Bridging the gap: High-yield bonds in acquisition financing

4 Bridging the gap: High-yield bonds in acquisition financing By James McDonald and Riley Graebner, Skadden, Arps, Slate, Meagher and Flom (UK) LLP High-yield bonds can be an effective means of financing acquisitions. According to AFME and PIMCO, in 2012, 17 percent of high-yield bonds in the United States and 8 percent in Europe were used to finance acquisitions. 1 However, funding an acquisition through a highyield bond financing creates challenges and benefits for the acquirer. This chapter examines high-yield bonds in the acquisition context and the mechanisms behind acquisition financing, specifically bridge loans and escrow arrangements. Why high yield? High-yield bonds can be an attractive alternative to a credit facility when financing an acquisition. The benefits include the absence of maintenance covenants (as high-yield bonds typically have negative incurrence covenants that impose fewer restrictions than a typical credit facility) and, in the case of fixed rate bonds, the ability to lock in a fixed interest rate for the life of the bond (for example, five to ten years). In many cases, these benefits can outweigh the burdens of financing an acquisition through a high-yield bond, namely call protection and public reporting requirements, as well as the potential need to arrange for a bridge loan backstop. Recent issuer friendly trends in high-yield bond terms have made bond terms more attractive to acquirers: redemption provisions have become increasingly issuer friendly, certain covenants have become less restrictive and, in some high-yield bonds, change of control provisions now provide more flexibility to sell the issuer s business without being bound to make a change of control offer (so-called portability clauses ). Some recent high-yield issuances have had shorter non-call periods (as compared to prior trends), a 40 percent equity claw redemption provision 2 (compared to 35 percent, which had been the customary level) and, in the case of secured bonds, the right to redeem up to 10 percent of the principal amount of the bonds in each 12-month period during the first 1 AFME, European High Yield Leverage Loan Report (June 2013) at 8, available at: http://www.sifma.org and Andrew R. Jessop and Hozef Arif, Pimco Viewpoint: High Yield or Medium Yield? We Report, You Decide (February 2013) at 3, available at: http://investments.pimco.com/insights. Figures exclude highyield bonds issued to refinance credit facilities used to fund acquisitions. 2 The equity claw redemption permits the issuer to redeem a portion of the bonds outstanding during the non-call period (typically, the first three or four years of the bond, depending on the bond tenor) using the proceeds of certain equity issuances (for example, initial public offering proceeds); the equity claw redemption permits the issuer to redeem up to 35 percent of the outstanding bonds (40 percent in some recent deals) provided that at least 65 percent of the originally issued bonds (40 percent or even 50 percent in some US deals) remain outstanding following the redemption. 14

Bridging the gap: High-yield bonds in acquisition financing three years of the bonds at 103 percent of the principal amount, plus interest. 3 In addition, some recent bonds have contained more issuer-friendly change of control provisions. For example, some recent European deals have contained portability clauses, which provide an exception from the requirement to make a change of control offer in circumstances that would otherwise constitute a change of control (requiring the issuer to offer to repurchase all outstanding bonds at 101 percent, plus interest), provided that the issuer meets a leverage test after giving effect to the transaction. Other transactions have included double-trigger change of control provisions whereby the issuer is not required to make a repurchase offer in a change of control situation so long as the bonds are not downgraded below a certain level in the period following the change of control event. Other issuer/sponsor friendly trends include less restrictive covenants with respect to dividends and other restricted payments. For example, some recent issuances, in particular by private equity sponsor portfolio companies, have included a broad exception in the restricted payment covenant (which limits dividends and other distributions, capital stock redemptions, prepayments of subordinated debt and certain investments) to permit any restricted payments where a leverage test is met (a feature previously more common in the loan market). 4 Challenges of using high yield There are, however, challenges to financing an acquisition through a high-yield bond. When compared to financing an acquisition with a credit facility, financing through high-yield debt involves coordinating the closing of an acquisition with what is effectively a public financing. The acquisition may be subject to conditions (for example, regulatory approvals) that may make timing difficult to predict. Funding an acquisition through a credit facility is generally easier to coordinate than through a high-yield bond. The two methods that address the issue of timing in acquisition financing through highyield bonds are: 1. Funding the acquisition through a bridge loan, which is then refinanced through a high-yield bond when capital markets conditions permit such a bond issuance. 