• 084 03/24/2019
    In a control private equity transaction, debt is commonly employed to acquire a business. This debt creates obligations of interest and principal payments that are due on a timely basis. If these payments are not made creditors can take action to recover the sums borrowed by the company. 
    For this reason much of the financial analysis involved in underwriting a transaction will focus on the company’s ability to make timely interest and principal payments. The degree to which a company’s performance can decline while maintaining its debt obligations is an indication of safety. For example, if a company can continue to meet its debt obligations even if revenue declines by as much as 25% it might make investors more confident. 
    To measure this flexibility, a company will be modeled under various scenarios with debt ratios for each projected period. This permits evaluating the business under a variety of different capital structures. On a most superficial basis, debt ratio analysis revolves around a comparison of liquidity or measure of profitability and the debt-related obligations of a company. The simplest approach is to look at the amount of cash a company has on hand relative to the total debt. By subtracting cash from total debt on the balance sheet you arrive at Net Debt. 
    Net Debt

    Net Debt

    The more stable and consistent a company’s earnings, the more likely you are to feel comfortable with a large net debt balance. If a company’s earnings history is volatile, you will likely want to identify a capital structure that allows you to pay down debt quickly. Overall the objective should be to have your cash position grow relative to the amount of debt on the balance sheet. If a company’s net debt position is negative, then you know that you can most likely meet all debt obligations immediately (because you have more cash than debt).
    From this point forward the ratios mentioned are likely to be found in credit term sheets and credit agreements. In addition to the items listed, it is not uncommon for creditors to require that a company maintain minimum levels of liquidity and EBITDA. 
    Debt-to-EBITDA Ratio
    Moving beyond cash on the balance sheet, the most frequently used measure of profitability is EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). The ratio of a company’s EBITDA in any period compared against the total sum of debt on the balance sheet is known as the debt-to-EBITDA ratio. 
    EBITDA provides a proxy for cash flow that facilitates back-of-the-envelope calculations surrounding the amount of leverage a company can comfortably assume. For example, if you knew that a company’s total-debt-to-EBITDA ratio was 2.0x you would likely comfortably assume that the company can easily meet its debt obligations. But if you saw that a company’s total-debt-to-EBITDA ratio was 5.0x it might be reason for concern. Absent some additional information, you really do not have a way to gauge if the company’s capital structure is appropriate.
    Consider for example, that you are comparing leverage ratios for a SAAS business and an asset-heavy transportation business. The former would likely have minimal capital expenditures, but it would not be uncommon if the asset-heavy transportation business had capital expenditures equivalent to roughly 50% of EBITDA. These are very different cash needs, and the discrepancy highlights the need to go beyond back-of-the-envelope math.
    For some additional precision, most credit agreements will include at least two financial covenants: (1) a measure of debt to EBITDA, and (2) the Fixed Charge Coverage Ratio.
    Fixed Charge Coverage Ratio
    The fixed charge coverage ratio is used to measure a company's ability to cover its "fixed charges" (largely debt-related payments but this can include additional obligations as you will see below) due in any given period. Below we will start with a simple visual and expand on this by including the definition a senior lender might use in a term sheet.

    FCCR Fixed Charge Coverage Ratio

    Formula from the image above:
    ( EBITDA – Capital Expenditures – Cash Taxes ) / ( Cash Interest Expense + Scheduled Debt Amortization )
    The Fixed Charge Coverage Ratio gets more precise by subtracting additional uses of cash from EBITDA to get to a closer approximation of cash flow for the period. The logic behind subtracting capital expenditures instead of depreciation and amortization (the “DA” in EBITDA) is that capital expenditures are a cash outflow whereas D&A are noncash items. After that, cash taxes are subtracted to arrive at a better approximation of cash flow. Interest expense is not subtracted, but it can be found in the denominator (interest expense is one of the "fixed charges").   
    To elaborate on the denominator, rather than reference gross debt, this calculation looks at the actual cash required to remain in compliance in each period. Since you are more closely comparing the cash available for debt payments to the debt payments required in each period, a lender typically requires that this ratio remain above a minimum threshold of 1.2x.  
    Example of what you might find in a senior debt term sheet:
    "Fixed Charge Coverage Ratio - Borrower shall not permit the ratio of (a) EBITDA minus the sum of (i) capital expenditures (excluding financed or equity funded capital expenditures), (ii) taxes, (iii) distributions, divided by (b) the sum of (i) cash interest expense and (ii) scheduled principal payments on total funded debt (including capital lease payments) to be less than 1.25x." 
    Notes on FCCR:
    1. It is not uncommon to see capital expenditures described as “unfunded capital expenditures” in the credit agreement. If capital expenditures are “funded” it suggests that additional debt was used to purchase the equipment. The debt raised offsets the cash outflow, and the interest and principal payments associated with this new debt end up in the denominator.
    2. Mandatory Debt Repayment might also be referred to as Scheduled Debt Amortization. The purpose is to include only the scheduled principal payments described in the credit agreement. Any optional repayment of debt would be excluded as would any repayment of debt under a cash flow sweep. 
    3. Finally, lease payments might also be included in the denominator with cash interest expense and debt repayment. 



