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

The private equity sponsors behind the Clear Chanel acquisition – Bain Capital and Thomas H. Lee Partners -- are looking at the possibility of paying a $500 million reverse termination fee to Clear Channel if they are forced to walk away for lack of bank financing. Maybe the sponsors can recover some of this from the lenders who promised to provide the financing – time will tell. The banks committed to provide about $16 billion of new debt, which they may struggle to sell given turmoil in the leveraged loan market.   And even if they do manage to sell it, they might face a mark-to-market hit of about $2.5 billion. Lawsuits recently begun in New York and Texas may clarify whether the banks are responsible for causing the deal to break.

The sponsors will have a hard time arguing that a material adverse change in Clear Channel’s fortunes has occurred, given that the company reported a 52 percent rise in fourth-quarter earnings. Assuming that some or all of the break-up fee has to be paid by the sponsors, who really has to foot that bill – the limited partners in the funds or Bain and THC?

An LBO partnership agreement typically provides that deal expenses, including “broken deal” costs, are paid by the investment partnership, namely, the limited partners. However, these costs are typically offset against the management fee paid by the fund to the sponsors. That provision makes the sponsor ultimately responsible for broken deal costs, but caps the exposure at the amount of the management fee. 

The impact of this situation can be seen in Blackstone’s recent 10K filing. There, in the MD&A section, Blackstone described certain shortfalls in management fee income that occurred during 2007. Prominent among the causes for this shortfall was a reverse termination fee that was paid when Blackstone terminated the acquisition of a subsidiary of PPH Corporation. Here is the relevant portion of Blackstone’s MD&A section:

"An increase in fund management fees of $47.2 million, as a result of $4.68 billion of additional capital raised for BCP V during the year ended December 31, 2007, was entirely offset by increased management fee reductions of $47.4 million. The increase in management fee reductions was due to increases of $38.2 million of broken deal expenses, which included a $24.2 million reverse termination fee incurred in connection with the termination of BCP V’s planned acquisition of a subsidiary of PHH Corporation, and $9.2 million of placement fees paid for additional capital raised by BCP V."

No wonder Bain and THL are suing the banks left and right.

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A recent spate of private equity cases has turned on the question whether the buyer has the right to walk away from a deal and pay a fixed price, known as the reverse termination fee.  Rather than be spurned, the target clutches at the specific performance clause in the merger agreement, and tries to push the deal through.  This year, so far, of the seven announced private equity deals for public companies, all have had reverse termination fees.  Moreover, each of the seven deals explicitly barred specific performance of the agreement.

As a result, private equity sponsors have the option to walk away from the deal for a fixed cancellation price.  In this environment, where guaranteed financing terms just aren't available, probably no other structure is possible for a leveraged deal.

 The recently announced deal to buy Getty Images, the pictures and video distributor, for $2.4 billion including debt, marks this trend.  The private equity firm, Heller & Friedman, rejected specific performance language and even added "no recourse" language directly in the merger agreement.  No recourse language typically states that the seller cannot directly sue the private equity firm for damages or specific performance. In Getty Images the merger agreement language states:

 
“[Getty Images] acknowledges and agrees that it has no right of recovery against, and no personal liability shall attach to, in each case with respect to [The Reverse Termination Fee Liability Limitation], any of the [Hellmann & Friedmann] Parties (other than [Acquisition] Parent to the extent provided in this Agreement and the Guarantor to the extent provided in the Limited Guarantee), through [Acquisition] Parent or otherwise, whether by or through attempted piercing of the corporate, limited partnership or limited liability company veil, by or through a claim by or on behalf of [Acquisition] Parent against the [Private Equity Fund] Guarantor or any other [Hellmann & Friedmann] Party, by the enforcement of any assessment or by any legal or equitable proceeding.”

It seems that parties have become disenchanted with the idea of specific performance as a remedy.  The courts have been reluctant to decree a merger, perhaps due to the significance of the remedy.  After all, how does one order the merger of two parties when one of them has changed its mind?  A merger requires willing parties on both sides to make things work.  Money, careers and even communities hang in the balance. The remedy itself seems unrealistic in the context of business combinations.

