An Overview of Acquisition Financing – Part 2
In a previous post, we looked at an overview of corporate capital structure. This post goes deeper.
Three Kinds Of Senior Bank Loan
The easiest form of senior bank loan to understand is the term loan. A borrower borrows a fixed amount of money for a fixed period of time for a fixed or variable interest rate. Term loans often have the lowest interest rate of any of the three main flavors of senior loans. If a facility is being put into place at the time of a large acquisition or a leveraged buyout, a portion of the consideration will almost certainly come in the form of a term loan.
Most companies of any reasonable size have a revolving line of credit. The “revolver”, as it is also known, is like a giant credit card for the company. The company can borrow and pay down as needed in order to smooth out seasonal cash flow issues, pay for inventory build-ups or do acquisitions. While there is typically a fee associated with keeping the facility open to compensate the lender for maintaining its own credit in reserve, the borrower is not paying interest on the full amount of availability under the revolver until it actually borrows money. The repayment terms vary depending on the creditworthiness of the borrower and the industry. Some companies must pay a significant portion of the revolver down every so often, while in other cases the full amount is due as a balloon payment at the end of the loan term. Unlike credit cards, all revolving lines of credit have final due dates. If a revolving line of credit is used for an acquisition, in most companies in our customer range the lender will want the right to do due diligence on the target and otherwise approve the acquisition. At a minimum, the lender will want the assets of the target to be use as collateral simultaneously with the closing of the acquisition.
Companies that do many commercial transactions involving the purchase of goods and companies that do a lot of acquisitions will often have something called a “letter of credit facility” as well. A letter credit is a document issued by a bank that it will pay the holder a certain amount if the holder presents a specified set of documents to the bank. Without going into all the uses the letters of credit can have in commercial settings, in the acquisition world they are often used to fund break-up fees. That way, if the buyer walks away, the seller can bring the letter of credit and appropriate documentation to the bank and be paid the break up fee, and the buyer will not have had to incur the interest charges that it would have under its revolving line of credit to hold the amount of the break up fee in escrow pending the closing or break-up.
Some potential acquirers will have bank credit facilities in place already. Others will be replacing or setting up new credit arrangements at the time of an acquisition. While the tasks will be different depending on the situation, they will share many elements.
What Do Bank Loan Documents Look Like?
Bank loan documents have a format that is not too far removed from merger agreements. The main areas of interest are:
- Operating provisions. These are provisions like the dollar amount, interest rate, types of loans, mechanism and other terms for borrowing and repayment, etc.
- Conditions to closing. Like a merger agreement, a loan agreement has conditions to closing. Some of the conditions are different from the ones we have talked about in the M&A context, but many of them overlap. Some of the ones that differ include those typical of this type of deal, like security documents and agreements with lower tiers of creditors.
- Representations and warranties. As with buying a company, a lender or other party providing financing (which is buying debt rather than equity) wants to know certain factual information about the borrower. If the loan is being made as part of an acquisition facility that is being set up at the time of the acquisition, the bank will want this information to include information about the target. If the target is acquired after the facility is set up, the bank will still want to subset of information about the target. Sometimes the borrower will be able to refer to the merger agreement representations and warranties, but otherwise not.
- Covenants, affirmative and negative. A “covenant” is an obligation of the borrower to do, or not to do, certain things. Typically the prohibitions include major asset sales or purchases, such as acquisitions. In other words, lenders like approving acquisitions unless they are not of a significant size compared to the size of the borrower and the credit facility. Some of the more interesting covenants are called “financial covenants,” which require the borrower and its operations to maintain specified financial ratios that vary depending on the lender, the borrower and the industry. Since secured lenders also want to ensure that they have enough collateral for their loans, they generally require the borrower to provide regular “borrowing base” calculations.
- Default. The loan documents list of things that can happen to give the lender the right to declare the loan due and payable before its due date. The agreement also describes the rights the lender has upon a default.
- Security. Whether security documents are incorporated into the loan agreement or whether they are separate instruments listed as documents to be signed as conditions to closing, lenders need their collateral in order for the debt to be considered as senior debt.
In future posts, we will examine bridge loans, an overview of other kinds of acquisition financing and major tasks in the acquisition financing process.