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

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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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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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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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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