There is a broad consensus across the UK private equity industry that 2009 is likely to represent the toughest market conditions seen for some time. These conditions will affect the industry's ability to raise new funds and make new acquisitions. Industry professionals and participants are likely to find that 2009 is a year in which they are required to devote considerable time to their existing stable of investments.
One of the factors that will curtail new investment is the lack of availability of debt finance. However, the drying up of credit will be a concern not only for firms that are looking to invest – portfolio companies could well suffer too. This article considers the issues that finance directors of private equity-backed companies, and principals of private equity firms, should be considering with regard to the debt position of investee companies.
There are two separate but related areas of concern. The first is the portfolio company that has been held for a significant period without having been exited. The term on the loan that financed its acquisition may be coming up for renewal in the short- or medium-term. The second is the investee company whose financial performance is suffering and which is consequently at risk of breaching one or more of the covenants to its lenders.
The domestic buyout scene expanded rapidly in the years following the dotcom bust at the start of the decade. It was commonplace then, as now, for such deals to be leveraged with debt finance. The industry norm is that private equity firms view their investment horizon at a round three to five years. Conventionally, therefore, one would expect that the majority of investments made during this period would by now have been exited and their related facilities repaid. It is undoubtedly the case that this is true for the majority of these investments but by no means all. In addition, it is likely that investments made more recently will be held for a longer period of time due to the difficulties of exiting in the current market, those difficulties being likely to persist into the medium term.
Attempts to calculate the outstanding finance used in connection with historic UK buyout activity are necessarily estimates. However, our research (using independent source materials from the Centre for Management Buy-Out Research and from firms that have published data following the recommendations of the Walker Report) suggests that some £4.3 billion of domestic private equity acquisition finance could be due for renewal in 2009. It is well reported that the sources of such finance are significantly less active in providing new finance at the current time and this includes refinancing existing debt as well as the provision of new facilities. A company whose facilities are approaching their term could find itself being in an analogous position with a company about to breach its financial covenants, in that it will be effectively beholden to its lenders.
Most finance directors and their private equity backers will be focused on ensuring that any reps and warranties contained in their finance facilities, particularly as to loan-to-value ratios, continue to be met. If a company breaches these covenants, what are its options? Traditionally the company would have approached its lenders to seek a waiver of the breach. In recent times the landscape for such waivers has shifted. Lenders have become increasingly keen to realise cash. This is as true of those banks which are now partly in state hands as with those which remain entirely privately owned. The government's desire that banks continue to provide finance to allow businesses to operate has been slow to permeate to the credit committee level.
Where a company is seeking a waiver from its lenders to a covenant breach it should pay careful attention to precisely what the waiver is offering. Is the waiver simply a standstill under which the lender agrees not to take any enforcement action for a prescribed period? If so, how confident is the company and its equity backers that the company will satisfy the covenant next time it falls to be tested? Such a waiver is in effect rather like paying someone to be your friend but only for a weekend: come Monday are you back where you started – and poorer as a result?
Companies will inevitably hope that the terms of the waiver also provide for a re-setting of the relevant test under the facility (for example the loan-to-value ratio) to reflect the revised economic climate. This may or may not be acceptable to the lender, but in any event is likely to affect the cost to the company of obtaining the waiver.
THE COST OF WAIVERS
Waivers are never free and there are a variety of ways in which lenders are likely to seek payment for any breaches. The most obvious cost to companies is that lenders invariably require a significant fee for the granting of a waiver. We have seen this on a number of occasions in recent times. Other costs to companies that we have seen recently include a hiking in the margin attaching to the loan and the insertion in the facility documents themselves of market-flex provisions.
The cost of obtaining a waiver may be felt not only by the company but also by its equity backers. Particularly where financial covenants such as LTV ratios have been breached, lenders are requiring an injection of new equity from shareholders and/or the sale of assets by the company with a mandatory pre-payment to the lender of the proceeds raised.
A LITTLE LESS COMFORT
Following a recent case (Tel€2 International Card Company SA and others v Post Office Limited) there is now a further new feature on the landscape for waivers. This is relevant in particular where a lender is agreeing not to take action in respect of a particular breach but where the covenant is not being re-set and falls to be tested again in the future. The lender will wish to ensure that by having agreed to an intended one-off waiver it is not prevented from later enforcing its rights in respect of a continuing breach. Until recently lenders took comfort from the usual “no waiver” provisions included in loan documentation. However, the Tel€2 case has cast doubt on whether such provisions are always effective or whether, by granting a waiver, the lender will by its conduct “affirm” the breach and be prevented from taking further action. Lenders will now inevitably send to the company a “no affirmation” statement in addition to the waiver itself. The effectiveness of such statements may yet be called into question but for the moment they look here to stay.
Even assuming that the company is meeting its obligations under its finance facilities and appears to be able to do so in the foreseeable future, is there any potential cause for concern? In former times one would generally have thought not. However, the current reality may differ. What issues are relevant for an investee company with, let's say, up to 24 months to run before the expiry of its facilities where there is no real expectation of an exit during that period?
Traditionally such a company would have looked at some point during this period to initiate a discussion with its lender regarding an extension of its facilities. Such an extension would have been perceived as likely to be granted, perhaps on restated terms, and if the incumbent bank did not prove willing to assist then there were other lenders who no doubt would. In the prevailing economic climate, however, finance directors and private equity principals should not take for granted that either option will now be possible. To do so may risk being caught asleep at the wheel.
In today's environment, companies must look to preserve their own position as their first priority, as their banks will certainly be adopting the same strategy. This may mean a shift in attitude from viewing the bank as first port of call in the event of possible problems to viewing the bank as potential foe as well as friend. There are often steps that a company can take to improve the position of itself (and its equity stakeholders) in advance of approaching lenders. The scope and quality of the bank's security net may not be as good when thoroughly reviewed as had been thought, which may give scope for reorganisation of the company's assets and liabilities within the permitted bounds of the finance documents.
This all goes towards ensuring that the company's bargaining power with its lender is maximised at the point that the lender is approached. The bank will then also be left in no doubt as to the plan of action that the company has in mind if agreement cannot otherwise be reached.
Andrew Watkins is partner in the corporate department and a member of the Trowers & Hamlins' restructuring and insolvency team.