Acquisition Financing – Investment Grade Bonds, Private Placements, Term Loan B, High Yield Debt
Bonds, notes and term loans for institutional investors are otherwise seen as much more permanent capital than bank debt and is not meant to be paid down opportunistically. Fixed income investors – which are a distinct group from lenders – have returns mapped out when they make an investment decision, and expect to be made whole with a hefty premium if there is no call option feature (callable bonds) contracted within the indenture (bond contract).
For material mergers & acquisitions (and especially in the case of leveraged buyouts), the acquiring company will usually require more debt than banks are willing to give them to fund the purchase unless they are incredibly cash-rich or underlevered. As the new cash flows are presumably able to service more debt, we can expect some of these acquisition bonds to be part of the longer term capitalization of the firm.
When this is the case, borrowers have a number of choices as it pertains to debt investors and they will usually borrow from a combination of the options below:
Investment Grade Bonds
This is usually the go to for large, blue chip companies. They will simply issue more bonds, which will likely trade in line with their current outstanding debt. Should the acquisition be particularly large to the point where it would jeopardize their credit rating, investment grade companies will issue common or preferred equity or sell non-core assets to raise funds.
Investment grade bonds pay fixed or floating semi-annual coupons that are determined via their credit spread over a reference government security or treasury bond or LIBOR. The coupons represent interest only and the total amount of the principal is due at maturity.1
As the name suggests, investment grade (“i-grade”) debt will usually trade at a coupon well below any sort of leveraged loan or high yield bond as they are required to have an investment grade credit rating from an investor accepted credit rating agency. As they are such a vanilla product, issuance fees for IG debt is usually the lowest.
Generally, fixed income investors either prefer Moody’s or are indifferent between Moody’s and S&P, but issuers will look for the rating agency that is most amenable to their desired rating. Should S&P or Moody’s (Moody’s being more conservative) have ratings that are not aligned, borrowers may eschew the lesser one for Fitch or DBRS when the approval of two agencies is required to market the deal.
As IG issues are not likely to run into problems with financial health which would jeopardize repayment or meeting interest obligations, there are usually no maintenance covenants for great flexibility in their operations. When credit quality deteriorates for certain IG issuers, they become high-yield “fallen angels”, which are worse from an investor perspective as the bonds do not carry the same protective covenants as original high yield issues.
Depending on the need for the debt in the capital structure as well as favorable pricing on either end of the curve, investment grade bonds usually have a tenor from 3-30 years (the most common tenors being 3, 5, 7, 10, 30) although 50, 100 year or even perpetual bonds are not unheard of2, but not necessarily used in acquisition financing.
Private placements are a favorite for certain yield hungry fixed income investors. Private placements are not distributed as widely as investment grade or high yield debt. As the investor number is small – given that these undergo targeted investor marketing – the terms and conditions can be bespoke or tailored to the investor instead of whatever is trading on the market.
Investment banks will help the issuer negotiate with select fixed income investors specifically, such as insurers or pension funds. In return for maintenance covenants to the comfort of the private placement investors, such as Debt/EBITDA or EBITDA/Interest, issuers can sometimes achieve lower effective interest rates for private placements as measured by spread against a benchmark treasury bond yield. With covenants constructed in accordance with the fixed income investors’ approval, the requirement of an external credit rating by S&P or Moody’s is not required.
As private placements are for investors such as insurers to earn a return on their float or pensions for their beneficiaries’ monies without a variable cost of funds, private placements usually have a fixed interest rate. Tenor will run up to 15 years – enough to cover most long tailed premiums or meet most other private debt investor mandates.
For a look from the investor side, check out:
Favorite industries include renewables, infrastructure, utilities and real estate.
Term Loan B
Term Loan B’s (bullet term loans or institutional term loans) are bond like instruments that institutional investors like to purchase as fixed income instruments. Term Loan Bs’ usually have a maturity of 5-7 years and are variable rate debt – so they will pay at a spread to LIBOR or another benchmark rate.
For instance, an investor may look at a TLB and see that it says L+450, which means the interest rate will be LIBOR + 450 basis points or 4.5%. If the reference LIBOR is at 2.5%, then the effective interest rate will be 7%. To ensure debtholders have adequate returns, there is usually a LIBOR floor – this is particularly useful in Europe, where TLBs are popular as stronger economies in the Eurozone have experienced negative benchmark interest rates.
From the issuer’s perspective, they will often prefer fixed rate obligations and will engage with an investment bank to be a counterparty to a floating-to-fixed swap to hedge out their interest payments.
An easy way to remember the two types of term loans – that is Term Loan A’s or TLA and Term Loan B’s (TLB) is by amortization schedule. A stands for amortizing and B stands for bullet – and as such, banks will usually dabble in TLA while hedge funds and asset managers will go with TLB.
However, as with most other loans, payments on TLBs still include some principal payment before the final maturity, although they are usually near the end of the TLB’s life, so they still resemble bonds for all intents and purposes. TLBs usually have some sort of call protection provisions that require the issuer to pay investors back at 101% of par should the term loan be repaid early.3
This is due to an evolution of investor needs – as the loan structure indicates, term loans were previously purely in the jurisdiction of traditional lenders such as banks. However, the development of a leveraged/high-yield market and growing investor appetite has led to TLBs becoming more like bonds and less like loans.
Attributes associated with loans that have been slowly shed from the TLB market include covenants – previously having protective maintenance covenants (Debt/EBITDA), TLBs now commonly use a covenant-lite structure as investors give up protections for yield – albeit incurrence covenants that high yield bonds have are still a must. Likewise, while banks traditionally held loans on their books, there is an active secondary market for TLBs.
TLB’s require external credit ratings and the spread to LIBOR may be priced relative to the current S&P or Moody’s rating.
High Yield Bonds or Junk Bonds
Junk bonds are a staple of deep debt capital markets and allow for less creditworthy borrowers to tap into a large pool of yield hungry investors. Junk bonds are extremely popular in the US where there is an extremely active secondary market.
High yield bonds are characterized as being the most junior capital in acquisition finance before capital with equity characteristics or equity content (subordinated debt, hybrid debt). High yield bonds, as implied by their description, offer strong effective interest rates due to the premium demanded by fixed income investors for their risk. Most high yield bonds have a tenor of 5-10 years. There is no amortization on HYB, and all principal is paid off at maturity in one bullet payment.
S&P and Moody’s are required for high-yield bonds to constitute high yield bonds – as by definition, high yield bonds are bonds with an external credit rating below the equivalent of BBB-. That said, there are non-rated bonds (NR) that are lumped together with high yield debt for analysis purposes.
High yield debts are structured to offer flexibility to the borrower while the investor has legal protections so that their capital is invested. Recall that borrowers do not have the interest of lenders in mind – their fiduciary duty is to shareholders. As such, high yield debt investors have incurrence covenants to ensure that their principal is protected.
These incurrence covenants may include no new debt issued that would bring Debt/EBITDA above a certain threshold, no dividends paid unless certain thresholds are met, no asset sales of a certain size without bondholder approval. If the management engages in shareholder friendly activity that is not covered by these covenants and the bondholders lose out, the court of law will side with the management.
1There are often par call provisions up to 6 months before the debt matures which allow for the issuer to redeem the bond at par (100 cents on the dollar) before the scheduled maturity of the bond
2These bonds are usually for corporates with long lived assets with low risk of obsolescence – for instance, a railroad invaluable to the North American economy such as CN Rail
3Also known as a soft call provision