Deal Magic
Some buyout firms are using new deal structures and different credit sources to fill the senior debt financing void.
June 3, 2009
The bank lending market's senior debt vacuum may have ground the leveraged buyout business largely to a halt, but it has spurred some private-equity firms to pursue a more creative approach to structuring deals.
Take Rock Hill Capital Group's recapitalization of SouthWaste Services Inc., a deal announced in May. The Houston buyout firm financed the purchase with an undisclosed amount of equity and mezzanine debt from Brown Brothers Harriman's 1818 SBIC Fund LP. But rather than arranging financing from a third-party lender, Rock Hill went to Houston liquid waste company's current lender, Macquarie Bank Ltd., for some additional debt financing.
"We're spending a lot of time focused on deals that have built-in leverage, targeting situations where there's already an existing relationship from a banking perspective," says Randall Hale, managing director of Rock Hill Capital. "We take some leverage off the company by buying some equity, and in exchange for that, we get some new leverage with new terms."
Hale would not discuss the specifics of the transaction, except to say it marked a departure from the traditional way buyout groups secure senior financing from lenders not affiliated with the target company.
Additionally, Rock Hill relied on a limited liability company unit structure favorable to company shareholders because of its pass-through tax treatment. The structure, according to Hale, infused additional growth capital into the business and restructured its balance sheet.
Bankers say that the dearth of senior debt financing will spur private-equity firms and lenders to work more closely together on transactions.
"Buyers have to be creative. I think you'll see a lot of situations where the buyers negotiate with the lenders to roll over their existing debt," says Adam Sell, a director at Loughlin Meghji & Co., a New York financial advisory firm.
Sell says working with an existing lender or group of lenders offers a less risky proposition for an investor; after all, the target company's lenders are already familiar with the business they have financed. "It's not a new investment decision. ... Having lived with a company through a cycle should give them confidence to stay with a credit."
Putting in new securities that can give a company more breathing room is another option for sponsors to take.
For instance, Sell says he held discussions with executives of one building products company that was highly leveraged. Though the executives had taken cost-cutting measures to improve the company's capital structure, the Loughlin Meghji professional discussed how putting in a slug of preferred equity with a payment-in-kind coupon and warrants could help the business improve its financial position.
The feature would allow the company to defer its interest payments for a specified period - a boon for a company having trouble meeting its debt service.
Rock Hill is not, of course, the only financial sponsor that has executed a deal in an innovative fashion this year.
In April, Javo Beverage Co. Inc. disclosed that New York's Falconhead Capital had invested $12.5 million in the company through a private placement of subordinated notes, paying 10% annually, and 50 million shares of its common stock. The publicly-traded Vista, Calif., beverage dispensing business used the proceeds to retire a $5 million working capital loan from Wells Fargo.
"We did a preferred equity structure where we're at the top of the capital table and have a huge amount of protection." says David Moross, the chief executive of Falconhead, which received a minority stake in Javo Beverage. "It's a win-win for everybody."
In another deal, a private-equity sponsor reached out to different financing sources and created a deal opposite that of the typical leveraged buyout.
ICV Capital Partners LLC announced its purchase of a majority stake in PFM Group in mid May. The New York buyout firm teamed up with the Michigan Employees Retirement System to invest in the Philadelphia company, which manages $35 billion of cash, fixed-income and multiasset class portfolios for municipal and state governments. ICV used senior debt financing from a pair of Pennsylvania community banks, Susquehanna Bank and TriState Capital Bank, rather than the traditional middle-market deal lending sources.
Tarrus Richardson, managing director of ICV, would not elaborate on the deal's enterprise value or financing figures. However, he said that by using community banks, his firm was able to get funding for its target company at around 525 basis points above the London interbank offered rate, compared with the 700 basis points over Libor that regular middle-market financing sources would provide.
The Philadelphia investment bank Griffin Financial Group LLC advised PFM on the transaction and pitched the notion that ICV turn to local funding sources, according to Joseph Harenza, the CEO of Griffin Financial.
"We've consistently been telling private-equity firms that they should look for loans from regional lenders," he says. "We helped them find a substitute for scarce and expensive lending."
The transaction, it turns out, was the inverse of the usual buyout, where private-equity firms fund their acquisitions with up to 70% senior debt and the remainder with equity capital or a combination of stock and mezzanine financing.
By contrast, ICV's purchase was structured with 70% equity and 30% senior debt, according to Richardson.
"In this market, we wanted more certainty to close, more operating flexibility and a ton of opportunity for growth through acquisitions. For a business in asset management, we think a safe and sound balance sheet is super important," he says.
Since PFM is left with less debt, the thinking goes, it will be better able to pursue future acquisitions.
Credit Suisse Group Inc., an investor in ICV's funds, also played a role in the deal by bringing the Michigan Employees' Strategic Opportunity Fund LP into the transaction, Richardson says.
The pension fund investment vehicle's contribution made up about 20% of the transaction's total equity contribution, which also included some preferred stock.
"If you're going to buy market-leading businesses, one way to do that is give up your upside return for some downside protection," says Richardson.
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