DEAL MECHANIC

Kohlberg Kravis Roberts' acquisition of Alliance Boots – the largest private equity deal seen in Europe to date – was never going to be a straightforward transaction. The US buyout firm was trying to buy one of the jewels of the UK high street – a company that employs about 100,000 people worldwide and, as a dispenser of prescription drugs, is only one step removed from a public institution.

However, KKR also had the disadvantage of trying to seal the deal amid an atmosphere of unprecedented political hostility towards private equity in the UK. Politicians publicly castigated the industry, while the GMB trade union, which had first shown its teeth over rival Permira's job cuts at the AA, quickly latched on to the Alliance Boots deal as another example of the industry's avarice and overweening ambition.

The buyout firm's ace in the hole, however, was its tie-up with Stefano Pessina, the deputy chairman of Alliance Boots who presided over the merger between Boots and his own family business, Alliance Unichem, in 2006. With Pessina as king-maker, KKR was able to build up a blocking stake of more than 25 percent, enabling it to see off a spirited rival bid from Terra Firma, HBoS and Wellcome Trust. However, it was forced to raise its offer by 14 percent, from an initial £10.00 to £11.39 per share – a hefty premium of almost 40 percent over the share price on the day before the bid was announced.

The result was a deal with an enterprise value of £12 billion (€17.8 billion; $24.3 billion). Not surprisingly, with a record-sized financing package up for grabs, many leading banks scrambled for a piece of the action, with no fewer than eight ultimately mandated: JP Morgan; Deutsche Bank; Merrill Lynch; Unicredit; Barclays; Bank of America; Citigroup and RBS. Two others, Goldman Sachs and Greenhill, acted on behalf of Alliance Boots.

The equity slice of the transaction initially amounted to £3.43 billion, rising to £3.93 billion by completion (see pie chart below). KKR and Pessina each committed £1.27 billion, equivalent to a 32 percent stake, with Pessina rolling over his contribution from the stake he sold to the acquisition vehicle (and netting a tidy £600 million windfall in the process). The remaining £1.39 billion was funded by a so-called equity bridge from seven of the lending banks – an arrangement where the debt providers agree to underwrite part of the equity in order to win a mandate, with a view to syndicating this on to institutional investors at a later date. This worked out rather nicely for KKR and Pessina. As well as being able to syndicate some of their own equity portion, they retained full control of the acquisition vehicle, and would also receive a transaction fee, reimbursement of their expenses, and an annual “monitoring fee”.

KKR finally clinched the deal in June, after shareholders voted in favour and it managed to resolve a long-running dispute over the company's pension fund, agreeing to contribute £418 million in cash plus a £600 million security agreement.

SUB-PRIME CONTAGION
However, this was not the end of the story. In addition to the equity bridge, the banks – led by JP Morgan and Deutsche – had initially agreed to provide an interim debt financing package of about £8.2 billion, plus a revolving credit facility of £820 million, to be refinanced on completion. But by the time they were ready to take this European record debt package to investors in July, market conditions looked very different. Wobbles in the US credit markets, caused by contagion from the US sub-prime sector, were starting to affect Europe too.

As a result, the lenders took a relatively conservative approach. The debt package (see pie chart below), which totalled £9.2 billion in all, featured a senior tranche of £5.05 billion, plus junior debt of £1.75 billion, which included a £1 billion second lien tranche and a £750 million mezzanine piece. The balance consisted of the revolver plus a property-backed bridge loan. The coverage ratio (of earnings to interest payments) was 1.7 times – below the historic norm of two times, but well above the coverage ratios of many aggressively structured recent deals. Following the controversy over covenant-lite loans, the senior tranche also included a covenant governing the company's debt to EBITDA ratio.

But even this was not enough for the offering to get away unscathed. First, Terra Firma withdrew its offer to buy a £250 million equity slug, leaving the banks with another sizeable portion of equity to syndicate. Amid increasing volatility in the credit market, where the deal was widely seen as a bellwether (“the whole market is looking to see how the Boots deal turns out”, Intermediate Capital Group's Tom Attwood said at the time) it soon became clear that debt investors would not bite at the original pricing. Eventually, the lenders were forced to re-price the senior debt package to 325 basis points above LIBOR – despite the fact that investors had been buying at 200-225 bp above just a few months earlier. Even this failed to do the trick, and at the end of July the lead underwriters decided to suspend the senior debt syndication altogether.

To avoid the junior debt meeting the same fate, the lending banks were forced to sweeten the terms significantly. The £1 billion second lien tranche was offered at 96 percent of face value, with the spread increased from 400 to 425 bp, while the £750 million mezzanine piece was priced at 95 percent of face value and the spread set at 600 bp – 300 bp for the cash component and 350 bp for the payment-in-kind. Call protection was unchanged, at two years for the second lien and three years for the mezzanine.

“The terms are quite extraordinary,” one surprised debt investor said on hearing the news. “They've clearly flexed it and it's priced to sell. The banks must be very serious about trying to shift it, and it will be interesting to see who bites on it at such a discount.”

Unfortunately, nobody did. In the first week of August, news emerged that syndication of the second lien had been pulled indefinitely. With credit markets still uncertain, it had proved impossible to sell the debt, even at such a big discount. The mezzanine tranche did get away, but as PEI went to press, the banks were still left with more than £6 billion of debt and £1 billion of equity on their books.

However, not everyone seems to think this is necessarily a terrible outcome. “There is no point in trying to sell a monster deal everyone is shooting at in a down market,” says Robin Menzel, head of debt capital markets at European merchant bank Augusta & Co. “Better to pull it, sit on it and express your confidence in the credit. Let it season, and wait for the market to recover.”

The seven banks left holding the Alliance Boots baby will be hoping that he is right.