2. An issuance of bonds prior to the closing of the acquisition, with the proceeds deposited into an escrow account pledged in favour of bondholders, the funds to be released from escrow only upon completion of the acquisition. If the acquisition is not completed by 3 Recent examples of the right to redeem up to 10 percent at 103 percent of the principal amount in acquisition financing include issuances by Lynx I Corp. for the merger with Virgin Media Inc., Styrolution Group GmbH and Kinove German Bondco GmbH. 4 Recent examples of this portability in acquisition financing include issuances in 2013 by Cerved Technologies S.p.A. and Trionista HoldCo GmbH to acquire ista International GmbH. Both the aforementioned issuances also included the leverage test exception to the restricted payment covenant as did the Virgin Media Inc. issuance. 15

High yield bonds deconstructed a deadline (one to three months, for example) from the bond issuance, the proceeds are returned to investors with interest (and sometimes with a one percent premium) pursuant to a special automatic redemption provision. Each of these mechanisms carries costs. Where a high-yield bond is issued into escrow, bond proceeds languish in an escrow account until closing. The return on funds held in escrow is typically significantly below the interest rate accruing on the bonds, creating a drag during the escrow period, which can become a significant cost with a long escrow period. Bridge loan commitments have a cost as well (in terms of fees payable for underwriters), which becomes even higher if the bridge loan must be funded. In either case, timing which drives cost is key. The goal is to time the closing of the acquisition to coincide as closely as possible with the closing of the bond offering. The escrow arrangement and the bridge loan are not necessarily mutually exclusive, as bridge loan commitment papers typically require an attempt to market a high-yield bond prior to closing (to avoid funding the bridge) and, if such a bond issuance is possible, the proceeds may be held in escrow pending closing of the acquisition. Bridge loan A bridge loan functions as a funding backstop, offering the acquirer a contractual commitment by lenders to provide committed funding to consummate an acquisition. It is a backstop in the sense that the commitment documents typically require the acquirer to attempt to raise the acquisition funding through a high-yield issuance prior to closing (to avoid funding the bridge), but the bridge loan is available to fund the acquisition if high-yield bonds are not able to be issued (due to market conditions) on or prior to the date of the acquisition. Even when funded, a bridge loan is not intended to be part of the permanent capital structure; the terms of a bridge loan and related commitment letters are typically drafted to discourage borrowing (fee arrangements incentivise the acquirer to issue a high-yield bond prior to closing to avoid bridge funding costs) and, once funded, to encourage repayment as soon as possible (fees effectively increase the longer it takes to repay the bridge with the high-yield bond). A summary of some of the customary provisions of the bridge loan documentation is set out below. Key terms of a bridge loan When lenders fund a bridge loan, they advance a loan to the borrower with interest typically based on the relevant interbank lending rates plus a margin, with the margin ratcheting up each quarter by 50 to 75 basis points to a maximum interest rate (or cap) by the end of the first year of the loan, with the cap negotiated at the commitment paper stage. The loans will be callable at par prior to the first anniversary. A bridge loan normally benefits from subsidiary guarantees and collateral to the same extent as bonds that are intended to refinance the loan. The bridge loan covenants will typically be high-yield bond-style incurrence covenants, but are often more restrictive in 16

