Expectations for lenders are high, as private equity firms seek the best financing options for deals. The pressure from PE is pushing lenders to provide less-traditional, more-varied financing structures, giving private equity firms a wide range of options. In the past, PE firms were conditioned to accept more traditional products. Lenders didn’t have to provide creative loan structures, because there wasn’t any demand for them.
But when the recession hit, lenders were forced to innovate to create more yield, and that search has continued in the recession’s wake. The trend lives on because many private equity firms like the full menu.
“When we’re competing for financing in an auction, many sponsors will ask for these structures,” says Heath Fuller, a managing director at Chicago lender NXT Capital. “Sponsors know there are many financing options out there and want to evaluate alternatives to find the optimal financing for a platform,” Fuller says.
More traditional deal structures, such as senior, senior stretch, unitranche, second lien, mezzanine and first-out last-out, are still used, very actively. But lenders are also providing swapping-lien structures, PIK Toggle loans and other less-traditional products that they developed originally as part of the hunt for yield, and now those products are requested by PE firms as a matter of course during the M&A process.
Swapping-lien structures, or bifurcated collateral structures, which aren’t necessarily new, allow one lender a lien on the current assets, and another lender a lien on the non-current assets. PIK Toggle loans allow the borrower to elect for interest to be capitalized, which means that the interest will be paid by incurring additional debt.
“This trend is now being driven less by the lending community and more by private equity firms with an appetite for seeing a whole menu of financing options,” Fuller says.
Private equity firms, in an attempt to maximize the amount of debt they can get on day one, are also considering a structure with what Fuller calls a “top off guarantee.” In that type of loan, the private equity firm offers a guarantee to entice a lender to provide additional leverage on a deal. The guarantee is extinguished when the company reaches the level of leverage that the lender would have provided without the guarantee. If a lender is willing to provide six times leverage, for example, the private equity firm will provide a temporary guarantee for another half- or three-quarters turn of debt, and the guarantee goes away once the leverage on the business goes down.
For more, watch, Rising Deal Flow Puts Upward Pressure on Lenders, says Jeri Harman.