Debt financing UK takeovers: key concepts and considerations for sponsors

October 2023  |  SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

October 2023 Issue

According to data from S&P Global, continued strong demand for private capital products increased private equity’s pool of committed capital to a record $2.49 trillion globally by the end of H1 2023.

This record dry powder level – which represents an increase of over 10 percent when compared to the global total of $2.24 trillion at the end of 2022 – comes at a time when M&A activity is subdued and there has been a significant slowdown in sponsor-backed transactions.

While a number of factors – including global economic and political uncertainty, rising interest rates, soft leveraged loan and high yield bond markets and increased scrutiny from global regulators – have driven this slowdown and continue to create headwinds, the scale of committed capital means that sponsors are under increasing pressure to find opportunities for deployment.

Under-deployment not only leads to reduced assets under management (which results in reduced management income and performance-related fees) but also jeopardises a sponsor’s ability to raise funds as they are unable to demonstrate a strong track record of putting investors’ money to work.

Against this challenging backdrop, one area that has continued to offer opportunities for sponsors is UK takeovers. While down from its 2022 peak, the US dollar has appreciated significantly against the pound in recent years. This trend, combined with UK equity market valuations that are low when compared with developed market peers, has meant that sponsors (particularly those with US dollar denominated funds) have been able to navigate the prevailing headwinds and find value in the UK public-to-private market.

If, as many anticipate, the debt markets continue to strengthen later in the year, we expect to see a further uptick in sponsor-backed UK takeovers, particularly large-cap takeovers which have been significantly hampered by recent debt market dynamics.

While the approach is fact specific, as the market improves there are a number of key concepts and considerations that sponsors looking to finance UK public-to-private transactions should keep in mind. A sponsor’s ability to swiftly and smoothly execute a takeover when the opportunity arises – and crucially get some of that accumulated dry powder out the door – may depend on it.

Cash confirmation requirement

The City Code on Takeovers and Mergers is a set of principles and rules which apply to UK takeover offers. The code is issued and administered by the Panel on Takeovers and Mergers.

Where an offer is for cash or includes an element of cash, the code requires that the bidder’s financial adviser confirm in the offer announcement that the bidder has sufficient resources to satisfy full acceptance of the offer (the financial adviser may be required by the panel to provide any shortfall in the cash consideration itself if it did not take reasonable steps to assure itself that funds are available).

As a result, the financial adviser will require that all debt financing documents be fully negotiated and executed prior to the offer announcement. Such documents may take different forms, but on a sponsor-backed takeover will typically comprise commitment papers for the full form facility agreement combined with an ‘interim facility agreement’, which is a short form facility agreement with a relatively short maturity date which is technically fundable but not intended to be funded. The full form facility agreement will then be negotiated and executed after the offer announcement and ultimately used – alongside sponsor equity – as the source of funds for the takeover.

Additionally, the financial adviser will typically require that at announcement: (i) any financing be available on a certain funds basis; (ii) all lender approvals, due diligence and know your customer checks be satisfied and that all documentary conditions precedent to the financing be satisfied or, if incapable of prior satisfaction, be in agreed form (other than those solely in the bidder’s control); (iii) a detailed sources and uses statement be agreed, showing the maximum cash consideration payable and matching funding sources; (iv) any foreign exchange mismatch be addressed; and (v) the bidder enter into a ‘representation letter’ containing representations and undertakings as to the nature and conduct of the offer and the financing.

Certain funds

Broadly, ‘certain funds’ requires that the bidder’s financing is fully fundable. In particular, provisions in the facility agreement will suspend the consequence of many defaults for a prescribed ‘certain funds period’ (sized taking into account the anticipated timetable for the offer), meaning that even if they do occur the lenders are still obliged to fund at completion – only limited drawstops will apply.

Similarly, the lenders’ other rights to take action that would typically arise absent the certain funds provisions (such as accelerating any drawn loans and cancelling any undrawn commitments) are suspended during the certain funds period.

Major representations, major undertakings, major defaults, illegality and change of control are the residual trigger events accepted by the market as being sufficiently material so as to justify a drawstop during the certain funds period, and their precise scope varies from deal to deal. As an overarching matter, sponsors should keep in mind that: (i) drawstops should only be included if they would otherwise typically constitute a drawstop under the relevant financing, for example on a New York financing there is no need to introduce additional European-style drawstops (other than offer-related undertakings) simply because the financing is provided in the context of a UK takeover; and (ii) anything which relates to the target group must not be included as a drawstop, as prior to the closing of the offer the actions of the target and its group are not within the control of the bidder.

