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

In the face of depressed earnings and a weak economy, a raft of cash-strapped private equity portfolio companies have stopped making cash interest payments to holders of their high-yield debt, electing instead to issue additional notes by triggering an option known as a payment-in-kind, or “PIK,” toggle. In February, Forbes Magazine reported that in recent months 23 companies had exercised PIK options on their high-yield debt.

Under the terms of a PIK-toggle notes indenture, an issuer can choose to pay accrued interest on its notes either in cash or by issuing additional notes, known as “PIK notes.” When an issuer chooses to pay interest in PIK notes, the annual interest rate for the notes usually increases by about 25 to 75 basis points. Generally, interest payments in PIK notes are reflected by increasing the outstanding principal amount of notes held by an investor in an amount equal to the PIK interest that accrued over the relevant interest period. Since PIK note interest payments are added to the principal amount of the outstanding notes, PIK interest – unlike cash interest – is compounded. At maturity, the issuer must pay its noteholders the total adjusted outstanding principal amount of the notes – including capitalized PIK interest – in cash.

During the private equity boom of 2005-2007, firms successfully negotiated senior and subordinated financing with strikingly permissive terms. Many senior bank loans, for example, were stripped of traditional covenants requiring borrowers to maintain certain financial ratios (such as Total Debt to EBITDA). The lenient terms on which banks were willing to fund senior loans, colloquially referred to as “covenant lite,” protected debt issuers from activating automatic default provisions merely by a deteriorating financial condition. 

At the same time, investment banks discovered that investors’ appetite for high-yield corporate debt allowed them to underwrite notes offerings on more issuer friendly terms. Investors, it turned out, were willing to provide debt issuers flexibility in how they chose to make interest payments in exchange for increased returns. Adding a PIK toggle feature to standard high-yield notes indentures appealed to investors and private equity sponsors alike. Investors purchased PIK-toggle notes primarily because they offered an overall higher rate of return on a high-risk investment. Private equity sponsors negotiated PIK toggle options because it gave them a cash alternative to servicing at least some of their portfolio companies’ debt. Sponsors thought PIK toggle options would help protect their equity investment from economic downturns by reducing a portfolio company’s need for cash when restricted by liquidity constraints. PIK notes became so popular that by November 2008 around 47 companies, most owned by private equity firms, had amassed a total of $33.4 billion in outstanding PIK notes. 

For sponsors of highly leveraged portfolio companies that require consistently high earnings in order to service their substantial debt obligations, PIK toggles were a creative way to mitigate a high-yield debt issuer’s risk of missing interest payments in the event that revenues declined. Indeed, PIK-toggle notes function like “interest lite” debt that allows companies to defer interest payments without incurring penalties, defaulting under the notes indenture, or breaching cross-default provisions in other financing documents. But the flexibility in financing provided by PIK notes came at a price: Moody’s Investors Service concluded that issuers of PIK-toggle notes in the years 2005 through 2007 typically paid 75 basis points more on their issued debt and received weaker corporate credit ratings than non-PIK notes issuers. 

Exercising their rights under PIK toggle options to suspend cash interest payments can help high-yield debt issuers reduce the costs of servicing their debt in the short-term, but this financing strategy does not address highly leveraged companies’ long-term debt servicing needs. Most PIK-toggle notes indentures only permit issuers to make PIK interest payments for a limited time (usually five years), after which they are required to make cash interest payments. Companies that currently pay PIK interest to their bondholders and whose PIK toggle options expire in the next 12 to 18 months will be most vulnerable to defaulting on their debt if current economic conditions continue. Unless such companies can begin to improve operating results significantly, they may find it prohibitively difficult to resume quarterly cash interest payments.

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The gospel according to the Delaware Chancery Court is that a board of directors owes a duty to obtain the highest price for shareholders once a decision to sell the company has been made.  So it was a surprise to learn that Leo Strine, an outspoken member of the Delaware Chancery Court, said at a recent M&A conference that the duty to squeeze out every last penny in every takeover was “not productive for society.”

