This type of supplemental payment for public stockholders may become more common in merger agreements.

Time will tell how the great push back by public stockholders affects the going private trend.

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It's hard to ignore the growth of covenant-lite lending in private equity deals, when even famous investment gurus like  Anthony Bolton remark on it, and at his farewell dinner no less.  Here is what Mr. Bolton had to say on the topic:

“I think the phrase is ‘covenant-lite’, but in many cases it appears to mean no covenant at all,” Mr Bolton said. He added: “Covenant-lite borrowing ... will come back at some stage to haunt the banks,” he said.

Quotes about covenant-lite lending are usually paired with a dire prediction, such as the premonition of another financial bubble.  But will covenant-lite lending really come back to haunt the banks?   

In a typical covenant-lite deal, the lenders give up what are called "maintenance" covenants.  As the name suggests, these are requirements that the borrower maintain certain financial standards at regular intervals.  For example, a borrower might be required to certify that at the end of each quarter, it has maintained a certain ratio of EBITDA to total debt.  These covenants are designed to be an early warning system that the borrower's earnings are deteriorating, and it might become unable to meet debt service requirements at some time in the future.  With these maintenance covenants gone, the lenders rely solely on what are called "incurrence" covenants.  These require that a borrower meet defined financial standards not on a regular basis, but only when there is a specific event, such as an acquisition.  For example, if the borrower wants to make an acquisition, it must certify that it will meet a specific EDITDA coverage test after the acquisition is taken into account.   

Finally, in covenant-lite deals, the other covenants are less restrictive, for example allowing for more extensive dividend payments or larger capital expenditures.

How bad are covenant-lite loans?  Despite the publicity these deals receive, they appear to be limited to large private equity deals involving companies with earnings cycles that are relatively well known or at least fairly predictable.  With companies like these, perhaps the function of maintenance covenants -- to provide an early warning system -- isn't necessary.  What good is a warning when the funds have already been loaned?  Perhaps maintenance covenants aren't really needed, and their elimination is simply a matter of efficiency.

Perhaps the traditional way of lending, where a borrower is required to certify periodically that it remains healthy enough to maintain its debt, is out of date.  Then again, if it is merely out of fashion, we may see it come round again.  Time will tell.

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Freescale Semiconductor  was acquired by Blackstone Group, Carlyle Group, Permira Advisers LLC, and TPG Capital LLC in late 2006.  A recent article by Henny Sender in the Wall Street Journal discussed how this consortium convinced its banks and other lenders to accept an especially lenient package of covenants and interest payment options.  A review of Freescale's public filings since the deal closed reveals just how lenient the package is.

Believe it or not, due to the way the deal is structured, the trade creditors in 72% of Freescale's business are functionally senior to all of the $9.5 billion that was borrowed to finance the acquisition.  The $9.5 billion is "structurally subordinated" to these trade creditors, because the borrower of these funds is the parent company and the trade creditors deal with subsidiaries that did not guarantee the parent's debt.  Pretty neat trick.

Here is one of the Risk Factors in Freescale's Form S-4, filed on March 8, 2007 in connection with a bond exchange offer:

Claims of holders of the Exchange Notes will be structurally subordinated to the claims of creditors of our subsidiaries that do not guarantee the Exchange Notes, including trade creditors. All obligations of these subsidiaries will have to be satisfied before any of the assets of such subsidiaries would be available for distribution, upon a liquidation or otherwise, to us or creditors of us, including the holders of the Exchange Notes.

In a separate section of the S-4 we learn who these lucky trade creditors are and the magnitude of the structural subordination:

Our non-guarantor subsidiaries accounted for approximately $4,594 million, or 72% of our net sales, and approximately $635 million of our EBITDA for the year ended December 31, 2006.

There's more.  Not only is the unsecured high-yield debt in this boat, but the secured debt is too!  Information about the secured debt is a little hard to find in the filing, which is an exchange offer for the unsecured notes.  But here it is:

As of the issue date, none of our subsidiaries will guarantee the Exchange Notes or the new senior secured credit facilities.

In other words, all $9.5 billion of the debt, secured and unsecured, sits at the parent company with 28% of the revenues.  The other 72% of the revenues run through various subsidiaries, none of which has guaranteed even the senior debt.  On top of that, the filing discloses that Freescale is allowed to incur an additional $1 billion of new debt, draw on a $750 million revolved and pay some of the bonds in PIK notes.  With the bulk of its trade creditors protected and plenty of excess capital, it's hard to imaging how this boat could ever go down.

Apologies to Polonius, but what a great time it is a borrower to be.

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The recently announced LBO of Harman International Industries by KKR and Goldman Sachs Capital Partners offers the great unwashed public the chance to own a piece of the post-acquisition company alongside the sponsors.  We have until the record date of the meeting called to approve the merger in which to buy the current shares of Harman and elect to exchange them for a piece of the "stub" post-closing equity.  The terms of the exchange will put us on the same terms as KKR and Goldman, that is, each dollar  we roll over into the stub will travel the same road to riches as the dollar invested by our new partners.  Who's your daddy now?

Taking the stub is not mandatory.  We can also take cash.

If there is widespread interest in holding a slug of the leveraged equity, up to 27% of the company could remain in public hands.  With the steady stream of SEC filings the company will be required to make, we'll be able to follow the progress of our investment.

You can count on one hand the number of recent deals in which stub equity has been offered to the public.  Does the Harman deal presage a new wave of investing, reflecting the stronger negotiating power of sellers?  Or is this a one-time thing. 

I guess that will depend on how well the stub does.  If it does as well as the historic performance of these PE sponsors, then the boards of directors of future sellers may even come under pressure to provide stockholders the opportunity to hold a piece of the stub.  From the PE sponsor side, offering a piece of stub equity may deflate the pressure to overpay.

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This is from an article in the Boston Globe quoting Scott Sperling and Kevin Landry of TA Associates:

"The reality is the markets are willing to provide extraordinary amounts of debt, almost indiscriminately," says Scott Sperling , copresident of Thomas H. Lee Partners, the big Boston private equity firm. "It's hard to put these companies into default. I can't think of the last time we had a real covenant in one of our deals."

Landry told me about the terms TA Associates secured recently to fund the purchase of a company. In particular, the interest rate was set at 2.25 percent over the floating London Interbank Offered Rate, or LIBOR. But TA Associates doesn't have to make all its payments in cash if the acquired company runs into trouble. It can make something known as a toggle payment, or "payment in kind," essentially borrowing more to make the regularly scheduled loan payment. The only penalty: an interest rate that rises 0.5 percent."

Covenants are a thing of the past.  The toggle payment, payment-in-kind and similar default-avoidance provisions, make even failures to pay interest a non-event. 

You could argue that what the lenders are doing is pre-agreeing to terms of a default work-out program.  They are saying, "we like the horse we rode in on, and are willing to give them time to get back on track when problems arise."  It is a show of faith in the ability of the PE sponsors to work out any problems or ride out short term economic issues.

Is it a bad idea for lenders to be handing over traditional lending rights to PE sponsors?  Maybe.  But is the cost and outcome of bankruptcy any better?

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