In today's low interest rate environment, leverage remains the smart option for financing mid-market acquisitions. For starters, it satisfies the corporate desire for enhanced returns on equity and cash conservation. Moreover, the competition for deals among established lenders and the many recent entrants into the market has driven down loan pricing and diversified product offerings making a tailor-made solution more achievable than ever before.
Lee Federman, Partner in the Banking and Finance team at law firm Dentons, here sets out some of the key issues borrowers should be aware of before embarking on a search for the right financing arrangements.
Evolving lending landscape
While established clearing and investment bank lenders remain active, they have been increasingly limited in their activities by regulatory and capital constraints. This has allowed debt funds such as Ares, Alcentra and KKR, to increase their market share with fixed income becoming the strategic asset of choice for investors. For a higher coupon, specialist debt funds have been able to offer increased leverage, larger bilateral commitments and greater covenant headroom and flexibility. So called 'challenger banks' such as OakNorth and Metro are also increasingly visible, particularly at the smaller end of the market.
Cost of funds
The primary financing consideration for a borrower will be the overall cost of funds. Lenders' 'all in yield' will likely include a fixed margin (set over LIBOR or EURIBOR potentially ratcheting up or down in line with the borrower group's prevailing leverage), arrangement fees payable at closing and any other periodic fees such as commitment fees on working capital facilities. Fees will also arise if a hedging product such as a cap or collar is purchased to protect against fluctuations in the underlying interest rate.
In a market currently suffering from a lack of M&A activity, strong borrowers often negotiate with debt providers in parallel to create the competitive tension needed to push down pricing and improve terms – specialist debt advisory firms can further facilitate this process.
Cash retention
Cash retention will also be at the forefront of the CFO's mind. Banks typically expect at least part of their term facilities to amortise quarterly to aid deleveraging and reduce refinancing risk. Some debt funds however may allow a more relaxed amortisation profile or potentially even a single bullet repayment at maturity. Debt funds rely on a stable coupon to satisfy their investors' return requirements and are often comfortable for available cash to remain in the business for reinvestment and income generation purposes.
Mandatory prepayments
All lenders will expect their loans to be immediately prepayable upon a change of control of the borrower or where it becomes unlawful for the lender to continue to lend. Debt funds may however be more relaxed than banks on mandatory prepayments out of net disposal or insurance proceeds and also in relation to the annual excess cashflow sweep after debt service (the amount of which is usually determined in line with leverage levels).
Financial covenants
Borrowers will have to comply with up to four financial covenants on an acquisition financing, each of which is designed to test its financial health and serve as an early warning sign if its condition starts to deteriorate:
- Leverage. This is the ratio of net debt to earnings and tests the overall sustainability of debt in the borrower's business. It is typically calculated on an adjusted basis to take into account acquisitions or disposals over the relevant testing period.
- Cashflow Cover. This is essentially a liquidity ratio matching the Group's operating cashflow against its principal and interest debt service obligations (otherwise known as the 1:1 test).
- Interest Cover. This is the ratio of earnings to interest costs and demonstrates the ease with which the borrower can meet its cash pay interest expense from operating profits.
- Capex. This is an annual limit on capital expenditure spend set with limited headroom against the borrower's business plan. Stronger borrowers will seek further operational flexibility by carrying forward and/or carrying back unused capex allowances to preceding and/or succeeding financial years.
It is important that the financial covenant related definitions in the loan documentation conform to the agreed financial model and the expectations of the CFO. Each of these financial covenants (with the exception of the capex covenant) is tested quarterly looking back at the results from the last 12 months.
In the current competitive lending market, some lenders may be willing to drop some of these four covenants (‘covenant loose’) or all of them (‘covenant lite’) – the latter is however still fairly rare for mid-market deals
Equity cures
Strong borrowers will seek to negotiate the right to inject new equity into the structure to cure an actual or potential breach of financial covenant and stave off any potential lender enforcement action. To the extent acceptable to the lender, such new money will likely be limited in usage and amount. At least part of it will also have to be applied in prepayment of the loan.
Negative covenants
Negative covenants are another key part of a lender's credit protection. They are designed to restrict the borrower from undertaking certain actions which may cause value leakage out of the borrower's group (e.g. disposals, acquisitions, debt incurrence, distributions to shareholders) and are subject to a set of pre-agreed exceptions and monetary baskets. The borrower will focus on these exceptions more than any other area of the loan documentation to ensure that it has appropriate flexibility to operate unfettered in the ordinary course of its business and to implement its business plan and growth objectives.
Security and guarantees
Lenders' principal downside protection comes in the form of asset security and guarantees. Typically, lenders will expect to receive security and guarantees from entities in the group representing at least 85% of the earnings, turnover and assets of the relevant group (including share pledges over all material entities). On cross border transactions, local lawyers should always be instructed as early as possible to identify any issues in or limitations to the grant of security or guarantees and a set of agreed security principles should be drawn up.
