Financing deal terms – traditionally the preserve of the European syndicated large-cap and upper-mid cap sponsored acquisition finance markets ( >£150 million debt) – have for some time been filtering down into the (often less liquid) mid-market. However, in another sign of sponsor, and vendor, strength in the current acquisition financing market, we have been observing financing processes of a type more frequently encountered at the upper end of the acquisition financing markets being adopted further down the deal size spectrum.
In this update, we take a look at the evolving nature of certain funds bid financing in some mid-market acquisition finance transactions.
Unsurprisingly, vendors (in particular private equity (PE) exiting a buy-out) and their advisers will wish to ensure certainty of funding from potential purchasers, be they trade or PE. Where all or part of the proposed consideration for a transaction is to be debt-funded, vendors will need to be comfortable that the debt proceeds will be available at completion. This gives rise to a natural tension between the needs of the financiers making that acquisition debt available on the one hand, and the sponsor/borrower and the vendor seeking certainty of funding on the other. Lenders will be concerned to ensure that they will not be required to make new financing available in circumstances where the credit profile of the bidder or the target group is no longer that on which they have based their investment thesis and credit sanction. This might in an extreme scenario be the case where there is a perceived 'technical' default, or where there is a change in the debt markets or something else beyond the control of the sponsor.
In many cases in the current market – characterised by plenty of liquidity chasing few assets – a vendor will be able to put much of the risk of failure to deliver funding at completion on to the sponsor/borrower. This is done through the SPA which, upon signing, places all the risk on to the purchaser.
But many vendors are seeking to make bid processes even more competitive as between aspiring buyers by assessing the strength of bids at an early stage in the bid process. This means a sponsor looking to debt-fund a buy-out will need materially to bolster its debt commitment to remove funding uncertainties. It will also need to demonstrate that it can do so at an earlier stage in the process than it or the lender might like, when there is little certainty around the bid ultimately being successful.
"Certain funds" in financing arrangements
"Certain funds" clauses – which limit the number of provisions in a leveraged finance loan agreement that can be used by a lender to refuse to fund an acquisition – are nothing new. The genesis of these clauses can be tracked back to the public M&A markets: in the UK, the City Code on Takeovers and Mergers (the "Code") prescribes that a bidder must only announce a bid after ensuring it can fulfil in full any cash consideration requirement in relation to that bid, and further to taking all reasonable measures to secure the implementation of any other type of consideration. A financial adviser must also confirm that funding will be available for the bidder to pay the purchase price for, and therefore to complete, the acquisition. In order to give such confirmation, the financial adviser will require that any debt financing be provided on a "certain funds" basis, meaning that it must not be subject to any financial conditions outside the bidder's control, other than regulatory clearances.
Sellers have long since adopted the certain funds approach in private M&A transactions (irrespective of the jurisdiction of incorporation of the target), particularly in the PE space. The Loan Market Association's form of leveraged finance loan agreement contains optional drafting for certain funds provisions. Whilst in some cases the absence of the Code regime means the certain funds analysis can be a little less stringent, for the most part a strong, well-advised sponsor will in the present market be able to negotiate acquisition financing terms with very few 'outs'.
European certain funds package
However, these provisions only apply once a facilities agreement is executed – which requires full financing terms to have been agreed. They also do not provide total coverage. For instance, documentary conditions precedent still need to be provided in a form and substance satisfactory to a lender/mandated lead arranger.
In the public M&A market, this is less of an issue, as providing long-form documentation to support a bid remains the norm. The position can be different in the European private large cap LBO market, where an increasingly common way to address this risk is through a formal commitment letter, rather than requiring a fully executed loan agreement. That commitment letter will typically append a detailed term sheet that could run to over 100 pages and will specify any conditions that remain to be satisfied before the financing will be available (as well as confirm credit committee approval, etc). To the extent delivery of documentary CPs is a condition, the commitment letter will typically go on to specify, line by line, the (confirmed) status of those CPs. It may allow a degree of 'wiggle-room' in light of the early stage of the bid and hence the number of potentially moving parts. A separate CP status letter might be used to report on status. This might include 'bidco' group security, corporate authorisations and legal opinions, as well as commercial CPs such as the diligence materials, model and, of course, the SPA. All of these items will need to be negotiated in short order.
A vendor may also require the bidder to deliver a short-form, short-duration interim loan agreement to support the bid. This is intended to fill in any residual gaps that may result from the commitment letter containing an agreement to negotiate in good faith any terms not detailed in the term sheet in the long-form documentation. The idea being that, if disagreement were to arise in full documentation – which would be very unlikely given the detailed terms already agreed and the reputational inertia to conclude the agreement – the short-term loan could be called upon to complete the acquisition (albeit leaving the sponsor with the 'bridge' financing to discharge). Together, the European certain funds package outlined above provides watertight assurance for vendors.
The full European certain funds package may provide assurance to vendors, but the legal spend and resource allocation to deliver a binding commitment, on what is often a very tight timeline, are significant. For a sponsor or potential lender/arranger, the cost will not be much less than that of negotiating full documentation. And, if the bid were to be successful, the overall cost is likely to be materially higher than taking a single-step approach. There is also an added burden to the vendor of conducting certain funds analysis on multiple bidders.
These costs have in recent times been something bidders have been willing to absorb as a cost of doing business in the large cap LBO markets. However, until very recently, the mid-market (especially at the lower end) has not typically supported such an approach. The perception has been that the cost, relative to the overall deal size, is disproportionate (and negatively impacts the bid price). The relatively benign economic landscape, and the ability to complete debt and equity for a 'standard' UK buy-out debt at more or less the same time, has traditionally tipped the scales in favour of only requiring the debt commitment to be finalised, on customary terms, in line with finalising the SPA and equity arrangements. Until then, a lesser form of commitment or comfort from a bidder would usually have sufficed.
So, from our perspective, it is a significant shift to have seen this approach being adopted in secondary buy-outs for businesses with an enterprise value in the £100 to £150 million range. If strong liquidity prevails in the debt markets and this practice becomes more widespread, this could lead more bidders using equity commitments to support bids ahead of implementing a leveraged refinancing post-completion.