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The role of debt in private equity deals

Banks play an important role in private equity transactions, particularly in buy-outs. Here, Bank of Scotland explains its lending criteria and some of the types of debt available.

Private equity transactions involve the acquisition of some or all of the shares in a business. This means that a high level of funding is needed to meet the acquisition price of these shares. This funding is met by equity money from both venture capitalists and management and, if suitable, by a bank providing debt financing. If a business is unlikely to grow spectacularly, then lower cost debt - instead of equity finance –can be used to ensure greater returns to equity shareholders. To give an indication of the normal level of debt involved, statistics compiled by Initiative Europe for April 2001 indicate that 58-60 per cent of buy-out financing in 2000 was met by debt funding.

In this type of transaction, banks will typically lend on the basis of a combination of quality cash flow generation and on safety in the inherent value of the business. Because these deals are so highly leveraged, the bank has to be extremely careful in assessing what type of business is appropriate for debt financing. Here are two extreme examples of private equity transactions that are suited and unsuited to bank lending.

The first is a start-up biotechnology company. The business doesn't have a product to sell yet - it is spending money on research and development to progress its product. This business is not forecast to generate cash for three years, but this is by no means guaranteed. And, until it does make money, it is cash-hungry. This type of business is not suitable for debt financing. It has to be entirely equity-funded as there are no cash flows or assets to support the debt. This type of transaction is highly speculative - it may give high returns in the future, but it may never make any money. The risk-reward profile for this type of transaction is suitable only for venture capitalists and not banks.

The second is a ferry operator. It is the sole operator on a particular route and revenues are ticket receipts generated from a fairly new ferry fleet. This is a very stable business with a steady history and few likely competitors. It has strong predictable cash flows that show inflationary growth. It needs little capital expenditure for refurbishing the existing ferry fleet and it needs no working capital. This is an attractive debt deal. The company is unlikely ever to experience a huge growth in profits, so a private equity firm and other shareholders will want to attract debt funding to ensure that their shareholding will achieve their required return on its investment. This means greater returns for private equity firms on exit.

Types of debt
If the equity transaction is suitable for debt, the main instruments that banks can provide are senior debt (including working capital facilities), mezzanine debt and asset-based lending.

Senior debt is among the cheapest - and the main source - of debt finance in private equity transactions. The loan is secured on the business' assets and has fixed repayment terms. It can be arranged either as a single tranche (A note) or as two or more ‘alphabet' tranches (A, B, C and sometimes D notes). The A note is the standard type historically seen in most transactions with a repayment profile spreading over six to seven years with an average life of between four and five years. Further debt tranches, such as B, C and possibly D notes (alphabet notes), tend to have a single (bullet) repayment after the A note matures. The delay in payment redemption reduces pressure on cash flows and allows the business to increase senior debt levels. The interest margins will be above those of the A note. This reflects the increased lending risk associated with the longer repayment period and usually higher leverage.

Senior debt tends to be the most preferable form of bank funding. It is a relatively cheap form of finance, it can be repaid early at little to no cost, it typically doesn't dilute equity and there is a mature market for providing senior debt. The only disadvantage of using term loans is that annual loan repayments may not suit companies that are ‘cash-hungry'.

Mezzanine debt meets the gap between senior debt and equity-type risk. It is termed junior debt and is subordinate to the senior debt, ie junior debt is paid off later than senior debt. Mezzanine funding has a higher interest rate than senior term loans. It will also include an ‘equity kicker'. Under this agreement, the bank will receive equity upon final repayment of the mezzanine debt. Mezzanine is repaid in a single repayment, typically after the senior debt. The advantages of using mezzanine are that it costs little to set up, it can cater for all sizes of transaction and it can be refinanced at any time after the deal has been completed. However, it tends to be more expensive than senior debt, especially with the equity kicker element. Plus, as with senior debt, mezzanine is usually a secured - albeit junior - loan.

Banks can also provide asset-based lending in private equity transactions as either invoice discounting or asset financing. With invoice discounting, the business receives cash up-front for outstanding debtors and a facility that tracks the debtors book. Similarly, asset finance packages, such as leasing and hire purchase can be put together to deliver the most appropriate cash flow-friendly and tax-efficient means of acquiring fixed assets, such as plant and machinery and vehicle fleets. Given that many businesses experience high growth rates, the demands of working capital requirements may affect the ability of good companies to release sufficient cash flow to meet redemption of acquisition funding.

Asset-based finance is flexible and grows with the business, it has fewer covenants than cash flow finance, tends to be competitively priced and can accommodate smaller deals.

Bank of Scotland Structured Finance has led the UK market for number of debt finance deals done over the last ten years. We have over 100 experienced professional staff operating out of ten offices in the UK and three European offices in Paris, Frankfurt and Amsterdam. It is through our teams' commercial, innovative, consistent and relationship-driven approach that we can maintain our market-leading position and provide the best debt packages tailored to our customers' needs.

For more information on structured finance lending, go to http://www.bankofscotland.co.uk/corporate/corporate-corpfin-index.html