Sounds like blasphemy.  For years the Delaware courts have been advocates for the view that once a decision to sell has been made, the role of the directors is to pursue the best price with singular intensity.  The consequences of this orthodoxy are on display today.  During the LBO heyday, this approach led to acquisitions, such as the purchase of cyclical technology manufacturer Freescale by a Blackstone-led private equity consortium, with borrowed funds totaling 8.5 times the company’s EBITDA.  Clearly, the need to service this massive amount of debt from the cash flow of a cyclical company with high cap ex requirements will likely crowd out other uses of cash, such as hiring more engineers, investing in research and development, or just weathering a cyclical downturn in the economy.  

Despite these dire consequences, on display everywhere today, the view that the good of society is best served by paying shareholders the very last dollar in an acquisition still prevails.  I guess it’s fair to ask where that last dollar went.  If it went back into the market, then today it is very likely much less than it was a year ago.  Vice Chancellor Strine may therefore be right in asking whether the benefits of the singular focus on shareholder returns is the most productive result for society.

We are of course going through a severe deleveraging phase in the history of finance capitalism, and the prevailing mood is to question the wisdom of the past.  In all likelihood, this too will pass.  As the poet Elvis Costello has said:

“History repeats the old conceits,
The glib replies the same defeats,
Keep your finger on important issues
With crocodile tears and a pocketful of tissues.”   

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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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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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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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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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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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The purpose of having the financial and affirmative and negative covenants in senior loan agreement becomes clear in the Defaults section of the agreement. It’s here that they get their teeth. 

Defaults

The first events of default are non-payment of principal or interest. There is generally no grace period for principal payments. Interest payments are usually given a short grace period of five days. After that, nonpayment results in immediate default of the entire loan.

Another category of defaults occur if any representation made by borrower proves to have been incorrect in any material respect at the time it was made. This is a static test, looking only at the representation on the date it was made and asking if it was true or false in all material respects on that date. The limitation to material issues is intended to rule out minor inaccuracies as a cause of loan defaults.  What constitutes materiality is not usually defined in much detail.

After nonpayment, the most important defaults are those involving covenants. These are not static events. Covenants apply to the activities of the borrower throughout the life of the loan. Failure to comply with a covenant can result in the default of the entire loan agreement, even if the borrower is current in its payment obligations. A covenant default is therefore a powerful tool in the hands of the lender, and lenders frequently use covenant defaults to impose additional restrictions on a borrower or even to accelerate repayment of the loan.

Covenant defaults usually have a cure period. The borrower is given a chance to correct the default before it becomes a reason to accelerate the loan. Covenant defaults are sometimes classified in two groups: those that have short cure periods, such as five days of less, and those that have longer cure periods, usually thirty days. The shorter cure periods are reserved for those important covenants that can’t be readily corrected, such as the delivery of an incorrect financial statement. The longer periods are reserved for the things that can be corrected with proper diligence, such as compliance with laws, removing liens from properties and delivering compliance certificates.

A special class of defaults is reserved for bankruptcy and insolvency. These generally trigger immediate default of the credit agreements.

Remedies

Once a default has occurred and the borrower has run out of time to correct it (if such a right exists) the lender has the ability to accelerate the loan and demand that all amounts due under the loan be repaid immediately. Any obligation of the lender to continue extending credit under a revolving credit facility is canceled. If the borrower fails to immediately prepay the loan, as is generally the case once a default occurs, the lender is then free to exercise the security instruments and liens it carefully acquired when the loan was made. Also at this time the defaulted loan begins to bear a higher, default interest rate.  

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Affirmative covenants are those things the borrower must affirmatively do during the term of the loan agreement. Most of these requirements are things the borrower would do in any case without being instructed by a lender, such as pay its taxes, comply with laws, and meet its financial obligations. Other covenants are matters that work to conserve the borrower’s cash flow, focus borrower on a specific line of business and generally keep its nose to the grindstone.

Negative covenants are the things the senior lender says that a borrower may not do. Most of these are things the borrower wouldn’t do anyway. The rest are designed to keep the borrower focused on running its business in the ordinary course and repaying the senior lender’s debt.

