Securitisation and Private Equity slaughter and may October 2004
contents Securitisation and Private Equity 1 1. Refi nancing an Acquisition 2 2. Providing Debt Financing for an Acquisition 4 3. Realising Private Equity Investments 5 4. Conclusion 6 Uses of Securitisation in Private Equity Transactions 7 slaughter and may
securitisation and private equity For many years securitisation has been seen as an attractive (but complex) tool for fi nancing assets in the consumer and trade receivables businesses. It is only relatively recently that the use of securitisation in a corporate context has become evident. This development (primarily driven by a series of U.K. whole business securitisations), together with the more recent arrival of CDOs (securitisations of underlying corporate loans and bonds), has given rise to a tool which can be used in a variety of ways in the private equity arena. Whilst much of the activity to date has been in the U.K. and the U.S., it has good prospects in Europe, particularly with the passage of pro-securitisation legislation in a number of European jurisdictions. Three of those potential applications are outlined in this note: > Securitisation as a means of refi nancing an acquisition > Securitisation as a means of funding the debt component of a private equity acquisition > Securitisation as a means of realising private equity interests 1 slaugh ter and may
1. refinancing an acquisition Short term bridging loans are commonly used to provide the debt fi nancing for the acquisition of a company in a private equity transaction. Following the acquisition, the bridging loans need to be refi nanced. 1.1 Alternative Funding Methods High yield bonds and/or longer term bank debt are often used to take out the original bridge fi na n cing. 1.2 Securitisation Methods Whole Business Securitisation: A special purpose vehicle ( SPV ) is established to lend to a business or group of companies within the target group (the Borrower Group ). The SPV fi nances the loan by the issue of rated debt securities in the capital markets. The loan is secured over the assets of the Borrower Group and further protected by a package of operational and fi nancial covenants imposed on the Borrower Group. Cashfl ows generated by the Borrower Group are used to repay the loan. Working capital is made available under separate bank facilities which will (normally) be subordinated to the securitised debt. Hybrid Structure: As above, except that the securitisation refi nances the senior portion of the bridging fi nance and a high yield issue simultaneously refi nances the junior portion. Possible in theory, but has not yet happened in practice. Receivables Financing: Alternatively, a homogeneous pool of assets in the target company is sold to an SPV, which fi nances the purchase by the issue of rated debt securities in the capital markets. The target company continues to service the assets and extracts any profi ts relating to the assets after the SPV meets its debt service obligations. 1.3 Advantages and Disadvantages > Higher debt proceeds levels, lower cost of funding and longer maturities may be achieved using a securitisation than through high yield bonds or bank fi nancing. The equity value is thereby increased. It has also been said that the covenant package (which will usually be driven by rating agency requirements) may be more fl exible than that required for high yield or bank debt. However, the costs of putting a securitisation in place, and the constraints which apply whilst it is in place, must be weighed against the funding advantages. > In particular, these types of securitisations require businesses with stable cash fl ows and a strong market position (e.g. high barriers to entry). Credit enhancement and liquidity support will usually be required in order to obtain the rating. The rating achievable will usually not be much higher than the normal corporate bond rating. Securitisations also have signifi cant start up costs in terms of documentation and systems for servicing the assets and reporting by the target company. The Borrower Group will also be restricted in its operations (through operational covenants relating to acquisitions and disposals and minimum and maximum capex requirements) and will be required to achieve certain fi nancial benchmarks (e.g. debt service coverage ratios) throughout the securitisation. 2 slaugh ter and may
> It may be harder to fl oat a company that has a signifi cant level of securitised debt, but it has been done and experience also shows that exits through trade sales or secondaries to other private equity houses should be less affected by having securitised debt in the business. 3 slaugh ter and may
2. providing debt financing for an acquisition A private equity house will provide the equity component of the funding package necessary for the acquisition of a company. The debt fi nancing is usually provided by other fi nancial institutions. 2.1 Existing Methods The debt fi nancing will usually be provided by banks or specialist lenders. The private equity investor will need to involve those fi nancial institutions in the negotiation of a combined debt and equity package. 2.2 Securitisation Methods The private equity investor establishes an SPV in advance of any particular transaction. The SPV raises money by borrowing under a warehouse facility from one or more banks, builds a portfolio of private-equity related (leveraged) loans and then refi nances that debt by issuing rated debt securities in the capital markets (the warehouse facility and then the debt securities being collateralised by the underlying loan portfolio). Whether during the warehousing phase or the capital markets phase the SPV provides, directly or indirectly (through the private equity house or a bank affi liate), the debt fi nancing for the transaction; the private equity investor continues to provide the equity alongside that debt. The private equity house (or an affi liate) manages the loan portfolio of the SPV and earns management fees. If it wishes to have access to the excess spread between the income on the underlying leveraged loans and the debt service costs of the SPV, it can (and usually does) invest in some of the junior debt securities issued by the SPV in the securitisation. 