M&A in the COVID Era – Part II – Debt Financing Opportunities for Middle Market PE Funds
The global COVID-19 pandemic has created uncertainty around the planned deal-making activities of many middle market private equity funds. However, this environment also creates significant opportunity to provide investment and financing to companies that find themselves in distressed circumstances.
COVID-19 has already had a dramatic impact on many middle market private businesses. This has resulted in an increase in financial covenant and payment defaults under existing financing documentation. In order to maintain operations, many companies are in need of financial covenant resets and supplemental tranches of debt for additional liquidity and business opportunities. Given uncertainty in the financial markets, there are opportunities for new investors not otherwise in the space to provide debt financing to companies on attractive terms.
Clearly there is market saturation with middle market alternative lenders, but investors that are nimble and have core industry knowledge (such as healthcare) via their traditional equity investment strategies will find debt opportunities in a down market. In exploring these potential financing transactions, funds will need to consider any relevant restrictions in their fund documentation and tax considerations with respect to funds and limited partners.
Principal Types of Distressed Financings
Senior Debt Term Loan Refinancing or Incremental Senior Lending
Providing a full refinancing of a distressed company’s existing senior debt or co-investing in an additional tranche of existing senior debt allows a new lender to step into the senior position. The new debt sits at the top of the capital structure, subject to intercreditor arrangements with any other significant creditors, such as revolving lenders or existing subordinated lenders. Senior financings as a general matter have lower returns than subordinated/mezzanine financings.
To the extent that it is not possible to provide senior debt, or senior pricing does not warrant investment, a potential lender may provide subordinated debt, subject to intercreditor or subordination documentation with senior lenders. While subordinated financings do not offer the down-side protections of a senior loan, they do have higher returns and can be provided in connection with other economic benefits.
As part of a bankruptcy plan, a new lender may provide super-priority secured financing to fund a debtor through its restructuring process and roll restructured debt forward as ongoing debt of the company post-bankruptcy. A DIP financing, of course, requires the distressed company to enter a formal in-court bankruptcy process. While a bankruptcy process can be streamlined, it will typically be quite costly. The financing (and pricing) will also be subject to scrutiny by the bankruptcy court.
Senior Term Loan Refinancing or Incremental Senior Term Loans
From the perspective of a distressed company with a senior credit facility in default, or in danger of default, it is preferable to amend or refinance the existing debt to obtain terms that it can comply with on a go-forward basis. This is the fastest and most straightforward method of both solving for ongoing defaults and providing liquidity.
Distressed companies may seek to amend or refinance to revise the following provisions, among others, of their senior documentation:
- Principal payments (amortization holidays, or reductions)
- Interest payments (interest payment holidays or PIK toggle)
- Waiver of certain mandatory prepayments to preserve liquidity
- Financial covenant reset or elimination of certain burdensome financial covenants
- EBITDA add-backs relating to market conditions (non-recurring COVID-19 items)
A refinancing may also be preferable from the perspective of a potential new lender. A refinancing removes the senior term lender as a competing creditor with greater collateral rights in a downside and puts the new lender in the control position.
There are also situations where an existing credit facility may not be in default and the existing senior lender is not anxious to be taken out, but is still unwilling to provide additional liquidity. This additional liquidity may be necessary for a company to maintain its business plan (permitted acquisitions, for example) and can be provided as an additional tranche or incremental term loan by a potential new lender. The new lender would receive the benefits of a senior secured position and would share in any collateral pro rata with the existing senior lender.
Structuring and Documentation Considerations
In a refinancing or funding of incremental senior debt, the collateral package and overall credit support will generally stay the same as under the prior or existing senior financing. However, a new lender may consider strengthening its position by requiring:
- A pledge of additional assets and/or guarantees by additional subsidiaries or affiliates, possibly priming existing lender’s security interests
- Additional guarantees or capital call agreements provided by equity holders, including principals and sponsors
A subordinated/mezzanine financing allows a distressed company’s existing debt to remain in place in a senior position. This provides additional liquidity and takes pressure off of the company’s senior leverage ratio, with higher returns for the new lender than available under a senior financing.
