Lending Law Report : Corporate Finance Lawyer & Attorney : Reed Smith Law Firm : Lending Transactions, Secured Investments

This post was written by my partner Ben Brimeyer, a member of the Financial Industry Group in Reed Smith's Chicago office.

In today's challenging economic climate, private equity sponsors are trying to figure out how to fill funding gaps in acquisition financings -- and how to provide additional capital to their troubled portfolio companies.  In lieu of providing additional equity, some sponsors are requesting the ability to participate as a lender in the senior debt facilities of the portfolio company.  Also, on occasion, it's the lenders who need to find someone to take a piece of a new loan, and the equity sponsor is the only one standing by ready to do so.

If the lenders decide to allow the sponsor to become a lender in their debt facilities, what steps should they take to best protect themselves, given the different hats this new lender will be wearing?

Voting rights. Given the sponsor's ability to control the borrower, the sponsor should not have the same set of voting rights available to the other lenders.  The sponsor should have the ability to protect its investment, but should generally be a silent participant, without the ability to interfere with actions the lenders may need to take.  The sponsor’s commitment should be removed from the calculation of required lenders, and the voting terms should provide that the vote of the sponsor won’t be required other than for a very specific set of items (typically 100% vote issues):

• Increase the commitment of the sponsor-lender
• Reduce the interest rate on the sponsor-lender's loans
• Reduce the principal amount owing to the sponsor-lender
• Change the pro rata treatment of the loans
• Subordinate the loans

Information/Meetings. It is important to ensure that the sponsor, as both the equity owner and a lender, does not have the same access to information, rights to attend bank group meetings and ability to require action by the agent as the other lenders have.  In this regard, the sponsor-lender should not be allowed to:

• Require the agent or any lender to take any action or exercise any remedy
• Attend any meeting between the agent and the lenders to which the borrower is not invited
• Receive any information or communication from the agent or any lender that is not sent to or by the borrower (i.e., shared among the lenders only) 
• Provide information obtained in its capacity as a lender to any member of management of the borrower

Bankruptcy. In a bankruptcy, the sponsor-lender’s interests differ significantly from the rest of the lenders, since the sponsor as equity owner receives a different set of rights. To protect the lenders from actions which may be taken by the sponsor-lender in a bankruptcy, the sponsor should agree not to impede any actions being taken by the agent, so long as the sponsor-lender is being treated equally with the other lenders.  The sponsor-lender should also agree that its vote in bankruptcy shall be cast in the same proportion as that by the other lenders, which results in the sponsor essentially being dragged along proportionally to the votes of the other lenders. This is particularly important if the sponsor-lender will hold more than one third of the debt, providing a potential blocking position on issues requiring a lender vote in a bankruptcy.

Allowing the sponsor to participate in the senior loans may be essential to completing a transaction or providing a portfolio company with additional liquidity.  It can be done, but with careful consideration of the challenges it presents to the rest of the lender group.
 

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Last week, our firm hosted a workshop at the annual conference for the Los Angeles chapter of the Association for Corporate Growth (ACG).  Our topic was “Finding Financing in a Difficult Market”.  No one in the room needed to be convinced that the market is indeed difficult these days. 

Our workshop was focused on trying to find the few bright spots in the market.  There was a senior lender on the panel, who indicated that the market for senior loans may not be quite as dead as people seem to think.  For example, the ABL market continues to be active and can be a good source of funding for underperforming companies that have valuable assets.  On the cash flow side of the house, there are some borrowers that the banks would like to loan money to, but many of those companies seem to be on the sidelines waiting for the market to change. 

Our experience in recent months has been that senior loans are still available in some situations, but for a number of companies this kind of financing can be hard (or impossible) to find.  Within this constricted market, we’re still seeing acquisitions and other types of deals getting done, but rather than relying solely on senior financing, most seem to involve a combination of sources of funds, including equity, mezzanine and sometimes various forms of second-lien/mezz hybrid financing. 

We’ve seen the role of mezz lenders in corporate acquisitions dramatically increase in the last few months.  In the workshop, I described a recent deal to acquire a middle market manufacturing company.  The private equity fund relied on a combination of equity financing, a structurally subordinated loan to the holding company, a small senior revolving loan for working capital, and a secured mezzanine loan that looked much like a second-lien loan. Piecing together financing from various sources –with some very complex intercreditor arrangements – got the deal done.

My corporate partner John Iino discussed a major trend that our mergers and acquisitions practice is seeing:  an increase in deals being done on an all-equity basis, without a debt component.  This is the only way to go when debt financing is unavailable.  Many of the acquisitions are strategic combinations.  And it's not uncommon to see the equity funding for companies (and transactions) come from foreign investors.

It will be interesting to see where the market takes us in the next few months.

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At long last, the Huntsman case has settled.  As recently reported, the banks providing the commitment for the acquisition financing have agreed to pay $1.7 billion (in a combination of cash and debt) to end the litigation. 

This case provides a good reminder of the need to be careful when issuing commitment letters.  Even though your commitment is conditioned on many things, and even though there are significant events that would appear to trigger a condition that lets you out of the commitment, you can still find yourself out of pocket.

In the Huntsman case, the commitment letter provided by the lenders included a typical condition that the borrower not be insolvent at the time the loan was to be made.  When it came time to fund, the banks thought the borrower was in fact insolvent, and refused to fund.  Regardless, these lenders have now spent significant time in litigation over this matter, and ended up settling for a not inconsequential sum.

Lenders, like all contracting parties, should be able to rely on the language of their commitment letters.  If the commitment letter provides the lender a right to refuse to fund under certain circumstances, and those circumstances come to pass, that right should be given effect.  Conditions on the obligation to fund are a necessary part of a commitment, particularly in an acquisition financing where the letter is usually issued in the early stages of the deal - at a time when there are still many unknowns.  Including a very clearly worded set of conditions, with strong language that makes the lender's intentions plain, can help protect the lender.

Of course, most lenders understand that they need to take litigation risk into account, especially when providing commitments for significant acquisitions.  It's part of the cost of doing business.  And, any time a very large dollar amount is at stake, the risk of litigation will increase.  As the Huntsman case illustrates, nothing is ever certain when litigation is involved. There are costs associated with defending the case even if you ultimately win.  Even with a strong case, you may find it advantageous to settle - sometimes for a rather large sum.

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