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The recent decision of the Delaware Court of Chancery in the case brought by United Rental against the acquisition vehicles formed by Cerberus Capital imposes an affirmative duty to be forthright, or not devious, in the process of contract negotiations. The ruling seems to undo decades, if not centuries, of negotiating wisdom and practice. 

The United Rental court was unable to dispose of the case on summary judgment, as the contract interpretations offered by both sides were plausible. Because no decision as a matter of law could be reached, the court had to delve into the real intention of the parties on the issue whether they intended to provide a specific performance remedy.

To do this, the court heard testimony from 7 witnesses over a 2 day period. United Rental had the burden of proof to show that the parties intended to allow the remedy of specific performance, rather than the $100 million termination payment offered by Cerberus.

After all this testimony, the court remained unable to determine the shared objective intent of the parties. It therefore proceeded to adopt the breathtaking “forthright negotiator” principle:

“in cases where an examination of the extrinsic evidence does not lead to an obvious, objectively reasonable conclusion, the Court may apply the forthright negotiator principle.  Under this principle, the Court considers the evidence of what one party subjectively “believed the obligation to be, coupled with evidence that the other party knew or should have known of such belief.” In other words, the forthright negotiator principle provides that, in cases where the extrinsic evidence does not lead to a single, commonly held understanding of a contract’s meaning, a court may consider the subjective understanding of one party that has been objectively manifested and is known or should be known by the other party.”

Calling the negotiations “deeply flawed”, because both sides “failed to clearly and consistently communicate their client’s positions”, the Court found that United Rental’s attorney “categorically failed to communicate that United Rental believed it preserved a right to specific performance”. The Cerberus attorney, on the other hand, did clearly communicate his understanding that the agreement precluded specific performance. Because the United Rental lawyer did not continue to repeat his view that the agreement provide for specific performance, and relied instead on the fact that the agreement contained inconsistent provisions, he failed to satisfy the “forthright negotiator” principle.

It may come as a shock to corporate attorneys that deviousness has been barred from contract negotiations. Yet that is law of Delaware:  “United Rental knew or should have known what Cerberus’s understanding of the Merger Agreement was, and if it disagreed with that understanding, it had an affirmative duty to clarify its position in the face of an ambiguous contract with glaringly conflicting provisions."

A duty indeed!

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Deep within Blackstone's recent 10Q, in the MD&A section, the company discusses the negative impact that the "considerable turbulence" in the housing and sub-prime mortgage markets has had on other fixed income markets. 

"Deteriorating conditions in fixed income markets prevented lenders from syndicating senior loans and high yield debt."

Translation:  when the music stopped the the banks got stuck holding our last deals.

"[T]he backlog resulting from pending private equity-led transactions reached record levels."

Translation:  the banks can't get rid of the paper.

"This backlog resulted in lenders becoming less willing to fund new, large-sized acquisitions and as a consequence, the volume of new private equity acquisitions declined significantly in the quarter."

Translation:  until the pipeline gets opened we can't get the big dogs closed.

"Recently announced private equity-led acquisitions have mostly been smaller in size, with less leverage and less favorable terms for the debt provided, including more onerous loan covenants."

Translation:  looks like it's back to Plan A.

"The duration of current conditions in the credit markets is unknown."

No translation needed.

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Judge Christopher A. Boyko's order dismissing a number of foreclosure actions brought by a CDO trustee throws a hard light on a common practice in real estate loan syndication.  Due to the cost of  properly assigning the notes and mortgages that get tossed into the CDO trust, the assignments are not actually completed.  Instead, documents are signed expressing an "intent" to assign.  A spokesman for Deutsche Bank, the CDO trustee, said that skipping the assignment process :

"[Is] typically done as a matter of cost efficiency, since for some extremely high percentage of mortgages there will never be any foreclosure activity, there's no legal need for the assignments to be recorded until they need to be used." 

Because the assignments were not completed at the time the foreclosure actions were filed, Judge Boyko ruled that the CDO trustee lacked standing to bring the action.  A dismissal on these grounds is not based on the merits, and the trustee is free to refile the action once it completes the assignment paperwork.