Offer-related undertakings

Lenders under any new facility entered into in connection with a takeover will often seek some degree of control over how the bid is conducted. Relevant undertakings typically build in flexibility for the bidder to switch between a contractual offer and a scheme or arrangement and to modify other terms of the offer (such as the price per share) within limits.

Broadly, the range of outcomes is as follows: (i) virtually no control (for example, an undertaking that the offer will be carried out in compliance with applicable law is included but very few (if any) other controls are granted to the lenders); (ii) minimal control (for example, additional undertakings which regulate price increases or changes to minimum acceptance threshold are also included); and (iii) substantial control (for example, further undertakings are included such as to keep lenders informed of material developments, deliver copies of offer-related documents when dispatched, impose restrictions on amendments to the offer documents and impose requirements relating to the de-listing and re-registration of the target).

A critical question will be whether the undertakings specify the minimum acceptance threshold that must be achieved in the context of a contractual offer. The key percentage thresholds are: (i) 50 percent plus one share, at which level the bidder obtains statutory control of the target and can pass ordinary resolutions; (ii) 75 percent, at which level the bidder can de-list and re-register the target as a private company (which is required for the target to grant any security and guarantees) and pass special resolutions; and (iii) 90 percent, at which level the bidder can compulsorily acquire the remainder of the shares via a statutory squeeze-out procedure so a 100 percent acquisition is certain.

Where parties come out on the offer-related undertakings varies from deal to deal and is often subject to extensive negotiation, with many sponsors pushing hard to achieve maximum flexibility on these key elements.

Publication of documents

The code requires that the bidder publish on a website unredacted copies of all debt financing documents entered into in connection with the offer by noon on the business day following announcement. This includes any commitment letters, fee letters, interim facility agreements and – most importantly from a sponsor’s perspective – flex and syndication letters. While flex arrangements are required to be disclosed, the panel will consider requests to extend the disclosure deadline for such arrangements on a case-by-case basis. How this extended deadline interacts with the syndication timetable will be a key question for sponsors.

Syndication

Practice Statement 25 (PS25) sets out how the panel suggests a syndication process be run so as not to breach the code during an offer period. Broadly, PS25 envisages that syndicatees will either put in place information barriers or enter into a standstill. Importantly, where a syndicatee lacks experience in dealing with UK takeovers, PS25 provides that additional enquiries regarding any information barriers should be made.

While responsibility for compliance with PS25 rests with the bidder’s financial adviser and the arrangers, in practice, given their interest in achieving a successful syndication, sponsors often expect to be involved in the PS25 planning process. This is particularly the case on cross-border financings where syndicatees may lack experience in dealing with UK takeovers and a tailored approach PS25 compliance can have significant advantages.

Foreign exchange issues

A foreign exchange mismatch (for example, where the debt financing is denominated in US dollars and the purchase price is payable in sterling) is a cash confirmation issue because, if not addressed, any post-announcement foreign exchange rate deviations can result in a shortfall in the cash confirmed financing source. As such, foreign exchange issues cannot simply be left until after the announcement.

Sponsors typically approach foreign exchange in one (or a combination) of the following ways: (i) headroom via debt financing; (ii) forwards; (iii) options; or (iv) deal-contingent forwards. Deal-contingent forwards are generally considered to be preferable, but each approach has its benefits and drawbacks and may be difficult to implement on short notice. Accordingly, it is important for sponsors to consider early in the process how any foreign exchange mismatch is intended to be addressed and agree an approach with the financial adviser.

 

Aaron Ferner is a counsel, and Claudia Herron and Joshua Bunn are associates, at Davis Polk & Wardwell London LLP. Mr Ferner can be contacted on +44 (0)20 7418 1332 or by email: aaron.ferner@davispolk.com. Ms Herron can be contacted on +44 (0)20 7418 1032 or by email: claudia.herron@davispolk.com. Mr Bunn can be contacted on +44 (0)20 7418 1066 or by email: joshua.bunn@davispolk.com.

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BY

Aaron Ferner, Claudia Herron and Joshua Bunn

Davis Polk & Wardwell London LLP

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