PE buying debt
I came across a post talking about CD&R buying the PIK notes for the Cornerstone buyout but I’m confused. Doesn’t this reduce the overall IRR of the deal? Why would they agree to do this (besides the banks having difficulty with syndication/demand)? Is it a case where this is their only hope of doing the deal but they will look to access debt later on?
I’m a student but very keen to learn hence wanted to make a post if anyone has any insights to share. Thank you :)
I am not particularly close to it, but I believe this was their way of plugging up the deal. Optically very low coupon and structurally subordinated at holdco vs the rest of the LBO financing. Heard the banks had issues offloading the senior secured bonds and loan so these PIK notes weren’t going to get syndicated. CD&R also already owned a huge chunk of the equity so acquiring the float here probably served as a double down.
2.99% is unbelievably low, especially for HoldCo PIK - should be interesting as more details emerge. CD&R may have an LP or pocket of capital leveraged to juice the returns. It’s not as if they were marketing them at those rates or would have been laughed off the phone.
What does "acquiring the float here" mean? Thanks in advance.
Makes sense, thank you :)
Maybe the debt fund (if they have one) bought the PIK while the PE fund still had the same equity invested.
Also, banks have been struggling to offload LBO debt and even been selling debt at 80 cents on the dollar in some cases, so CD&R had to do this to get the deal over the line maybe?
They don’t have a credit business afaik, and yes it sounds like this was their way to get the deal done
ah could be that they wanted to get the deal done badly and also do a massive favour to their lenders then
80 for junior maybe. Senior debt are ~89-93 last I checked.
Firstly, it is important to understand the basics of how Private Equity funds usually arrange financing and underwrite their equity investment into deals.
As a market standard, PE funds usually arrange fully underwritten debt. In practice, this means that the underwriting banks are committing to provide the debt for the buyout at a maximum interest of X% but are trying to syndicate the deal at the lowest interest rate possible. In times of rising rates, the one that has the risk of not being able to syndicate are the banks.
In the current market environment, the banks are trying to get rid of these commitments by selling them to debt investors at a discount. This is usually called Original Issue Discount (OID). In normal conditions, this is usually just a part of the financing fees and is anywhere between 0-3%. Currently, there are some deals where the OIDs have reached levels of 15-30%. As a numerical example, this means you can buy $100 bonds yielding 5% for $80 currently. That means you pay $80 now and get $100 back at maturity plus the interest payments inbetween.
These OIDs have led to massive losses for underwriting banks as they are trying to syndicate their deals. For example, Bloomberg recently reported that the losses for the banks on the Citrix buyout are estimated at $1bn.
Currently, the banks are trying to minimise their risk and losses on these deals and sometimes try to work with the acquiring PE fund on a mutually beneficial solution.
For example, the banks reach out to the acquiring funds and offer them the riskiest tranche of the financing structure, i.e. a very junior piece, at a discount. If the fund is still convinced of his investment thesis, they might be interest to buy this piece of paper if the returns on the incremental capital work and they have a pocket of money available. If the money is coming from the main buyout fund, it will usually not be levered and I believe most buyout funds would target at least 20% IRR / 2.0x MOI (as opposed to >25% IRR d/ ~3.0x MoI for equity investments) given the lower risk of a debt piece vs. an equity investment.
Funds might also have other pockets of money available for credit investments, e.g. their own credit arms like Bain Capital Credit, Caryle Special Situations, etc. or a dedicated vehicle set up for these type of events. These credit funds usually have back-leverage available to juice the returns.
In the specific example of Cornerstone, my guess is that the banks offered CD&R a heavily discounted piece of paper which implies a higher yield for CD&R than the 2.99% coupon payment mentioned in the news. The banks will have done this in the hope that while taking some losses on the PIK notes (and giving away these returns to CD&R), they will be able to syndicate the remainder of the book at lower losses, ultimately reducing their losses on the whole deal.
Given that CD&R is the contractual counterparty of the underwritten commitments, this is also an opportunity where the banks can try to renegotiate the terms of the underwrite with the sponsor. However, given the sponsor is a well-educated investor, they will only agree to this if there is some tangible benefit for them.
Very logically explained on your end. Thank you for this, genuinely. Hope you get to enjoy the weekend wherever you are :)
Writing posts on WSO is what some people do to enjoy their weekend 😉
What's your thoughts on the reasoning behind the Institutional Debt Market being shut off i.e., not wanting to buy paper expect at steeply discounted levels (OID in the 80s as you mentioned)?
Is it that the Institutional Market now thinks these deals are too levered / in the wrong industry for a potential recession on the horizon? ... are the Institutional buyers seeing something that a large portion are not?
The Bank Pro Rata market and Private Credit markets are still open for business though the former has a meaningfully lower leverage point appetite and the banks are only going to hold so much levered paper i.e., the former will probably dry up rather soon if the markets in general don't get better.
The high OIDs mentioned in my earlier post are primarily a function of the caps (i.e. the maximum coupon rate) defined in the underwrite from the banks.
Let’s take the example that banks have underwritten 7-year bond for a solid business at 5.0% in January 2022. The 10-year US Treasury yield is up ~1.5% since January (from 1.4% to 2.9%). As a result the investors want to get at least 6.5% now given they wanted a spread of ~3.6% for the incremental risk to the US Treasury.
The expectation of a looming recession might add another 0.5-1.0% to the return expectations of an investor. Then you end up at expected returns of 7.0-7.5% instead of 5.0%.