2.3 Advantages and Disadvantages > The private equity investor is able to provide a one stop funding source for the acquisition and thereby participate in larger private equity transactions (than might otherwise be the case) without having to use its own balance sheet for the debt component of the funding package. It can control the process without having to involve other lenders in the negotiations, and probably execute the transaction more quickly. It can also earn fees on the management of the underlying portfolio and get the benefi t of the excess spread arbitrage between the income on the underlying loans and the SPV s funding costs. > The management fees will usually be available at different tranched levels in the SPV s payment waterfall - the larger (more subordinated) fees will only be available once certain IRR targets have been met. Equally, as holder of any junior (equity) securities, it would take the risk of fi rst loss if the underlying loan assets default. > The private equity house must bear the initial expenditure of setting up the SPV. Warehouse funding may not have signifi cant cost benefi ts the pricing advantage is probably only fully realised once the rated debt securities are issued into the capital markets. 4 slaugh ter and may
3. realising private equity investments Private equity investments are illiquid until the investee company is sold or fl oated. 3.1 Existing Methods The private equity investor retains its investments until the companies in which it invests are sold or fl oated. The investments are held on balance sheet. 3.2 Securitisation Methods The private equity investor sells its equity investments to an SPV which fi nances itself by issuing, directly or indirectly, rated debt securities in the capital markets. The SPV uses CDO techniques to make the portfolio suitable for securitisation investors: these include tranching of the SPV s debt securities, the availability of fi nancial insurance policies (known as insurance wraps ) to guarantee debt service on the securities and ensuring appropriate diversifi cation of investments through compliance with rating agency-approved portfolio guidelines. The private equity house manages a dynamic portfolio (made up of primaries and secondaries) in return for management fees. 3.3 Advantages and Disadvantages > Depending on the nature of the private equity investor s investment in the SPV, the sale either provides an exit from the investment or removes the investment from (or provides a better treatment for) the investor s accounting or regulatory balance sheet. It may also give rise to benefi cial treatment in its income statement. It also provides an opportunity to earn management fees, some elements of which will be dependent on achieving specifi ed IRR targets. > However, given the inherent nature of private equity interests, the cashfl ows generated by the investments will not be suffi ciently stable and regular for the purposes of obtaining the requisite rating without the provision of credit enhancement (most commonly through overcollateralisation of the underlying assets and the availability of unrated subordinated tranches below the rated debt) and liquidity or an insurance wrap. A number of individual private equity investments dating from different points in the economic cycle ( vintages ), and from different industries and geographical areas, are necessary to address the concentration risks. In practice, to date, most transactions have required fi nancial insurance policies from rated insurers to be acceptable to investors. > The transaction may suffer from negative carry during an initial ramp up period. The SPV will raise funds at closing but these cannot be immediately fully invested. During this time, the portfolio will be less diversifi ed and the uninvested portion will have a negative cost of carry. Recent structures have minimised this by issuing partially funded notes, by using a warehouse to accumulate investments until they reach a critical mass and by staggering multiple issuances of notes. The structure will also usually allow the adoption of an overcommitment strategy, but this will be subject to rating agency limits. 5 slaugh ter and may
4. conclusion Securitisation can provide a tool for achieving higher levels of debt proceeds, lower cost of funding and/or longer term funding than bank funding or the high yield market in the context of acquisition refi nancing. In addition, it provides the private equity house with the ability to provide the debt component of a funding package (as well as the traditional equity component) thereby enabling it to participate in larger transactions and execute transactions more quickly. It moreover allows it to increase funds under management and earn management fees. Securitisation also provides a mechanism for realising its private equity investments through the debt capital markets. But, these benefi ts must be weighed against the costs and operating constraints (the latter usually imposed by the rating agencies). These may limit some of the desired fl exibility. Needless to say, there are also some diffi cult legal and tax hurdles to be overcome, particularly on crossborder transactions. However, transactions have taken place in each of these areas, and this is an interesting option for private equity houses to consider. This note is intended to give general information only. It does not seek to be an exhaustive statement of the law and readers should take specific legal advice on any matter which concerns them. Slaughter and May October 2004 6 slaugh ter and may
uses of securitisation in private equity transactions Warehouse/ Securitisation Vehicle Private Equity Investor Debt Sale of Equity Equity Private Equity CDO Target Company Borrower Group Target Assets Sale of Assets Receivables Financing Secured Loan Whole Business Securitisation 7 slaugh ter and may
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