Here is a list of certain affirmative and negative covenants that are often negotiated in the credit agreement of a private equity transaction:

Affirmative Covenants:

• Ordinary Course Conduct of Business. Conduct its business in the ordinary course and use its reasonable efforts, in the ordinary course, to preserve its business and the goodwill and the business of its customers, advertisers, suppliers and others having business relations with it.

• Payment of Taxes. Pay and discharge before the same shall become delinquent, all lawful material governmental claims and all material federal and material state, local and foreign income, franchise and other taxes, assessments, charges and levies.

• Maintain Insurance. Maintain insurance with responsible and reputable insurance companies or associations in such amounts and covering such risks that are sufficient, appropriate and prudent in the conduct of the business of the kind conducted by the borrower.

• Access to Information. Let the lender have access to books and records, visit properties of the borrower, meet with management and meet with auditors.

• Books and Records. Keep proper books of record and account, in which full and correct entries shall be made in conformity with GAAP.

• Maintain Condition of Assets. Maintain its properties in good working order and condition and preserve its permits and intellectual property.

• Additional Collateral. Deliver any supplements or amendments to the collateral documents as may be necessary to reflect and fully protect the lender’s security interest in the collateral.

• Deposit Accounts. Where collateral includes cash, deposit all cash in controlled collateral accounts.

• Real Estate. Comply with all obligations under lease agreements, and deliver mortgages on any real estate acquired subsequent to the loan.

Negative Covenants:

• Indebtedness. Borrower will not create, incur, assume or otherwise become or remain directly or indirectly liable with respect to any Indebtedness except for expressly permitted items that are typically subject to caps and refunding limitations.

• Liens. Borrower will not create or suffer to exist, any lien upon or with respect to any of its properties or assets, whether now owned or hereafter acquired, or assign any right to receive income, except for items expressly permitted such as those arising in the ordinary course of business or by operation of law.

• Investments. Borrower will not make any investments in any other party except as specifically permitted or as may be necessary in connection with the borrower’s ordinary course of business.

• Sale of Assets. Borrower will not sell, convey, transfer, lease or otherwise dispose of, any of its assets or any interest therein except as specifically permitted or as may arise in the ordinary course of business (subject to caps and permitted baskets).

• Restricted Payments. Borrower will not pay any dividends on stock or redeem and stock subject to permitted exceptions.

• Prepayment and Cancellation of Debt. Borrower will not prepay or cancel any debt subject to compliance with defined restrictions such as leverage ratios.

• No Mergers. Borrower will not merge with another party or enter into any fundamental transaction that changes the identity of borrower.

• Change in Nature of Business. Borrower will not make any material change in the nature or conduct of its business, except for businesses reasonably related to the business already carried on or ancillary or complementary thereto.

• Modification of Subordinated Debt Documents. Borrower will not change or amend the terms of any subordinated debt if the effect of such amendment is to (i) increase the cash pay portion of the interest rate on such debt, (ii) change the dates upon which payments of principal or interest are due, (iii) change any default or event of default, or change any covenant with respect to such debt in any manner materially adverse to borrower, (iv) change the subordination provisions of such debt, (v) change the redemption or prepayment provisions of such debt or (vi) change or amend any other term if such change or amendment would be materially adverse to borrower.

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Financial covenants are specific financial benchmarks that the borrower must satisfy during the term of the loan. The covenants generally change over the course of the loan, reflecting improvements in growth and financial condition that are expected to occur. The following are typical financial covenants in senior loans made in connection with private equity transactions:

• Leverage Ratio. Compares the borrower’s total debt from all sources to its EBITDA (earnings before interest, taxes, depreciation and amortization).

• Interest Coverage Ratio.  Compares the borrower’s EBITDA to its cash interest payment obligations.

• Fixed Charge Coverage Ratio. Compares the borrower’s EBITDA minus capital expenditures to its fixed obligations for interest, principal on debt, cash dividends of preferred stock and income tax liabilities.

• Capital Expenditures. The amount the borrower can spend on capital expenditures.