Assuming, of course, that paperwork exists and can be found.  The paperwork underlying a large CDO is massive.  The notes and mortgages on which the CDO is based are originated in broker's and lawyer's offices around the country, and a book entry is made somewhere reflecting the loan.  That book entry is what is placed in the CDO trust, not the note and mortgage itself. 

Deutsche Bank tried the compelling argument that “‘Judge, you just don’t understand how things work.’”  That didn't go down well with Judge Boyko, who wrote that this attitude “reveals a condescending mindset and quasi-monopolistic system where financial institutions have traditionally controlled, and still control, the foreclosure process.”

The balance of power in the foreclosure process may tip toward plaintiff's attorneys if other courts begin demanding proper documentation of syndicated loans.

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In the investment world, there is no shortage of firms where everyone drinks the koolaid, believing the firm is a truly unique organization with values and a culture shared by no one else. Most times, the koolaid drinking is done in private, at partners’ meetings or golf retreats where the steady gaze of outsiders does not interfere with the collective daydream. It is therefore jarring to see the drinking done in public, especially in so formal a setting as a prospectus for an initial public offering.

The Summary section of the IPO prospectus of Blackstone Group contains the following announcement:

We Intend to be a Different Kind of Public Company

While we believe that becoming a publicly traded company will provide us with many benefits, it is our intention to preserve the elements of our culture that have contributed to our success as a privately-owned firm. In particular, as described below, we intend to continue to manage our business with a long-term perspective, to focus at all times on seeking to optimize returns to the limited partner investors in our investment funds and to retain our partnership management structure and culture of employee ownership of our business. 

Because our businesses can vary in significant and unpredictable ways from quarter to quarter and year to year, we do not plan to provide guidance regarding our expected quarterly and annual operating results to investors or analysts after we become a public company.

The logic here appears to be that one fosters a long-term perspective on business by refusing to provide guidance to investors about quarterly and annual operating results. But then, it is not really evident how these things are connected.  Is it really true that by not disclosing its quarterly and annual profit expectations, which Blackstone surely prepares internally, the firm will better manage its business for the long term?

It seems one thing to believe in the long-term perspective, after having drunk deeply from the bowl.  It is another thing to prominently feature the belief in an IPO prospectus.  But then, it was only a statement of intent. 

And what of the belief itself? Do private equity firms really manage their investments with a “long-term perspective”? Happily, Christina Padgett of Moody's Investor Service has recently written on this subject. In a recent report, Ms. Padgett wrote:

While Moody's would agree that leverage is likely to impose discipline and provide higher equity returns, the current environment does not suggest that private-equity firms are investing over a longer-term horizon than do public companies, despite not being driven by the pressure to publicly report quarterly earnings"

The report goes on to note that Celanese US Holdings, a chemical business owned by Blackstone Group, borrowed money within a year of the acquisition to pay a dividend to the private-equity firm, removing more than 95% of the cash equity originally invested in the deal. 

Blackstone's investors at least can breath a sign of relief, knowing that the firm has a sharp eye for the short term as well as the long. 

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The recent tax proposal submitted by the two top lawmakers on the Senate Finance Committee "closes a loophole" in the treatment of publicly traded partnerships. 

Years ago, 1987 to be exact, Congress passed legislation treating publicly traded partnerships as corporations.  It excluded however partnerships that derived at least 90% of their income from interest, dividends, and gains from the disposition of a capital asset.  Blackstone and other private equity firms that are flocking to go public have relied on this exemption since most of their income qualifies for the exclusion.  The exemption is huge -- corporations pay up to 35% of their income to Uncle Sam.

The new bill provides that the exception from corporate treatment for a publicly traded partnership, 90 percent or more of whose gross income is qualifying income, does not apply in the case of a partnership that derives income from investment adviser services or related asset management services.  Such a partnership is treated as a corporation for Federal tax purposes and is subject to the corporate income tax.

This strikes at the heart of the private equity firm, which receives fees and carried interests from investment adviser services.  As such, the legislation is pointed directly at firms such as Blackstone that hoped to be publicly traded partnerships without paying a corporate tax.

Reflecting, however, the strong connections that Blackstone must have in Washington, the new bill contains a 5-year exception for any private equity firm that is already public or that has an IPO registration statement already on file with the SEC.  As my tax colleague Stephen Foley notes, Blackstone may have successfully lobbied for the ability to be one of the few private equity firms that can ever go public.

