LBO: Optional Debt Repayment
I have a few questions on optional debt repayment in an LBO (i.e. you’ve made your mandatory debt repayments and have excess cash to prepay some of the principal on outstanding debt). All of the LBO materials I’ve reviewed say that in this instance, you should repay your revolver first, followed by Term A loans and then Term B loans.
1. Why do you repay the revolver first? If you have a Term B loan with 7% interest vs. a revolver with 5% interest, wouldn’t you want to pay off the Term B loan first since the cost of carrying that debt is higher?
2. Along the same lines, if you have both a Term A loan outstanding at 5% interest and a Term B loan outstanding at 7% interest (no outstanding balance on your revolver), and you have excess cash for an optional repayment, can you repay the Term B loan first or are you required to pay the more senior debt first?
First thing is the Revolver and Term Loan B are typically of comparable asset coverage and usually carry the same interest rate, so that first point is moot.
Second, you repay the Revolver because that is meant to be a working capital line. And if you think about it the Revolver is incidentally "revolving"... so if you pay it down, you can always re-draw it if you'd like some more capital. If you pay down the Term Loan, you can't redraw it... which is obviously less desirable as a sponsor you want to maximize your liquidity and not irreversibly reduce your financial leverage unless you absolutely have to.
Third, Term Loan B = Term Loan Bullet, Term Loan A = Term Loan Amortizing. The Term Loan A has a specific amortizing schedule and one of the reasons thats the case is because its generally paper that's held by "non-traditional" holder's of that paper.... i.e., the banks that are doing the financing or specifically investors of TLA paper. The waterfall of repayment / cash sweep associated with bank debt is typically explicit in the credit agreements to ensure: (a) the asset coverage of the paper doesn't change materially and unjustifiably through the life of the loan (b) no additional paper benefits disproportionately, especially if I'm higher in the capital structure
This is why in event of asset dispositions, often times you need to use the proceeds to paydown debt, you can't pay a dividend with it. You were lent $100m against $100m of assets, if you sell $20m of them and pay that $20m out, the lenders now have a $100m loan against $80m of assets. The same logic can be applied to each tranche of the capital structure. If you think about seniority in the capital structure, the most senior debt has the best asset coverage and as a result has the tightest pricing (ie its the cheapest), the most senior tranches are also the ones that would (typically) have in their credit agreements that they are repaid first in a cash sweep. So the case where you would want to repay a junior tranche before a senior tranche (a) isn't very likely and (b) if for some reason there is a reason to do this, you're generally going to be limited through your credit agreement (e.g., restricted payment basket).
We'll done mate. You've been doing a great deal of giving recently.
.....so I thought I'd show my props by aiming for the banana sign and my fat fingers hitting the shit button instead....
Good question (at least one I know I had when I started) and great answer.
Interview relevant: please help! Can you explain the concept of restricted payment basket? I can't find that exact term with the definition and given my circumstances am leery of making any logical jumps. Thank you very much.
I'll say first that every credit agreement is its own legal document, so when evaluating an individual credit, you need to read the covenants and the definition of terms.
But generally speaking, restricted payments typically means cash returns to shareholders, ie dividends or share buybacks. It should be obvious how the interests of creditors and equity holders are directly at odds here. The "basket" is a figure or calculation that limits how much money the firm can pay out to its owners.
Understood. Thank you very much for the explanation.
In simple terms; you pay back the revolver because if you need that capital again in the future you know you can redraw the debt. Saving a small amount of dough on interest rates is generally less critical versus maintaining maximum liquidity / options.
I started writing this and then began reading Halberstram's response... very thorough. Look up.
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