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The closing conditions in a senior loan agreement spell out what hoops the borrower must jump through before it is able to draw down the loan proceeds. The first condition is that borrower must sign all the contracts diligently prepared by the bank’s lawyers to document and secure the transaction. In addition to the main credit agreement, the bank’s lawyers prepare the following documents:

• Promissory Notes. Different promissory notes reflect the different term loans and revolving credit facilities provided by the senior lender.

• Intercreditor Agreement. Where there are two or more lenders, as is usually the case in private equity transactions, the intercreditor agreement spells out the relative rights of the creditors with regard to the borrower’s assets in the event of a default.

• Guaranty Agreements. Each subsidiary of the borrower typically guarantees the credit facility, thus giving the lender a direct security interest in the assets of the subsidiary.

• Security Agreement. Borrower and its subsidiaries pledge and grant security interests in all of their assets to secure the loan. In the event of default, the lender can repossess this collateral under Article Nine of the Uniform Commercial Code.

• UCC Filings. As part of getting security interests in the borrower’s assets, the lender must file UCC instruments in the borrower’s state of incorporation.

• Mortgages. If real estate forms part of the collateral package, the borrower will sign real estate mortgage documents, giving the lender a first mortgage on the land. These are especially important where real estate forms the principal asset of the borrower, as with resource or agricultural companies.

• Pledge of Certificates and Accounts. Certain assets, such as stock certificates and bank accounts, are not covered by the UCC and separate arrangements have to be made to perfect security interests in these assets, usually by taking direct possession. Any other assets that are not covered by standard UCC security documents, such as ships, require their own forms of pledge agreements.

• Landlord Waivers. Where a borrower, such as a retailer, has significant leased premises, lender will require waivers from landlords that give the lender priority over collateral located at the premises.

• Opinion of Counsel. Borrower’s counsel will be asked to give legal opinions as to the validity and authorization of the credit documents and certain conditions of borrower such as good standing and litigation.

• Certificates of Insurance. Certificates from insurance companies certifying that the borrower maintains the prescribed levels of insurance, and naming the lender as an additional insured under the policies.

• Solvency Opinion. Lenders sometimes require an opinion from a valuation expert that borrower is technically solvent after incurring the debt, in order to address possible risks under bankruptcy law.

          Finally, anything that borrower has specifically promised to do, such as deliver an audited financial statement, is a condition to closing.

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Senior credit facilities in private equity deals generally include one of more term loans and a revolving credit facility. The term loan is a fixed amount that is loaned for a defined term. The loan is usually repaid in fixed installments of principal and interest so that the loan balance decreases with each payment.  

The revolving credit facility is a commitment to loan funds from time to time based on the borrower’s inventory and accounts receivable. The facility will have an upper limit of availability, but the actual amount that can be borrowed will vary from month to month based on the amount of inventory and receivables. Each month the borrower has to pay interest on the outstanding balance and, if the loan balance exceeds the borrowing base, and amount of principal equal to the excess. When the facility matures, usually in a year, the entire amount becomes due and payable. If conditions are good, the facility is generally renewed. 

A portion of the credit facility may be dedicated to providing letters of credit, if the borrower uses these instruments in its business. Senior credit facilities can be prepaid, thought there are often penalties associated with prepayments that occur other than at stated intervals. The facilities must be prepaid with the proceeds of assets sales, public offerings and other extraordinary transactions.

Interest rates may be computed on the basis of bank prime rates or LIBOR, with certain rights to switch back and forth between the two forms of loans as financial conditions may determine. Senior lenders also charge a number of fees on the initial borrowings and on the specific commitments that are made to provide ongoing financing.

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A company with stable growth, revenues and cash flow and assets to serve as collateral can usually get bank financing. This is the least expensive form of capital. Banks charge interest rates keyed to various indexes. Interest costs have been low recently, and look to remain that way for the foreseeable future.

Bank financing documents can appear lengthy and complex, although the lending relationship is quite simple. After providing the funding, the lender is primarily concerned with receiving scheduled payments of interest and principal. The many protective clauses in the loan agreement are designed to maximize the lender’s chances of getting repaid in the event of a default and giving it an early warning if financial problems start to develop before an actual payment default occurs.

