Ever since the seminal SunGard transaction in 2005, which marked the beginning of the end for buy-side financing conditions, sellers and PE sponsor buyers, in their pursuit of greater deal certainty, have sought to ensure that the funding conditions of the acquisition financing arrangements mesh, to the greatest degree possible, with the buyer’s closing conditions under the related acquisition agreement. This so called “SunGard conditionality,” combined with the elimination over the years of buy-side financing conditions in virtually all PE deals, the associated evolution of more meaningful specific performance rights for sellers and generally more robust reverse termination fees (RTFs) (from roughly 3-4% of equity value in 2007 to 5-8% today), have made PE buyers substantially more competitive with strategic buyers in the eyes of many sellers. Indeed, in today’s market, SunGard conditionality is essentially so ubiquitous in large-sponsored transactions and now, increasingly, even in middle-market sponsored deals, that any buyer whose financing package does not feature SunGard conditionality in a competitive auction would, all else being equal, be at a disadvantage.
In today’s deal environment, however, sponsors are increasingly competing for deals by deploying existing portfolio companies for follow-on acquisitions, rather than through Newcos backed by the sponsor. But to their surprise, some PE buyers are discovering that their portfolio companies’ debt financing arrangements may not permit them to incur debt to finance a follow-on acquisition on a SunGard basis. This has created the prospect that a portfolio company of a sponsor pursuing a follow-on acquisition may be at a competitive disadvantage to a strategic buyer or a stand-alone sponsor backed Newco.
Happily, we are seeing technology emerge in the market for well advised PE sponsors that integrates provisions into the financing arrangements of their portfolio companies that accommodate SunGard-like conditionality in follow-on acquisitions. Though still nascent, we believe that if current market conditions continue, shrewd sponsors will continue to develop this type of deal technology to strengthen their portfolio companies’ competitive position for follow-on acquisition bids.
Traditional Portfolio Company Financing Facilities
Traditionally, credit facilities and, to a lesser extent, bond indentures of many sponsor portfolio companies have included conditions to the availability of debt financing in connection with follow-on acquisitions by the portfolio company that are in addition to the very limited SunGard conditions. These conditions might include, among others:
- the absence of any defaults under the credit facilities or bond indenture, as applicable;
- the accuracy of all of the representations and warranties in the credit facilities; and
- pro forma compliance with a leverage or coverage ratio.
Typically, each of these conditions has been tested on the date of incurrence of the additional debt (usually the closing date of the follow on acquisition), introducing the risk that circumstances change between signing and closing.
General Market Practice Post SunGard
In the relatively recent past, many sponsors and portfolio companies simply concluded in many cases that the additional conditionality relating to the absence of defaults and the accuracy of representations were, as a practical matter, largely within a portfolio company’s control or otherwise relatively remote risks that a portfolio company could reasonably bear, even if the acquisition agreement did not include a financing condition. Though likely true in most cases, many sponsors found it difficult to completely ignore the potentially disastrous downside risk if these conditions were not met and the debt financing were not available – typically, the payment of an RTF under the acquisition agreement. Moreover, in today’s seller friendly market, even the limited financing risk related to the absence of defaults and the bring down of representations at closing could disadvantage the portfolio company’s bid in a competitive auction.
Sponsors and portfolio companies have often viewed the very “un-SunGard” condition relating to pro forma compliance with a leverage or coverage ratio as a financing condition for a follow-on acquisition as more troubling. This condition introduces financing risk relating to changes in EBITDA of the portfolio company and the target between signing and closing (when the ratio would be tested). This risk is of particular concern in deals with long periods between signing and closing due to regulatory approvals and the like. Depending on the circumstances of any given transaction (e.g., if the cushion to the model is tight or the prospective closing date is sufficiently distant to make EBITDA projections unreliable), sponsors and their portfolio companies may need to arrange for committed financing to backstop the portfolio company’s capital structure in case the ratio test cannot be met at closing. A backstop commitment is a significant transaction expense that any buyer would prefer to avoid. In addition, even if the sponsor and its portfolio company have evaluated the relevant EBITDA risk and are willing to forgo the protection of a backstop commitment, a sophisticated seller will identify the incremental financing risk and insist on getting comfort that the buyer will meet the required ratio at closing.
Today’s “Real Time” Emerging Market
The good news is that, over the last year or so, many portfolio company credit facilities and at least one bond indenture have been upgraded to eliminate some of the risks outlined above. In particular, it has become quite common for recent credit agreements to provide that, if a buyer is drawing on an incremental facility in connection with an acquisition, only those “specified representations” agreed to by the portfolio company and the financing sources providing the new debt (instead of all of the representations) must be brought down at closing, thus, aligning the financing with typical SunGard standards. Alternatively, some credit agreements provide that all of the representations must be brought down at the time of signing an acquisition agreement (when compliance is more clear) and not at closing. In addition, under these credit facilities and the bond indentures of the same portfolio companies, the absence of defaults condition typically is tested at signing of an acquisition agreement, and not at closing, thereby eliminating the risk that a default occurring between signing and closing could prevent the portfolio company from incurring the debt to finance the follow-on acquisition.
These are meaningful improvements over the traditional approach to add-on acquisition financings and can provide portfolio companies with financing commitments that approximate SunGard conditionality.
The even better news is that, though the technology is cutting edge, and thus continues to evolve, particularly in bond indentures, we have been increasingly successful of late in representing portfolio companies in eliminating the EBITDA risk inherent in ratio baskets by providing in such portfolio companies’ financing agreements that if any incurrence ratio must be tested in connection with an acquisition, the ratio(s) may, at the option of the portfolio company, be tested at the time the acquisition agreement is signed instead of at closing. This development allows sponsored portfolio companies to forego the expense of a back-stop financing but still credibly represent to a seller that their financing arrangements for a prospective transaction have SunGard-like conditionality.
Given the recent surge in the volume of follow-on acquisitions, and sellers’ high degree of focus on financing risk since the credit crunch, many sponsors may be surprised to learn that the financing agreements of their portfolio companies impose conditionality with respect to the debt financing of follow-on acquisitions that a seller would typically reject in a normal sponsored acquisition. It is less surprising that well advised sponsors, through the use of evolving provisions like those outlined in this article, are now increasingly able to allow their portfolio companies to enjoy, from a financing perspective, the same competitive profile as a stand-alone financial buyer.