LBO capital providers & the underwriting process
Reading Rosenbaum & Pearl's IB book, and trying to wade my way through a point of ambiguity. My background isn't fin, I'm sure the following structure / content of questions will make that clear.
In terms of where the capital is coming from that is going to the sponsor in exchange for the debt securities, is all of the capital coming from the IBs? So the risk that the IBs now have is "shit, I've got a huge chunks of debt on my books that I might not want from an investment perspective, so I need to sell these (dear god, let me sell these)." I feel like I'm missing some other risk here that the IB is assuming when it is underwriting the debt.
Additionally, I get a little jumbled about the capital provider when it says that Bank and Institutional are providing capital for the revolvers and term loans. I feel like it is wrong to assume that they are giving money to the IBs who are turning around and giving it to sponsors.
Any clarity, a walkthrough or story of the process is greatly appreciated.
I'll try to be brief and elementary to help you put the pieces together. Note, you shouldn't expect to understand transactions right away. It's a learning process. First step, forget EVERYTHING you think you know about investment banking, including what you read in the media (that much is clear).
Investment Banks simply advise either the company ("target") selling itself (called sell side advisory) or the company ("strategic") / investor ("private equity") looking to acquire the "target" (called buy side advisory). Most of the book focuses on sell side.
If the acquisition is made by a "strategic" (generally another company / corporation), it typically gets financed via some combination of cash and common stock (meaning the buyer gives shares to the seller for the rights to its company), all cash, or all stock. This isn't always true, but for simplicity's sake, let's start with it.
If the acquisition is made by a private equity company, the transaction is funded by a combination of equity (think of it like cash) and debt. The equity generally comes from the private equity firm's capital base, which consists of investments that were made into its fund for the purpose of allowing the private equity group to buy and sell companies (again, not always the case, but trying to be rudimentary here).
The remaining funding comes from banks and other lenders, in the form of credit or loans.
The easiest analogy is buying a house. When you buy a house, you have to put up a down payment (equivalent to private equity fund's equity) and the rest is financed by a mortgage (equivalent to loans or debts).
The investment bank in this case, simply advises the buyer and seller (real estate agent) on the value of the house (company, in our case).
This isn't complicated nor is it a "point of ambiguity". Banks lend some money, but they aren't in the business of making multibillion dollar loans for LBOs, so they mainly help find investors who are and get them to buy the bonds/loans.
The sponsor puts in some cash/equity (call it 20-30pct), banks lend some money, and other investors lend the rest.
Scenario 1: Private equity needs $100 to LBO a company. Bank structures $20 revolver (unfunded) and $100 term loan (funded) to fund the $100 purchase price.
The bank can structure this deal as either best efforts or bought.
Best efforts Scenario 1: Bank will make a best effort to structure a $20 revolver (unfunded) and $100 term loan (funded). It has no obligation to deliver the full amount. First step in the simplest sense is to negotiate engagement letters and term sheets. After that is done, bank will make best efforts to find investors to commit to $20 revolver and $100 term loan. Because revolvers are often unused and perceived to be more "secure", one or many banks will commit money to it. Term loans will attract different type of lenders/investors such as CLOs, hedge funds, etc. They will commit money to it. If all goes well, bank receives enough orders to "fill the books", make allocations, and provide a $20 revolver and $100 term loan (funded) to the private equity to LBO the company. Because it's best efforts, the bank does not guarantee the full $20 revolver and $100 term loan and the deal will either get downsized or pulled.
Bought Scenario 1: Bank is committed to structure a $20 revolver (unfunded) and $100 term loan (funded). It is obligated (well not really but let's keep it simple) to deliver the full amount and fund any shortfall. First step in the simplest sense is to negotiate commitment/fee letters and term sheets. After that is done, bank will find investors to commit to $20 revolver and $100 term loan. Bank will need to find lenders/investors for the $20 revolver and $100 term loan. If it cannot "fill the books" bank is on the hook for funding any shortfalls. Because it's bought, the bank guarantees the full $20 revolver and $100 term loan and the deal gets done.
thanks banker00, very clear.
I'm curious: who are the types of investors lining up to finance (a) junk debt, (b) revolvers, (c) any other types of typical IB-sourced debt?
a) Mezzanine/sub debt funds, hedge funds, mutual funds, insurance companies (i.e. Prudential), other asset managers or investors looking for high-yield fixed income
b) Banks or other senior lenders (i.e. GE Capital, Capitalsource)
c) same as "A"
Hedge funds, mutual funds, insurance companies, pension funds...
typically banks will lend to revolvers given these instruments are normally unfunded and closer to the assets or more secure. this is a key factor because banks can put aside less capital. banks will also lend to revolvers to get a bigger piece of the deal, build relationships, and secure future revenues.
term loan investors are hedge funds, clos, cdos, etc as the above posters mention. given term loans have nominal amortizations, longer tenor, and hence higher yields these instruments attract such lenders/investors. lately you'll find increasing appetite for such instruments due to the fact there isn't a lot of place to find such yields.