  • 083 03/03/2019
    This post references an example LOI template, which is available for download. The company described in the LOI is fictional.
    A Letter of Intent (LOI) is a largely non-binding document entered into by the potential sellers and buyers of a company. This document helps serve as a guide for the documentation required to consummate the transaction (the “definitive agreements”). The primary objectives of the LOI are twofold:
    1. Establish a Value: The LOI will describe the total consideration offered to acquire the common stock or assets of the business. In the example LOI available for download you will see that the offer is made on a cash-free and debt-free basis. There is also generally an escrow (see below) and an adjustment for working capital. 
    2. Secure Exclusivity: Once a buyer enters into a LOI, it is their responsibility to engage third party counsel to work towards a close. This is an expensive and time-consuming process. To give the buyer the confidence to proceed with this due diligence, the seller will grant exclusivity for a period of time (“exclusivity period”). During the exclusivity period the company is prohibited from discussing a potential transaction with other parties and is required to conduct its business in the ordinary course consistent with previous practices.
    Beyond these two objectives, a LOI will also typically address the following:
    Capital Structure
    The LOI will state how the buyer intends to fund the transaction. More precisely, it will detail the amount of leverage the buyer intend to secure. This is more relevant if the sellers intend to remain with the company, and even more so if they intend to remain shareholders. More debt raises the risk profile of the business, which should make any shareholder uncomfortable. 
    A portion of the total consideration (Enterprise Value) will sometimes be placed in an escrow account. The funds placed in escrow are held by a third party for a negotiated duration. If at the conclusion of this time period there are no material findings, the funds are released to the seller.
    Employment Agreements
    Employment agreements for key members of the management team will be detailed in the LOI on a very superficial basis. This can range from language including actual figures for salary and bonus to a mutual understanding that both buyer and seller will work towards terms that are acceptable to both parties.
    A buyer will typically want to secure a non-compete in an effort to prevent talented operators from competing with the business when their employment agreements terminate. 
    Conditions to Closing
    A thorough understanding of what the buyer expects prior to close can facilitate the process and eliminate the potential for any surprises. For example, if the business requires a highly specialized facility, the buyer might want to include that they require a long-term lease prior to closing.
    A major priority in any transaction is to reduce exposure to potential for loss. For this reason the buyer will want to detail how they expect to be indemnified by the seller for damages related to certain items. This is accomplished via representations and warranties made in the definitive agreements. 
    Management Fee
    Any fees that the buyer intends to charge either on an ongoing basis or at close are typically described in the LOI.
    PDF of Example LOI: Letter of Intent



  • 082 03/03/2019

    Document available for download at the bottom of this post.

    I once worked on a transaction where every item had been negotiated and all documentation was drafted and in final format, but a single number in the Subordination and Intercreditor Agreement nearly caused the entire transaction to fall apart.

    A disagreement between the Subordinated Creditor and the Senior Creditor on the appropriate number of days for the Standstill Provision threatened to ruin months of work, which would have left all parties with hundreds of thousands of dollars of dead deal costs.

    Up to that moment I had spent little time thinking about this document, but since that episode I always try to make sure the lenders financing a transaction are on the same page long before we are days from funding.

    The purpose of this post is to briefly explain how the Subordination and Intercreditor Agreement governs the rights of the Senior Creditor and the Subordinated Creditor. There is a downloadable PDF file that includes examples of language that you might see in this document to help provide greater context. In summary, the variables to look for in this document are as follows:


    There will be no negotiation surrounding subordination. The Senior Creditor will require that the Subordinated Creditor’s claims on the business are junior to the Senior Creditor until the Senior Creditor has been repaid in full.

    Standstill Provision:

    The Subordinated Creditor will be prohibited from taking any action to enforce payments on the subordinated capital in the event that the Senior Creditor has provided a notice of default. As an example, in the event of a Senior Covenant Default, the Subordinated Creditor might have to wait 120 days before they can act (i.e. exercise remedies available in the Subordinated Note Purchase Agreement).

    Blockage Period:

    The Blockage Period allows the Senior Creditor to prohibit otherwise permitted payments to the Subordinated Creditor for a defined period of time. Items to take into consideration as it relates to the Blockage Period:

    1. The reason for the Blockage Period should be well defined. Is this allowed in the event of a Senior Covenant Default or only in the event of a Senior Payment Default?

    2. The Blockage Period should be limited to a number of days (180 days, for example).

    3. The total number of Blockage Periods should be limited.

    Purchase Option:

    This provides the Subordinated Creditor with the option to purchase the Senior Loan.

    PDF File: Subordination and Intercreditor Agreement Summary



Models are:
A) really boring
B) pretty sweet
C) super important
D) somewhat easy
E) kind of hard
F) fun
G) all of the above



*Answers a, b, c, d, e, f and g are all correct.