The funding of leveraged acquisition deals by way of different layers of funding has become more common in South Africa following the experience of the US and European markets. A leveraged acquisition or LBO (leveraged buy out) typically involves the acquisition of a company by a private entity where the ratio of the debt component of the financing in relation to the equity component is high. In this article we provide a brief look at the different layers of leveraged funding and our experience of this type of financing in South Africa.
The layers of funding generally encountered in the South African market include senior debt, second lien debt, mezzanine debt and PIK funding. An LBO transaction would very seldom include all of these layers, but one or more of these layers of funding would typically be used in a larger LBO. As in the US and Europe, multi layered debt in South Africa has originated largely due to the economic drive to achieve higher returns on equity. This has been supported by the growth in the number of financial institutions (other than banks) wanting to participate in the private equity market, many of which have mandates to invest in higher risk subordinated debt or quasi equity products and not in senior debt products. As a result of this development, arranging and underwriting banks who wish to syndicate their debt on the secondary loan market have taken the requirements of these financial institutions into account when structuring their debt products.
The first layer of funding is the senior debt. The senior lenders will rank first amongst lenders in that they will be entitled to payment of interest and the repayment of the senior debt owed to them in priority to the other classes of lenders and they will be entitled to first ranking participation in the security typically provided by the borrower group in an LBO transaction. Owing to the reduced risk profile of senior debt relative to other debt layers, the senior lenders will receive a lower margin. For example one could expect a margin differential of between 2,5% to 5% in a South African LBO transaction between the senior lender margin and say the mezzanine lender margin. This margin differential may also be greater or lesser than the range referred to above depending on deal specific factors.
A further layer of funding is the second lien debt. The term second lien is derived from the nature of this form of debt which generally has second ranking security, hence "second lien" (the term "lien" is used primarily in the US to describe various forms of security for debt). Second lien funding is not prevalent in the South African market and is more commonly used in the US and European markets. Second lien lenders would rank, by way of security, behind the senior lenders, but ahead of mezzanine lenders, PIK lenders and/or other junior creditors.
A further layer of funding is mezzanine funding. Mezzanine funding is much more common in South Africa than second lien funding and has been used as a funding layer in a number of prominent LBO transactions in South Africa. Mezzanine debt gets its label from its hybrid nature being an instrument that can be categorised as being somewhere between senior debt and equity in economic terms. Set out below are some of the typical characteristics of mezzanine debt found in the South African market:
- Repayment of the mezzanine debt will usually be in the form of a bullet repayment and such repayment is subordinated (contractually and/or structurally) to the repayment of the senior debt.
- It is subordinated in right to repayment to the senior debt and will therefore carry a higher interest rate than the senior debt (see above).
- Senior lenders may have the right to block interest payments to mezzanine lenders in certain circumstances.
- The mezzanine lenders would typically only be entitled to accelerate the mezzanine debt if any of the following circumstances apply, namely if an insolvency event applies to the borrower, or if certain key events of default are continuing and then only after the lapse of a standstill period (90-150 days), or if the senior lenders have accelerated the senior debt or if the senior debt has been discharged.
- The mezzanine lenders may obtain the right to appoint a representative to attend as an observer at board meetings of the borrower.
- Although the mezzanine debt is generally in the form of a bullet loan, the borrower may be successful in asking for all prepayments (both voluntary and mandatory) to be applied first to the mezzanine debt, being the more expensive debt.
- The mezzanine lenders would only obtain second ranking security.
- The mezzanine lenders may benefit from an 'equity kicker' in the form of a warrant instrument or share option.
A further layer of funding (which may be included as a tranche of mezzanine debt) is PIK debt. PIK denotes "payment in kind" and a PIK debt instrument would typically provide for all cashflows from the borrower to the lender to be paid only on final maturity of the instrument. PIK interest accrues and capitalises periodically over the life of the instrument, thus increasing the underlying principal amount owed (i.e. compound interest). PIK funding has been used in some of the largest LBO transactions in South Africa and in these transactions has been structurally subordinated to mezzanine debt so that it is the last layer of debt before equity.
It is submitted that South Africa is continuing to develop precedent and practice on the use of these layers of funding but that a more standardised approach will, amongst others greatly assist in syndication and demonstrate that South Africa is an attractive and developed debt market for foreign investors. One factor that will have an impact on the development of this type of financing in South Africa is the tight liquidity in global markets. This will clearly have an impact on the domestic market and will require awareness of the latest developments and innovations in the global debt and equity finance market.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.