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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 most recent issue of the excellent Deal Lawyers newsletter has a piece by Geoffrey Levin at Kirkland about club deals. 

It discusses the clubbing phenomenon from the standpoint of large public company sellers, noting that clubbing can be a great tool to coax out the best offer from a field of bidders and satisfy Revlon fiduciary duties.  Clubbing has been written about extensively as a way for private equity firms to make bids they otherwise might be loathe to consider.  Levin points out that sellers have to watch out that clubbing doesn't dry up the pool of bidders.  He goes through a number of useful provisions to insert in the seller's confidentiality agreement to strike the right balance between fostering club land and not getting crushed in the process.

Club deals get a lot of press, though they are far more prevalent at the top end of the private equity market than elsewhere.  Most deal makers naturally would prefer not to share the fruits of a successful bid with other firms.  Also, clubbing gets its popularity from the fact that target companies currently outstrip the ability of existing firms to swallow deals whole.  As fund sizes get larger, that may not be such a problem in the future.  Finally, a lot of syndication of risk in large deals can go on behind the scenes, as firms sell off chucks of equity exposure in private transactions.

One thing that may come of clubbing in the not so distant future is the merger of large private equity firms.  By working together through the purchase, management and sale of deals, PE firms will get to know one another and see the benefits of even closer affiliations.  If you think about the large PE firms as the premier capital aggregators of the 21st Century, you might conclude that they will become the Goldmans of the future.

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Contract parties very often want to pre-select the court in which any lawsuit arising under the contract must be brought. Issues of convenience and perceived fairness typically underlie the desire for these clauses. To be enforceable, forum selection clauses must be clear and unambiguous. 

A recent case from the Delaware Court of Chancery illustrates what happens when a forum selection clause is badly drafted. 

A manufacturer of microbial degradation and mold control products sued the investment banker it hired to assist with acquisitions. The manufacturer believed that the investment banker misused confidential information in the course of their relationship. The engagement letter tried to select the Southern District of New York as the sole forum in which litigation could be brought. The manufacturer sued in Delaware and the investment banker moved to dismiss the action.

Here is the defective forum selection clause:

“Any lawsuits with respect to, in connection with or arising out of this agreement shall be brought in a court for the Southern District of New York and the parties hereto consent to the jurisdiction and venue of such court for the Southern District as the sole and exclusive forum, unless such court is unavailable, for the resolution of claims by the parties arising under or relating to this agreement.” (emphasis added).

Because both the manufacturer and the investment banker were Delaware corporations, and no federal question existed, there was no basis for subject matter jurisdiction in the Southern District. That court was “unavailable”.

The investment banker argued that the parties “intended” to select any court located within the territory of the Southern District, not just the federal court called the Southern District of New York. But that’s not what the contract provision actually said, so the Delaware Court of Chancery ruled against the banker. For a forum selection clause to work, the parties must use “express language clearly indicating that the forum selection clause excludes all other courts before which those parties could otherwise properly bring an action.”  If the contractual language is not crystal clear, “a court will not interpret a forum selection clause to indicate the parties intended to make jurisdiction exclusive.”

The lesson? Use a proper forum selection clause, like this one:

Each party agrees to personal jurisdiction in any action brought in any court, Federal or State, within the County of New York, State of New York having subject matter jurisdiction over the matters arising under this Agreement. Any suit, action or proceeding arising out of or relating to this Agreement shall only be instituted in the County of New York, State of New York. Each party waives any objection which it may have now or hereafter to the laying of the venue of such action or proceeding and irrevocably submits to the jurisdiction of any such court in any such suit, action or proceeding.

 

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The Third Circuit Court of Appeals in Philadelphia recently decided an important case concerning whether a leverage spin-off can be attacked under fraudulent conveyance rules in bankruptcy.

In 1998 Campbell Soup Co. dropped the assets of its Vlasic pickle and Swanson dinner businesses into a newly formed subsidiary, and paid itself a $500 million cash dividend with funds borrowed against the assets. Campbell then spun out the new company to its stockholders, and Vlasic became a free-standing public company. Unfortunately, the pickle and frozen dinner businesses suffered and within 3 years of the spin off, Vlasic was in bankruptcy.