This will typically take the form of a senior subordinated term loan facility with a maturity date following the maturity of the senior debt, repayment of principal at maturity and regularly scheduled cash pay interest. It is preferable to structure a subordinated/mezzanine credit facility at the operating company level with the same collateral package and guarantee support as the senior debt, but to the extent required by the senior lender, a subordinated/mezzanine credit facility can be structured as unsecured debt at the operating company or even structurally subordinated unsecured debt at the holding company level.
There are additional protections and economic incentives available to be included as part of a subordinated/mezzanine financing package, such as warrants, equity co-invest rights, no-call periods and prepayment penalties to increase IRR on investment. A potential lender can also reduce their risk by requiring a preapproved budget and more stringent periodic reporting, frequent lender calls and board observation.
Structuring and Documentation Considerations
It is important for a potential lender of a subordinated/mezzanine financing to understand the terms of the existing senior debt and any other competing creditors, including the following, among others:
- The amount of senior debt
- Ability to upsize or incur additional tranches of senior debt
- Additional permitted debt and the priorities of such permitted debt
- Permitted refinancings of senior debt
- Parameters for amendments to key terms
A potential lender should also consider the possibility of layering (additional debt being incurred ahead of the mezzanine debt in the company’s capital structure) and whether the senior debt can be divided into multiple tranches with different priorities and/or into first lien or second lien pieces.
The most important item to confirm in the senior debt is the extent to which subordinated/mezzanine debt is permitted to receive payments. If cash pay interest is not permitted, an amendment of the senior debt documents may be required.
Subordinated/mezzanine documentation should generally mirror senior debt documentation, with appropriate cushions applicable to covenants and thresholds. From a lender’s perspective, the documentation should require a senior leverage ratio financial covenant. In all cases, the subordination or intercreditor documentation governing the relative rights, including voting rights, of the senior and mezzanine lenders will be a central point of negotiation.
Under the Bankruptcy Code, the filing debtor is encouraged to restructure its business and is permitted to incur new debt to assist with the restructuring process. The Bankruptcy Code gives special rights to lenders willing to lend to a debtor and take the risk associated with a DIP loan.
One of the principal rights providing to DIP lenders is the ability for new money lenders to prime (or jump ahead of) existing pre-petition creditors. To achieve a priming, existing lenders need to be assured that the value of collateral securing their debt won’t be diminished. Protections (“adequate protection”) are often negotiated with existing lenders to include liens on post-petition assets and cash payment of interest and legal fees and expenses. The Bankruptcy Code gives the court the power to trump all state law lien perfection requirements and “deem” liens perfected just by entering a DIP order. Federal court orders make lenders’ collateral position rock solid.
DIP financings often have short terms and function as bridge loans to long-term exit financings post-bankruptcy. A potential lender could consider lining up an equity stake in restructured business post-bankruptcy.
Structuring and Documentation Considerations
Existing lenders may seek to provide a protective DIP financing to protect against their rights being primed.
Distressed companies may seek to repay existing lenders with DIP financing proceeds. It is in the interest of DIP lenders for proceeds to fund operations and not payments to existing creditors. DIP financings can require proceeds to be applied in a manner consistent with a court-approved budget and can include certain non-essential activities.
DIP financing documentation should generally mirror the company’s existing senior facilities documentation, with case milestones and other necessary changes.
As part of a bankruptcy proceeding, a distressed company can sell its assets “free and clear” of any interests pursuant to Bankruptcy Code Section 363 (a “363 Sale”). DIP lenders have the right to “credit bid” the value of the secured indebtedness extended to a distressed company in exchange for any assets purchased in a 363 Sale. Per Bankruptcy Code §363(k):
“At a [363 Sale] of property that is subject to a lien that secures an allowed claim, unless the court for cause orders otherwise the holder of such claim may bid at such sale, and, if the holder of such claim purchases such property, such holder may offset such claim against the purchase price of such property.”
DIP lenders will have to contend with other competing bidders in a 363 sale, but are in a strong position to succeed since they can bid the value of their secured DIP financing, while competitors will need to provide new consideration.