Bridging the gap: High-yield bonds in acquisition financing certain respects than the covenants intended for the bonds that are to be issued with the purpose of repaying the bridge loan. For example, bridge loan covenants generally include tighter restrictions than those typically included in high-yield bonds on dividends, and more restrictive thresholds and lower baskets for certain covenants; the idea being that a bridge loan is not intended to be a long-term financing solution, therefore making the issuer subject to more restrictive covenants while in the bridge, in part to incentivise the issuer to issue take-out bonds to repay the bridge loan. The bridge loan agreement will also include prepayment covenants (for example, in connection with certain asset sales and securities issuance) that are not customary in the high-yield bonds. If the bridge loan has not been repaid after one year, the loan is converted into a term loan for the remaining duration of the bridge (also called a rollover loan). Lenders have the option of converting their term loan into exchange notes at any time following the oneyear anniversary of the bridge loan subject to certain conditions, including minimum principal amounts of loans to be converted into notes so an exchange note indenture (pursuant to which exchange notes can be issued) is executed at the time the bridge loan converts into a rollover loan. Rollover loans and/or the exchange notes essentially serve as permanent financing for the bridge loan. Bridge loan agreements will provide for the creation of an exchange note indenture with either a description of notes appended as a schedule or a clause requiring the terms of the exchange notes to be consistent with the covenants, events of default, thresholds and baskets (or at least no less favourable to the borrower) of the bridge loan or certain specified precedents. Typically, the terms of the exchange notes are less restrictive in certain respects than a bridge loan, namely with respect to the ability of the issuer to make restricted payments. Commitment papers Commitment papers set out the terms of the bridge loan commitments and are typically executed at the signing of an acquisition agreement (or the submission of a bid). The initial commitment papers set out the key terms of the lenders commitments, including total amount of funds committed, interest rates under the bridge loans (if funded), provisions for marketing bonds in advance of and (if the bridge loan is funded) following funding of the loans. The commitment papers typically require the acquirer to attempt to market high-yield bonds in advance of closing the acquisition, if market conditions permit. If it is not feasible to market a bond in advance of closing to satisfy the full funding commitment, then the bridge loan will be funded at closing of the acquisition. However, this backstop funding may not be certain as a bridge loan and escrow agreement require certain conditions to be met for the funding or refinancing of acquisition funds. The commitment papers for a bridge loan include the following: y commitment letter; y fee letter; 17

High yield bonds deconstructed y term sheet (which is more precisely an annex to the commitment letter); and an y engagement letter. 5 All of the above must be coordinated with the acquisition agreement. Commitment letter The commitment letter sets out the key terms of the bridge loan, including the conditions precedent to funding as well as an outline of the bridge loan s representations, warranties and covenants. The borrower/acquirer should seek to align the conditions precedent in the acquisition agreement with the conditions precedent in the commitment letter to the greatest extent possible. Conditions to funding the bridge loan Commitment letters typically contain conditions precedent to the funding of the bridge loan, which typically require that: y all conditions precedent in the acquisition agreement have been satisfied; y no company material adverse effect (MAE) has occurred; y the acquisition agreement has not been amended in a manner that is materially adverse to the lender; and y certain specified representations, commonly referred to as SunGard provisions, or certain funds provisions, are true and accurate at the time the acquisition is completed and the bridge loan funded (see below). 6 With regard to the condition that the acquisition agreement not be amended in a manner that is materially adverse to the noteholders, such provisions frequently define materially adverse as any change to the definition of MAE in the acquisition agreement or any reduction in the purchase price of more than a certain percentage. In addition, commitment letters generally contain a target MAE condition as a condition to funding. Acquirers will typically seek to ensure that the definition of MAE in the commitment letter conforms to the definition in the acquisition agreement. SunGard provisions provide a series of standard representations, common in commitment letters, which must be accurate as a condition to the lenders funding obligations. Under typical SunGard provisions, only the accuracy of the following representations is a condition precedent to funding: 5 The engagement letter appoints the bridge lenders or their affiliates as underwriters for the bonds that will ultimately finance the acquisition or the bridge loan, if drawn. The engagement letter sets forth the underwriters commission and the basic terms for the bidders obligation to cooperate in the listing process, such as delivery of the offering document, customary opinions and due diligence in the offering process. In some cases, sponsors may seek to tie documentation to a previous deal or sponsor precedent. Some provisions commonly found in the fee letter, such as securities demand, may be included instead in the engagement letter. 6 The term SunGard provisions arose from the 2005 acquisition of SunGard Data Systems, Inc. by a private equity consortium. The commitment letter in the SunGard acquisition limited the conditionality of the financing commitment by correlating the acquirer s obligations under the acquisition agreement with the conditions precedent for the lenders to fund the bridge loan. 18

