Nov 2016 by Nick Veronis & Caroline Rasmussen
Imagine you are a private equity sponsor with a great company in your sights. Diligence on the business is almost complete and has revealed strong prospects for both organic and roll-up growth.
Imagine you are a private equity sponsor with a great company in your sights. Diligence on the business is almost complete and has revealed strong prospects for both organic and roll-up growth. You have a great rapport with the company’s management team, who has indicated that you are their preferred partner, and your entire investment committee is excited about the deal. You then uncover a smaller company in a complementary business line within the same industry that would be a value-enhancing "tuck-in" or "addon" acquisition for your original target. What is your main focus at this point? Your focus is obtaining debt financing to get this deal done. Private equity sponsors will typically contribute about 40% of a buyout deal’s total price tag in equity (capital from their fund), and seek debt to make up the remainder of the purchase price. When looking for a lender, a private equity firm generally wants to know three things – that they are working with an experienced lender who will (1) move quickly, (2) price the debt fairly, and (3) be able to support their deal over time.
Most sellers want to maximize value and move quickly to get their company sold, in many cases holding auctions involving multiple bidders. In these scenarios, it is critical for buyers to line up debt financing that they can count on, quickly. Going to a bank for a loan could take up to three months, ample time to lose the deal.
Rather than going to a traditional commercial bank, the PE firm may approach an investment bank for syndicated debt financing. The investment bank essentially acts as an intermediary between the PE sponsor and institutional debt buyers such as insurance companies and hedge funds, marketing the deal and offering buyers pieces of the full amount that is required. Let’s assume this is a transaction that requires debt financing of $250 million; the bank may (or may not) provide a firm commitment to backstop a portion of the debt (e.g., $60 million), but with respect to the remaining $190 million, the sponsor now faces pricing risk and execution risk. Depending on market conditions and other factors, there may not be sufficient demand to provide debt at the terms (amount, pricing, structure, yield, etc.) sought. In this circumstance, frequently the investment bank arranging the syndication will “flex” the terms to increase demand, which can include things like increasing the interest rate offered and adding or increasing prepayment premiums. Thus, in any syndication, there is no certainty on how expensive the debt will be until the syndication is complete.
These scenarios illustrate why direct lending is a vital and core part of the private equity industry. With a direct lending firm that has a large enough balance sheet to provide and hold the entire amount of debt financing required (a "buy and hold" lender), PE sponsors not only have certainty of capital but also certainty of execution in terms of price. In addition, direct loans are easily customized; for example, in the hypothetical deal above, the PE firm may structure a delayed draw term loan into the debt facility, to enable it to take efficient advantage of the add-on acquisition opportunity. Finally, the broadly syndicated debt markets are generally unwilling to finance smaller companies with less than $30-$40 million in EBITDA.1 These advantages (and certain direct lenders’ ability to be reliable sources of capital not only in good times, but also in volatile markets when other financing options are unavailable) make them a highly attractive financing solution to the private equity community.
(1) - Investing in Middle Market Loans, www.pionline.com/lsta
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