Developing trends in private equity financing

September 2022  |  SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

September 2022 Issue

While debt markets have cooled in 2022, two important trends in private equity financing have gained steam. The first, in the new issuance context, is the continued rise of ‘direct lenders’, which have now taken on lead financing roles in midsize and mega leveraged buyouts (LBOs) alike. The second, in the ‘liability management’ context, is the increasing frequency of partnerships between creative borrowers and creditors to raise capital and reduce liabilities.

Whether these trends continue, or whether the former ultimately curtails the latter, remains to be seen.

Direct lending: the new kid on the block grows up

In contrast to traditional banks, which syndicate their debt commitments to the broader market, direct lenders are private investment funds that raise committed capital, make concentrated debt investments, and hold them for the long term. Initially most prevalent in the middle market, in recent years direct lenders have taken on increasingly larger deals.

Direct lending commitments have historically tended to be more expensive than those from traditional banks. In exchange, direct lenders can offer sponsors greater certainty of economic terms by providing commitments without ‘market flex’ demanded by traditional banks. Direct lenders have also been less constrained by some bank lending conventions. For example, in technology LBOs in particular, direct lenders have carved out a niche by lending against ‘recurring revenue’ rather than traditional earnings before interest, taxes, depreciation and amortisation (EBITDA) metrics.

During the first half of 2022, facing inflation and credit quality concerns, leveraged financing markets have been what participants call ‘unconstructive’. Rates and spreads have risen sharply. Commitments from traditional banks have become more expensive and subject to more onerous ‘flex’ terms, as traditional banks have found themselves stuck holding, as of this writing, approximately $80bn of commitments that they have been unable to sell to the market, or able to sell only at a loss.

Direct lenders have not been immune to the market conditions, and, like syndicated loans, direct loans have become more expensive. But everything is relative, especially in the financing markets, and the direct lending pullback has been less severe than that in the traditional syndicated markets. As a result, the pricing difference between traditional bank commitments and direct lender commitments has collapsed, and in some cases direct lenders have become the cheaper option. The resulting market impact has been swift.

A case in point. In late June 2022, in one of the biggest LBOs announced this year thus far, Zendesk agreed to be acquired by a private equity consortium for about $10.2bn. To fund the deal, the consortium obtained roughly $4bn in debt financing commitments from direct lenders, constituting one of the biggest direct lending commitments in LBO history. Zendesk is not an anomaly – five of the 10 largest LBOs announced in 2022 have been funded, at least in part, by direct lenders.

It remains to be seen whether, when calm markets return, traditional syndicated markets revert to being the cheaper option for most borrowers. But for finance specialists at private equity financing firms, one thing is clear: direct lender relationships have become a critical component of the Rolodex.

Liability management transactions: the modern dynamic

Distressed ‘liability management’ situations are evolving in consequential ways. While such situations have long been the realm of sharp-elbowed negotiations, historically each distinct class of creditors (whether secured versus unsecured or 1L versus 2L) tended to play the game as a team sport, with each class protecting its interests from, and looking to gain an edge on, the other.

But high-profile transactions have fundamentally altered this dynamic. Today, the winning creditors in a liability management transaction are usually the informal group that was most creative and flexible in proposing capital solutions to the borrower. The losing creditors are usually those that were not swift, decisive or lucky enough to be on the winning team. In many cases, the winners and losers started the game as holders of the same class of debt, highlighting the importance of close monitoring of these situations as they evolve.

Perhaps the ‘big bang’ of this modern dynamic was the 2017 J. Crew transaction, wherein J. Crew contributed valuable IP assets to an ‘unrestricted subsidiary’, raised attractive financing at the unrestricted subsidiary from a select group of lenders, and then used the proceeds of that financing to address looming liabilities that J. Crew would otherwise have struggled to address. The dynamic gained further speed with 2020’s Serta transaction, in which Serta and a group of existing lenders holding a majority of Serta’s loans agreed to: (i) provide new financing on a ‘first out super senior’ basis; (ii) exchange existing loans into ‘second out super senior’ loans; and (iii) amend existing credit documents to permit the previous two parts, over the objections of the minority, non-participating lenders.

In both J. Crew and Serta, litigation swiftly ensued (and in the latter, it remains ongoing two years later). But J. Crew and Serta have become an established part of the financing lexicon, and financial sponsors continue to develop similar, and more sophisticated, transactions to address tight liquidity situations and capture the deep discounts reflected in leveraged loans or bonds.

Take, for example, WESCO International’s recent liability management transaction. WESCO effectively conducted the Serta transaction, with a twist. In Serta, participating lenders held a majority of the existing debt, enabling them to approve the necessary amendments to permit the exchange. In WESCO, however, the consenting lenders did not initially have the required majority. To overcome this hurdle, WESCO used existing flexibility under its credit agreement to turn the friendly, participating lenders into the majority by issuing to them the requisite amount of additional loans.

While relevant litigation outcomes have been somewhat mixed, there have been enough decisions in favour of borrowers and ‘winning’ creditor groups to keep the momentum going. In early July 2022, the Delaware Bankruptcy Court ruled in TPC Group that a priming transaction effected in tandem with a majority of existing creditors was not prohibited by the four corners of the agreement, with the court stating bluntly that to the extent “holders want to be protected against self-interested actions by borrowers and other holders, they must include such protections in the terms of their agreements”.

As a result of this modern dynamic, in distressed liability management situations, the drafting of relevant debt documentation has become more critical than ever. Borrowers in such situations should comb through their documents to understand the full menu available to them. Lenders should be nimble, constructive and open-minded; being a user-friendly first mover, bringing both a willingness to provide capital and the ability to think creatively, is likely to be rewarded – and the opposite approach is likely to yield opposite results. Both parties should recognise that loan documents may permit actions not expressly contemplated at the time they were executed but which nonetheless create strong points of leverage for the borrower or a group of lenders.

What will the future bring?        

Whether these two trends in direct lending and lender relations continue apace remains to be seen. It is possible that the former will begin to have an effect on the latter. If capital structures are increasingly held by a relatively small number of concentrated direct lenders, will there be reason or room for these types of liability management transactions? If direct lenders continue to win market share, will they push to ensure that future debt documents are more restrictive of the types of liability management transactions increasingly seen under the modern dynamic? Time will tell.

 

John R. Sobolewski is a partner and Benjamin S. Arfa and David G. Sheinfeld are associates at Wachtell, Lipton, Rosen & Katz. Mr Sobolewski can be contacted on +1 (212) 403 1340 or by email: jrsobolewski@wlrk.com. Mr Arfa can be contacted on +1 (212) 403 1310 or by email: bsarfa@wlrk.com. Mr Sheinfeld can be contacted on +1 (212) 403 1067 or by email: dgsheinfeld@wlrk.com.

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BY

John R. Sobolewski, Benjamin S. Arfa and David G. Sheinfeld

Wachtell, Lipton, Rosen & Katz

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