Bridging the gap: High-yield bonds in acquisition financing y Any representation in the acquisition agreement that, if not satisfied, would permit the acquirer to terminate its obligation under the acquisition agreement. y Building block representations and certain other specified representations under the borrower s control, such as basic corporate matters, enforceability of loan documentation or compliance with certain regulations. Fee letter The fee letter sets out the fees payable to the bridge lenders and the administrative agent. All fees, except for the administrative agent s fee, typically equate to a certain percentage of the bridge loan committed, funded or outstanding. The fees paid to the lenders associated with a bridge loan are usually broken down into the following: y Commitment fee The borrower pays the commitment fee whether or not the bridge loan will become funded. y Funding fee The borrower pays the funding fee (also called a takedown fee) only if the bridge loan is funded. Therefore, if the acquirer is able to issue the bond at or prior to closing, it does not pay this fee. y Rollover fee The rollover fee is payable only if amounts under the bridge loan remain outstanding after one year. The rollover fee (also called a conversion fee or exchange fee) is payable at the one-year anniversary of the bridge loan, if the bridge loan remains outstanding as of that date. 7 y Bridge ticking fee Some fee letters call for a fee to compensate the bridge lenders for the cost of carrying the bridge loan underwriting commitment on their books between the time the commitment letter is executed and the acquisition closing date. It is payable whether or not the bridge loan is funded. y Administrative agent s fee This fee is payable only if the bridge loan is funded and compensates the administrative agent for acting in this capacity. In certain circumstances, some of these fees are rebated in connection with a repayment of the bridge loan facility through a high-yield issuance. The funding fee and rollover fee are typically rebated if the bridge loan is repaid via a high-yield bond issuance within a certain period following takedown or rollover, as applicable. Rebates are payable on a sliding scale. Typical rebate provisions return 75 percent of the fees for repayment within 30 to 90 days, 50 percent for repayment within 90 to 180 days and 25 percent for repayment up to 270 days. Before the financial crisis, some bridge loans provided for a rebate of 100 percent for repayments during the first 90 days. 7 Some engagement letters for a bridge loan will also include an alternative transaction fee (called a tail fee), which acts more as penalty against the borrower that completes the same transaction with another lender within a year after signing an agreement with the first lender. 19

High yield bonds deconstructed The fee letter also includes flex language and securities demand rights. Flex language (or flex rights) grants the lender the right to change the pricing, structure and other terms where it determines such modification necessary in order to successfully syndicate the loans. Pricing flex permits the lender to increase applicable margins on the bridge loan and structure flex gives the lender the ability to reallocate the bridge loan between various tranches. For example, the lender could have the right to shift certain amounts of the notes from one currency tranche to another currency tranche or from a senior secured tranche to a senior (unsecured) tranche or a payment-in-kind (PIK) tranche, The amount of structure flex in deals has increased following the financial crisis. Bridge lenders typically have the right to demand that the borrower attempt to sell highyield bonds (also known as a securities demand) to repay the bridge loan or avoid bridge loan funding (in the case of a securities demand in advance of the closing of an acquisition). Upon receipt of a securities demand notice from the bridge lenders, a borrower is required to produce an offering memorandum suitable for marketing of high-yield bonds pursuant to customary standards under Rule 144A of the US Securities Act of 1933 and to cooperate in the offering process, including making management available for roadshows, participating in underwriter due diligence and procuring customary legal opinions and an auditor comfort letter. Bridge lenders are often limited in the number of securities demands they can make as well as to a minimum amount for each demand so issuers are not constantly required to attempt to market bonds. If an issuer fails to comply with a securities demand, the bridge loan typically provides for an increase in the interest rate (subject to an agreed cap). 