Financial information
Lenders will always expect a raft of detailed financial information. Monthly management accounts, quarterly financials and annual audited financial statements will be required along with quarterly financial covenant compliance certificates. Borrowers will further be expected to provide a budget, financial model and give an annual presentation on the on-going business and financial performance of the borrower.
Acquisition diligence
Lenders will not typically undertake their own diligence on the target company but they will expect to be able to rely on all due diligence reports prepared for the borrower. This supplements the representations provided to them in the loan agreement. The lender will also expect to be kept informed on the negotiations on the acquisition documents and to receive copies of the signed versions as a closing condition to the loan.
The UK is set to be one of biggest winners from the EU-Canada CETA free trade deal. With 10,570 companies already exporting a wide variety of goods from baby wipes to aircraft parts to Canada and supporting over 240,000 jobs, the UK economy is in the best position to benefit from the removal of import duties, lifting of barriers and potential trade growth, according to data from a new web tool on CETA published by the European Commission.
And it is not only big business that is taking advantage of the free transatlantic trade as 79% of the EU exporters to Canada are small and medium-sized enterprises.
In exports to the second biggest North American economy, the UK is ahead of both Germany and France which have 10,464 and 9,732 companies respectively selling goods and services to Canada and significantly fewer jobs benefitting from that trade – 141,000 for Germany and 77,000 for France. Whilst there are more Italian companies (13,147) trading with Canada, they only employ about 63,000 people in total.
"CETA in your town", the new interactive map and tool developed by the European Commission, gives a snapshot of EU-Canada trade relations by drawing on a subset of the many companies in cities and towns all over the EU that export to Canada, with examples of products they export.
The trade with Canada is spread fairly evenly across the UK and across business sectors, the map shows. The leading Welsh town for exports to Canada, for example, is Swansea with three companies exporting foam masking tape, ores, slag and ash, bottle closures. Belfast has six companies selling carpets, pharmaceuticals and animal feed to Canada. Glasgow's exports include steel fittings, theatrical goods and alcoholic beverages supplied by some 10 companies with a further ten businesses in Bristol selling a range of items such as aircraft parts, cereals and baby wipes.
The Comprehensive Trade and Economic Agreement (CETA) between the EU and Canada is expected to save exporters over £425 million (€500 million) a year in import duties. It was signed by the President of the European Commission Jean-Claude Juncker, the President of the European Council Donald Tusk, the Prime Minister of Slovakia Robert Fico, and the Canadian Prime Minister Justin Trudeau on 30 October 2016, but the deal still has to go through two main stages of democratic oversight. First, the European Parliament must give its consent to CETA for it to apply provisionally. The second stage involves parliaments in EU countries and only once they approve the agreement will CETA come fully into force.
(Source: EU Commission)
Private equity-backed initial public offerings remained a popular exit route in 2014, according to data published by the Centre for Management Buy-out Research (CMBOR), sponsored by EY and Equistone Partners Europe Limited. New deal activity by volume was higher than 2013, while value rose for the second successive year.
While 2014 did not see any deals above €5 billion, the €1 billion+ market saw sharp growth with 11 deals closing last year – comfortably surpassing 2013 figures.
The €100 million to €250 million bracket also saw growth to report its highest value and volume levels since 2008, while the €250 million to €500 million segment also reached the highest value since 2008.
“2014 was a particularly strong year for the mid-market, which has seen the highest level of deal activity since before the financial crisis. However, this activity has predominantly been led by the exit market; with a huge amount of dry powder ready for deployment across the mid-market buyout funds, the challenge for 2015 will be investing in the right assets at a fair valuation,” said Christiian Marriott, Investor Relations Partner at Equistone Partners Europe Limited.
Total deal values in 2014 reached €61.3 billion – above 2013’s €58.7 billion figure. Deal numbers were also higher: 613 for 2014 versus 562 in 2013. The UK accounted for €18.6 billion followed by Germany’s €11.2 billion and France’s €7.7 billion.
UK buyout value equalled £14.9 billion in 2014 compared to £15.1 billion in 2013.
Sachin Date, EY’s Private Equity Leader for Europe, Middle East, India and Africa (EMEIA) said: “PE-backed IPOs are at a record high since 1998 with 43 PE-backed IPOs worth €44 billion closing in 2014, as financial sponsors continue to capitalise on strong valuations. 2014 also recorded 188 trade sales in exit value terms (€32.2 billion) – the highest since 2011 – and 170 secondary buyouts. 2014 saw the highest value of refinancings ever recorded and has more than doubled since 2012 to the tune of €51.7 billion.
The exit value of above €101 billion is the highest since 2007 and this is only the third time it has crossed the €100 billion mark.
Going into 2015, the European private equity market is expected to steadily improve in line with progress made in the last two years. The pending deal pipeline is around €20 billion in the first few months of 2015.