This yields an OID of approximately 10-15%.
For Leveraged Buyouts, a lot of banks are currently risk off given rates are very volatile and they just burned their fingers which meant heavy losses for them. JPMorgan and Morgan Stanley just reported Q2 losses of ~$250-280m each on loans they held for sale.
Private Credit funds are licking their fingers at the moment and it’s their job to be lending to companies at the right risk-adjusted returns for them. But that definitely does not come in cheap given the banks are not lending to all businesses right now.
I am familiar with Cornerstone (and a lot of recent other event driven deals) and can confirm the HoldCo PIK notes was offered back to CD&R at a heavy, heavy discount (In excess of the range the person above me referenced). Banks are pissed and some did not agree to it and ended up holding it on the balance sheet. The existing capital structure is still in place so you can derive what yield proposition this would have to be with the Senior Uns at 70 cents on the dollar. Though at NC18, the YTC returns is equity+ returns. Sponsors can usually help out banks by offering more flex/shorten tenor/take down pieces or plug tranches, but for a lot of them, their equity is underwater depending on when they announced the transaction so arent too keen to assit.
A lot of banks are burned recently - every bank on wall street is basically on Citrix - but new underwrites have been sweet as banks own the debt in the low 90s / high 80s (w/ the lead getting a juicy "structuring fee"). Interesting you mentioned private credit - its pretty much their market, but hearing a bunch of them (well known jumbo ones) are closed for business for the upcoming months - a number of them have crystalized losses on day one after coming into commitment papers at higher OIDs
Thanks for sharing your insights as well, especially on the specific example.
Interesting on the note re banks and private credit funds - my remarks are primarily from my experience on a recent deal in Europe and things appear different in the US.
Interesting stuff. Thanks for sharing.
Thank you so much for this! I had a few questions, If you don’t mind:
1) “banks are committing to provide the debt for the buyout at a maximum interest of X% but are trying to syndicate the deal at the lowest interest rate possible.”
can you further explain this? What do you mean maximum interest rate? Is the bank instituting that max, or the company, and why is it in place? Also, why would they then syndicate at a lower rate? I’m just kind of confused by this process.
2) “In normal conditions, this is usually just a part of the financing fees and is anywhere between 0-3%”
What do you mean they are “part of the fees?” Are you saying, for example, if the company has to pay $5mm in fees to the bank to raise debt, part of that $5mm goes to cover the OID? Could you please provide an example/more detail? Does the bank pay the difference in OID vs Par value to someone?
Also, how is OID related to bonds trading at a discount? I understand that If the coupon rate is greater than the the “market rate”, then a bond will trade at a discount. Is this unrelated? Is the 5% yield example you gave inclusive of the IOD?
Thanks so much!
Not OP but work in LevFin -
1) Name of the game; banks underwrite a loan at an indicative rate (what they think they can clear the market with, given prevailing conditions). To the extent market is not receptive to the loan / pricing / document, banks negotiate "flex terms" for themselves that allows them to change certain parts of the credit agreement / pricing to sell to investors, without taking a loss themselves. As part of this, they negotiate a pricing cap. Let's say a loan is underwritten at indicatives of L + 500 and 99 - the parties would have also negotiated a pricing cap (i.e. worst case scenario pricing that the company / Sponsor would face to limit downside for them - this is the risk the underwriting bank is taking) of let's say 125 bps (50 as OID). That would yield pricing cap of L + 575 at 97 (happy to talk through that math). Meaning, the Company / Sponsor, in the worst case scenario syndication would face a rate of L + 575 at 97 (assuming it's issued at max OID, certain nuances to this but it's an assumption). However, if the bank is still unable to sell the loan at that price, the bank would face a loss of any pricing worse than an OID of 97 (banks can't exactly pay quarterly to increase the margin - they would just sell at a steeper discount to increase the yield for the investor). Suppose the loan is $100 and clears at 90 (this would happen if investors feel the OID / yield is still too low at 97), banks are taking a loss of $7 and company / Sponsor facing their original OID cap of 97.
2) the Company / Sponsor issues the loan at a certain OID to incentivize lenders to buy the loan. No one really buys loans at par in a normal market - there's always some OID - and it's usually agreed upon at time of underwrite (at 99 in above example, with a max OID agreed in the pricing cap). The Company / Sponsor usually also pays the bank an u/w fee of 2.25% for 1L TLBs.
On last q, OID is related to bonds trading at a discount because on a bond, the underwriting bank can't increase the rate that they have committed to the Company / Sponsor (besides any rate cap they may have). If the bond is underwritten at a cap of 8%, and the market thinks the clearing yield of that issuance is 12%, the only thing that can change is the OID increasing to yield 12% with a cash payment of 8% per annum.
Thanks so much for your help. Quick question: what is back-leverage? Google says that it's when a sponsor finances the equity investment with loans. Is that what you mean here?
Credit funds can usually obtain leverage on their debt investments, known as back leverage. Very simply (using round numbers), if a credit fund wants to invest $100 in a 1L TLB yielding 10%, they can get 1x debt-to-equity leverage on that investment such that the fund would put up $50 of their own money, and $50 of borrowed money at 5%. They collect $10 of interest in any year, pay $2.5 in interest on the borrowed money ($50 * 5%), resulting in $7.5 net interest earned on their $50 investment or 15%.
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