8 Term sheet 8 The term sheet sets out a summary of the key representations, warranties, covenants and events of default for the bridge loan documentation as well as the exchange notes. Some term sheets are more detailed than others. The term sheet also contains the conditions precedent to funding the bridge loan, some of which mirror the commitment letter and some which are in addition to those found in the commitment letter, including: 8 In the United Kingdom, the requirement of the Takeover Directive (2004/25/EC) (the Directive ) implemented by means of Part 28 of the Companies Act 2006 (the City Code ) for certain funds cash confirmations has led to a practice where enforceable financing documentation is executed (and all conditions precedent other than those in the bidder s control or identical to the bid conditions are satisfied) before any public bid can be announced. Similar regimes and approaches exist in other European jurisdictions. The acceptance of this practice has led to its adoption in European private acquisitions, either as a bid condition or as a means of the bidder demonstrating to the seller that it is serious and highly committed. Of course, full documentation can take some time to produce and in very tight timescales an approach of using an Interim Loan Agreement is sometimes used. An Interim Loan Agreement is a binding financing, but intended as a short duration facility that will be replaced as soon as full documentation can be settled. In the United States, in contrast, term sheets or other such interim loan agreements in lieu of full loan documentation remain common. The discussion on term sheets and the provisions therein applies equally to the full loan documentation where law requires or the parties choose to forego interim agreements (except as noted). 20

Bridging the gap: High-yield bonds in acquisition financing y consummation of acquisition concurrent with bridge loan funding; y payment of a minimum equity contribution by the sponsors; y receipt of proceeds for all sources of funding for the acquisition; y delivery of historical and pro forma financial statements; and y delivery of a preliminary offering memorandum for marketing the high-yield bonds (this requires the target s counsel to assist in preparing a draft of the offering memorandum). Offering memorandum The delivery of a preliminary offering memorandum is normally required as a condition precedent to funding the bridge loan. Furthermore, as a practical matter, in the event the bridge loan is funded the borrower effectively must keep current a preliminary offering memorandum during the term of the bridge loan (that is, the first year) to enable the issuer to comply with a securities demand. The commitment letter will typically require that the issuer endeavour to cause the target to assist in the offering process; the target management s assistance is generally necessary in connection with the drafting of the offering memorandum and related due diligence process, particularly where pro forma financials are needed in the offering memorandum. The acquisition agreement should include appropriate undertakings for the target to provide this assistance. The offering memorandum will include sections describing the acquisition and expected synergies, the acquirer and how the proceeds from the offering will be used. Moreover, depending on the significance of the acquisition (in relation to the acquirer s business), audited and pro forma financial statements may be necessary in the offering memorandum. Escrow agreement 9 9 Escrow arrangements provide a comparatively simple solution to the problem of timing where a bond offering can be completed prior to closing the acquisition. In this event, the proceeds from the offering are deposited into an escrow account, which is pledged in favour of bondholders. The funds are not released from escrow until the acquisition is complete. Other credit support (for example, subsidiary guarantees and share and asset pledges) is typically put in place on the release of funds from escrow, as the target s assets can only be pledged after the acquisition has closed. The bonds will contain a special redemption provision. This provides for mandatory redemption of the bonds in the event the acquisition does not close within a fixed time frame following the issuance of the bonds, at a redemption price equal to the principal amount plus accrued interest and, in some cases, a one percent premium. The cost of the escrow arrangement is the interest rate drag which is the interest rate bonds bear from the issue date but the proceeds earn only nominal interest from the 9 Escrow arrangements need not be used exclusively in the acquisition context. The authors are aware of at least one context in which an escrow has been used where the use of the proceeds was contingent on regulatory approval. 21

