Almost every deal has to contend with acquisition financing. Very few buyers can buy their targets solely with cash resources from their own operations. They must either obtain financing for the particular acquisition, have an existing credit facility in place that they can draw on for the acquisition, pay using stock or pay by giving the sellers a note for some or all of the purchase price (“seller financing”). Acquisition financing and existing credit facilities are the primary means of financing in most cases.
The Structure of Corporate Debt
The best place to start is by describing corporate debt from a 30,000 foot view.
Corporate debt obligations are like a big slice of frosted layer cake. The top layer, containing the frosting and decorations, is called senior secured debt. It is called “senior” because it takes priority over all other debt, except for certain statutory claims (debt below it in the cake is called “junior”). It is called “secured” because the creditor holds collateral as security for payment in the form of liens and mortgages on all the real and personal property of the company and usually all the members of the consolidated group. There may also be guarantees and other means to encourage and backstop the payment obligations. Senior secured debt usually comes from banks, insurance companies and other lenders.
You may have heard the term “syndicated loans.” When the size of a loan gets too big, a lender will sell off pieces of it to members of a loan syndicate, leaving the main lender as a partial owner who receives a fee for managing the loan and funneling payments through to the syndicate members.
The next layers, the junior debt, are also called “subordinated debt.” There can be multiple layers, with various priorities under various circumstances. Lower layers have fewer protections. higher layers often come from private lenders in the first instance. There are often “intercreditor agreements” between holders of different layers of debt in order to specify their respective rights. In order to comply with certain tax rules about the characterization of debt and equity, companies that do have publicly held subordinated debt are generally organized using a holding company structure, with the obligor of the debt being a top-level holding company that has no operations and all operations been conducted through subsidiaries.
Some larger companies may have publicly traded debt, or bonds. Most bonds are unsecured and subordinated to the senior debt.
Particularly when the fees would be too great for the borrower to bear, a lender may take an “equity kicker” in the borrower. This usually takes the form of a warrant to purchase a certain number of shares of common stock at a nominal cost. The warrants have typical shareholder protection including anti-dilution and registration rights (rights to cause the company to register the shares to be publicly traded or to participate in a public registration of shares by the company or other stockholders).
Further down the chain comes preferred stock, which may be issued in multiple series, each having fewer and fewer rights on liquidation. Preferred stock has a “liquidation preference,” meaning its holders get paid before the holders of common stock, and in the modern world has payment due dates like a loan so it is not outstanding in perpetuity. Some preferred stock can convert into common stock if specified events occur. Among other things, preferred stock almost always has anti-dilution rights.
At the bottom of the layer cake is common stock, which can also come in different series having different control and other rights.
In future posts, we will discuss different kinds of senior bank loan, what bank loan documents look like, bridge loans, other kinds of acquisition financing and important tasks in the senior financing process.