It's also important to know that a Rev, TLA and TLB all have the same seniority with regards to claims on the collateral the deal is secured against (and they're usually all governed under the same CA). The reason that the Rev/TLA are lower risk and priced tighter is shorter maturity (usually 5 years) vs a TLB (usually 7 years) and the TLA will have a heavier amort schedule (7.5% / 7.5% / 15% / 15% / bullet or something similar) vs a TLB (1% a year with bullet at maturity) so the weighted average life of the debt is a lot shorter and this carries less risk. TLB's can also be covenant lite and therefore have no max leverage ratio, interest coverage, etc.
Banks are also term loan investors/lenders that come into play if bonds aren't available (i.e. MM companies).
Banks actually don't really like holding revolvers unless they're going to be funded. The "pro rata" market is comprised of the revolver/term loan A structure. The reason it's called "pro rata" is because each institution that come into this part of the cap structure is given their "pro rata" share of the revolver. Unfunded revolvers still require capital to be held against it yet you're getting next to no return especially if its unfunded. The banks really want the TLA piece since its funded, shorter tenor than a TLB, and has higher amortization than a TLB would.
Just wanted to clarify
why would banks like funded revolvers?
They're going to have to hold capital against it regardless of if its funded or not, and on an unfunded revolver you're only earning the commitment fee which is like 20 - 35 bps in today's market so you're getting killed from a cost of capital standpoint. Since banks are so flush with cash they're lookin for more funded assets in order to earn a return so holding an unfunded revolver really doesn't do anything for them. Revolvers in general are priced so tight that most banks lend to a revolver mainly on a relationship basis and to drive ancillary business (treasury management, lead on a future transaction, etc). That's one of the reasons the big balance sheet banks have such high market share in leveraged finance, they can take down big chunks of the pro rata piece of the cap structure thus improving the relationship and allowing them to be like "hey, we took down 30% of your revolver on the last deal so let us lead your new HY notes offering" which is a much bigger few event.
agree with your point that revolvers serve as loss leaders to build relationships and secure revenue streams. still doesn't make sense why you think banks lending to funded instruments is an optimal strategy. yes even unfunded revolvers require capital commitment but funding increases that RWA capital requirement quite dramatically which minimizes your effective yield which is why banks typically don't lend to funded instruments such as term loans unless they really have to. lending is a capital intensive business and capital is finite. once you reach a limit, you would need to forgo business, wind down, or chase smaller deals (smaller revenues). smart lending is primarily an originate to distribute business and the idea is to maximize returns by minimizing capital from getting tied up in low yielding instruments while preserving capital ammunition to continue chasing deals. lastly why would a client agree to launch a funded revolver deal in the first place when they can just do a term loan for the same price while maintaining back stop liquidity?
Understand the point on increasing the RWA with it being funded and what not. On my desk we're pushing for more funded assets in the TLA space. If you're sitting on a bunch of liquidity like banks are now, you want to earn something on the $ as opposed to 0 which is what's happening when you have the cash just sitting there. I'm not close to the actual credit underwriting process side of things (on the origination and structuring side of it), but basically every time an institution wants to lend to one of these deals they go through a credit process where they look at the risk of the deal and see if the returns clear the hurdle rate for the given asset, so when it gets approved we're saying that it's a worthwhile use of capital.
In terms of funded revolvers at close, it's really situation specific and there are a lot of different dynamics at play. From the client perspective, the revolver provides a lot of flexibility and a low cost of capital. If I can go out and fund an acquisition with 300MM of revolver draw on a 500MM facility at L+150 when I don't think I'm really going to need the excess liquidity, why would I go issue a TLB at L+400 @ 99 with a 1.25% floor? Also you can always go out later and raise incremental TL or bonds to pay down revolver, increase liquidity and lock in fixed rate longer term financing. Granted a TLA would be priced the same, and a large majority of the time you're going to use the TLA to fund the large majority of whatever it is you're using the proceeds for with minimal draw on the Revolver but there are also cases where a client will only use the rev to fund whatever it is they're doing.
Quick questions (recently moved to US from Europe).
Do US RCFs not include clean down clauses?
Also, are RCF commitment fee pricing not typically 50% of the margin?
Oh, also with regards to the finate capital piece of your comment, yes that's very true. But if you're a JPM or a BoA, not really at the top of your worry list at the moment haha
appreciate the insight. and you'd be surprised that BBs are focusing more on capital usage as of late.
No problem. Yeah it definitely ebbs and flows, but that's the financial industry for you
Sorry to keep blasting comments, keep getting distracted between work and this. Banks are more or less the only lenders to Revolvers and Term Loan A's (pro rata market = banks. TLB, 2nd lien, etc. = institutional market = your clo's, insurance companies, asset managers, etc.) so plenty of funded assets being held by banks.
what does "funded" or "unfunded" exactly mean?
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