High yield bonds deconstructed investment of the escrowed proceeds 10 while the issuer awaits the close of the acquisition. This approach requires the acquisition and financing deals to close at roughly the same time, typically within one to three months of the bond issuance, as the cost of extended escrow periods are high and also investors do not favour extended escrows. The offering memorandum describes the conditions for the release of the proceeds from the high-yield bond issuance from escrow. These typically include: y consummation of the acquisition upon the terms described in the offering memorandum; y ownership of the entire share capital of the target by the issuer immediately after consummation of the acquisition; and y absence of default as of the completion date. Acquisition agreement considerations The acquisition agreement demands a target s attention because it guides the financing. The acquirer will frequently seek to align condition precedents in the acquisition agreement with the conditions precedent in the acquisition funding documentation. Negotiation over the alignment of certain provisions takes place over a few key issues affecting financing in the agreement including: y any financing condition; y target s covenant to cooperate with financing; y MAE definition and reference date; y representations and warranties; and y any conditions precedent to closing. In the bridge loan context, the acquisition agreement should require the target to provide all assistance in connection with the bond marketing and documentation process that the acquirer has agreed to provide in the bridge commitment papers. The lender may seek to ensure that such provisions are expansive enough to meet the financial institution s needs for marketing and syndicating the financing. This may conflict with the borrower s desire to ensure that in the acquisition lending documentation, the MAE definition and reference date, the representations and warranties and the conditions precedent to closing should align closely with the acquisition financing documentation. Conclusion High-yield bonds can provide an effective mechanism for acquisition financing. They offer issuers flexibility (as compared to the constraints of bank facility covenants) and they 10 A typical escrow agreement will limit the escrow agent s use of proceeds to investing the escrow property in US government debt and money market funds with maturity dates before the end of the escrow date. In some cases (for example, where the issuer is a newly formed finance vehicle) there are legal limitations on the use of proceeds to avoid the registration requirements of the US Investment Company Act of 1940. With three-month US treasury yields between 0.03 percent and 0.11 percent during the first half of 2013 (and money market account yields traditionally only a bit higher), investment interest from the escrow proceeds provides negligible returns. 22

Bridging the gap: High-yield bonds in acquisition financing provide the ability to lock in a fixed interest rate. Perfecting the timing of an acquisition with high-yield financing comes from choosing the right mechanism and setting up the bridge and/or escrow to function in conjunction with the acquisition itself. Weighing up the benefits against the burdens, high-yield bonds frequently provide compelling advantages in the context of acquisition finance. The opinions expressed are those of the authors and do not necessarily reflect the views of the firm or its clients. This chapter is for educational and informational purposes only and is not intended and should not be construed as legal advice. The authors would like to thank Mark Darley, Michelle Gasaway, Steven Messina and Michael Zeidel, partners at Skadden, Arps, Slate, Meagher and Flom LLP, as well as Sarah Knapp, a summer associate in Skadden s London office, for their assistance. Any errors or omissions are the authors own. James McDonald is a partner in Skadden, Arps, Slate, Meagher and Flom (UK) LLP s London office. Mr.McDonald concentrates on corporate finance transactions with a focus on international offerings of securities, including high-yield debt offerings. His transactional experience includes representing issuers and underwriters on a broad range of offerings in Europe and the United States. He has advised on highyield and other financing transactions, including transactions involving the following issuers: TMF Group Holding B.V., HellermannTyton Finance PLC, Avanza Spain S.A.U., SEAT Pagine Gialle S.p.A., Mark IV, LLC, Stena AB, Eco-Bat Technologies Limited, New World Resources and LyondellBasell Industries AF S.C.A. Riley Graebner is an associate in Skadden, Arps, Slate, Meagher and Flom (UK) LLP s London office. Riley focuses on cross-border capital markets and mergers and acquisitions. His representations include TMF Group Holding B.V., Zobele Holding S.p.A., HellermannTyton Finance PLC, Altimo and Ares Life Sciences. 23