The trade creditors of Vlasic argued that the payment of the dividend to Campbell at the time of the spin off was a "constructively fraudulent transfer".

In orchestrating the spin-off, Campbell “negotiated” with the people who were to manage the business, but it would not take less than a $500 million cash payout. There was lots of evidence that Campbell massaged the businesses before the spin out to achieve the biggest cash payout possible. Vlasic had to restructure its debt shortly after the spin off, but went on for a year or so to operate relatively well.   In fact, the public markets valued the equity of Vlasic at $1 billion, even with the $500 million debt.

As the court said, the company did not collapse, but rather slowly declined. The game ended a little more than 2 years after the spin off.  At trial, the issue was whether the assets of Vlasic were “reasonably equivalent value” for the $500 million payment made to Campbell. Based on the fact that Vlasic traded at a $1 billion market value after the spin off, the trial court answered “yes”. 

The bankruptcy creditors tried to argue that Campbell’s prior manipulations had a lingering effect on the market value of the company after the spin off.  The Court of Appeals didn’t buy the argument, referring repeatedly to the fact that public investors valued the company at $1 billion after the spin off.

Soup's on!

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Several recent deals illustrate the extent to which financial covenants have all but disappeared from senior loan agreements in private equity transactions. The following transactions were chosen at random.

• In the October 2005 acquisition of Neiman Marcus by Texas Pacific Group and Warburg Pincus, the $2 billion senior loan facility provided by Credit Suisse and Deutsche Bank Securities had no financial covenants. The agreement did have the usual negative covenants, but even these were significantly weakened. For example, the restriction on incurring other indebtedness had 23 exceptions.

• In the November 2005 acquisition of the Vitamin Shoppe by Bear Stearns Merchant Banking, the senior revolving loan facility provided by Wachovia Bank had one financial covenant. It said that if the availability on the revolver was nearly tapped out (less than 10% remaining) then during the four preceding quarters the Fixed Charge Coverage Ratio had to be at least 1.1 to 1.0, or barely enough to cover the charges.

• Finally, in the January 2006 acquisition of AMC Entertainment by J.P. Morgan Partners and Apollo Management from Bain Capital Partners, the $850 million senior credit facility provided by Citicorp had one financial covenant. This covenant provided that as long as the revolver remained outstanding, the company had to maintain a ratio of Senior Debt to EBITDA, on a pro forma basis (!), of at least 3.25 to 1.0.

These random selections from the credit agreements of large and mid-market deals illustrates the extent to which lenders have turned over the risk of defaults to the ultimate purchasers of the debt, namely, the CLO pools.

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The ratio of total debt to EBITDA in mid-market private equity transactions is now as high as it was in 1997 – 4.7 times for companies with less than $50 million in EBITDA and 5.4 times for companies with more than $50 million of EBITDA (Source: Standard and Poors). The ratio of EBITDA less CapEx to Cash Interest in highly leveraged loans is also falling – in the 4^th quarter of 2006 the ratio fell to 2.2 times (Source: Standard and Poors).

At the same time, the covenants being written for leveraged loans are becoming more “lite”: several years ago, loan covenants were written at a 15% discount to model; now they are being written at a 25% discount.

“Covenant-lite” transactions come in many forms. In their most direct form, the covenants that require the borrower to “maintain” certain financial ratios are eliminated altogether, and the lenders are left to rely only on covenants that restrict a company from “incurring” or actively engaging in certain action. For example, a covenant that requires a company to maintain a ratio of debt to EBITDA can be breached if the financial condition of the company deteriorates, as the covenant is measured periodically, usually quarterly. But a covenant that only restricts a company from incurring new debt cannot be violated simply by a deteriorating financial condition, the company has to take affirmative action to breach it. 

Less direct forms of “covenant-lite” include carve-outs in traditional maintenance covenants that forgive in advance a certain measure of deviation from the standard. It is sometime more palatable to embed these carve-outs in a traditional loan covenant than discard the covenant altogether.