Asset Based Financing

Companies often seek “asset based financing” from lenders. In this financing, a company borrows against its tangible assets, such as fixed assets, receivables and inventory. The amount available to loan is tied to the appraised value of assets or the amount of eligible receivables and inventory a company has at the end of a measurement period.  The availability of funds for fixed assets is determined at the start of the loan, and the loan amount remains constant, subject to repayment through amortization. The availability of funds for liquid assets such as inventory and receivables is constantly changing. A formula is used to determine the exact amount of funds available to borrow. These borrowing limits are the critical measures of credit availability. Typically, borrowing limits don’t exceed 80% of the eligible receivables and 50 to 60% of eligible inventory. 

A typical definition of an eligible receivable is one that arises in the ordinary course of business; is not disputed or subject to any right of set off, allowance or adjustment by the customer; is not more than 60 days old; and is owed by a customer whose financial condition is satisfactory to the lender in its sole discretion.

Eligible inventory has similar contractual limitations as to the quality, age and condition of the goods. Generally, a borrower must have a perpetual inventory system that keeps close track of inventory levels. The inventory may be subject to a fair market valuation if that measurement is lower than cost. Although these definitions and the discretion given to the lender to cancel the loan raise concerns, in practice the lender is subject to an obligation of good faith and fair dealing which tempers arbitrary lending practices.

Receivables Financing and Factoring

The financing of accounts receivable is the linchpin of asset-based lending. Receivables are popular with lenders because they are self-liquidating and provide short-term sources of cash. The assets cannot be stolen, lost or damaged. However, problems can arise when the account debtor (the customer) has offsets or counterclaims against the borrower. These can compromise the collection of the receivable and reduce the lender’s collateral base. Lenders typically perform some due diligence on account debtors to make sure there are no hidden defenses to collection of the receivables.

Receivables financing is structured so that the account is immediately assigned to the lender without notifying the customer. The borrower merely acts as a conduit for the collection from the customer, and payments are applied directly to repayment of the loan. The lender monitors the collection of accounts daily and bases it’s lending on the amount of outstanding accounts. Another form of receivables financing is "factoring", where the receivable is actually sold to the factor at a discount to face value. The customer is notified that an invoice has been sold and the seller must repurchase the receivable if non-payment is due to a manufacturing problem. The credit risk is absorbed by the factor.

Customary Terms of Loan Agreements

A typical loan agreement will cover the following topics, in a fashion that strongly favors the rights of the lender:

1. The interest rate, how interest is computed and how often interest is paid.

2. The schedule for repaying principal.

3. Any fees payable to the lender at the closing or during the term of the loan.

4. Affirmative covenants such as delivery of financial statements and other reports on a periodic basis; allowing inspections of major facilities and assets; payment of other obligations and taxes when due; compliance with applicable laws and maintenance of net worth and other financial ratios.

5. Restrictive covenants prohibiting the borrower from entering into merger or acquisition transactions; incurring other obligations for borrowed money; paying dividends or making distributions to shareholders; making loans to third parties or selling assets other than in the ordinary course of business.

6. Defining the events of default such as failure to pay interest or principal when due; breach of representations or covenants; and becoming insolvent or declaring bankruptcy.

Security Interests and Guarantees

To secure a bank financing, the borrower must provide credit supports, such as pledging specific assets or providing guaranties of third parties. A pledge of assets simply means the lender has a preferential right to be repaid out of the proceeds of the asset in the event borrower fails to repay the loan. The pledge is accomplished by granting a security interest in the assets, if they are personal property such as accounts receivable, inventory or equipment, or by granting a mortgage if the assets are land or buildings.

A guaranty is the promise of another party to make good on the loan if the primary obligor defaults. The guarantor may be a stockholder or subsidiary of borrower or some other company under common control with borrower. Most guaranties give the secured lender the right to pursue the obligation directly against the guarantor if the borrower defaults. There is usually adequate consideration for a guaranty if it is required by the lender as a condition of making the loan.

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