In addition to covenant-lite structures, private-equity sponsored deals have started to include a greater number of “equity cure” provisions. These enable a borrower to cure a covenant deficiency by adding more equity into a deal to count as EBITDA, thereby curing the breach. The additional equity does not have to be used to pay down debt and can be used for different purposes such as capital expenditures. In effect, the private equity sponsor is pre-negotiating an equity infusion without having to get lender approval.

This trend is of course a function of the amazing amounts of liquidity available in the credit markets to fund acquisitions.  The impact of these covenant-lite transactions will be to retard the speed with which lenders will be able to take control over troubled deals.  That may not be such a bad thing.  Lenders are not equipped to own a business and typically sell too quickly when forced to take over a company.  The next downturn may provide less opportunity for distressed debt investors than previous business investment cycles, as fewer private equity sponsors may be handing over the keys to their lenders.  

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In a recent case from Delaware’s chancery court, the clear language in a merger agreement, controlling dispute resolution matters, was enforced by the court even where the method specified wasn’t the best way to resolve the dispute. The case underscores the importance of thinking carefully about the implications of arbitration clauses, and especially how two or more arbitration schemes relate to each other. 

Matria Healthcare entered into an agreement to acquire CorSolutions Medical for $445 million. Both companies were engaged in the disease management business. Nearly 5% of the purchase price ($20.3 million) was set aside in an escrow account to satisfy claims that the closing net working capital of CorSolutions fell short of a minimum target. The escrow account was also available to satisfy claims under the indemnification provisions, including breaches of representations and warranties.

Continue Reading...

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Fortress Investment Group LLC, one of the first private equity funds to go public, manages private equity funds with more than $17.5 billion in committed capital. The stock was priced at $18.50 on February 8, 2007 but quickly began trading at $31 per share on the first trading day. It has since tracked a steady decline and currently trades at $25 and change.

One of the private equity funds that Fortress manages provides debt and equity funding to other sponsors of private equity transactions. This fund finances small to mid-market transactions, deals with $5 million and more of EBITDA. Fortress provides “one stop financing” for these deals, lending all of the debt needed to finance the transaction and even part of the equity when necessary and attractive. The company likes to see a capital structure consisting of at least 40% of equity before it will finance the other 60%.

At a recent private equity conference, a representative of Fortress admitted that it was getting to be a struggle to find quality deals in the mid-market arena. One-stop financing has become the norm, and the field is seeing a good deal of competition on the lending side from hedge funds, mezzanine lenders and others. Sponsors are looking for and getting friendlier covenant and deal terms in order to maintain control of the company if a downturn in the economy should occur. The absence of good quality deals gives sponsors the ability to drive down interest rates and covenant protections.  At the same time, the amount of debt financing provided to sponsors is at peak multiples.

The pressure to continue putting funds to work is sure to lead to poor credit decisions by lenders.  Whether the gurus at Fortress will also fall to these temptations remains to be seen.

 

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Credit continues to be readily available for buyouts of all sizes at attractive terms.  One notable features of leveraged acquisition financing in the past few years has been the growth of “second lien” debt financing in place of traditional “high yield” debt financing.

As the name suggests, the providers of second-lien financing get a security interest in the underlying collateral, but it is ranked second to the senior debt. Specifically, the second-lien lender agrees to subordinate its security interest to the rights of the senior lender. Over time, as the senor term debt is repaid, the second-lien financing achieves a higher position in the capital structure, as it remains senior to trade and other unsecured debt. Under the Bankruptcy Code, holders of second-lien debt will have priority over unsecured creditors, the right to adequate protection, the right to post-petition interest, and the right to object to sales of collateral unless they are paid in full from the proceeds of sale.

The growth and popularity of second-lien financing has nearly eclipsed traditional high yield financing, especially in large transactions. But even in the mid-tier arena, second-lien financing is making rapid inroads on traditional high yield financing. The difference in pricing between second-lien and high yield financing can be 200 to 300 basis points. Whether the second-lien position is adequate compensation for this reduced interest will be discovered when the next round of defaults and workouts hits the private equity markets.  

In many ways, second lien financing is a product of the collateralized loan obligation market. CLOs are pools of capital that invest in collateralized loan obligations. The vast amount of cash that has poured into CLOs in recent years has increased the availability of financing structured as second-lien debt.

 

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