Friday, November 30, 2012

Back in Fashion Again: Financial Engineering to Enhance Debt Capacity

Private equity adds value in the following ways:

1) Buying right: reflected in low(er) purchase price multiples due to, for example, proprietary deal sourcing and market timing

2) Improving operating income: based on the sponsor's industry experience and management quality

3) Financial engineering: emphasis on taxes, leveraging and restructuring skills

4) Sell right: achieving multiple expansion based on improved operations and market timing

The focus of this post is on financial engineering to enhance debt capacity. An earlier post discussed internal debt capacity based on a firm's operating cash flow-EBITDA.  We will now examine how to supplement internal debt capacity using alternative financial instruments. These instruments were developed during the 2004/2007 leveraged transaction bull market to support rising purchase price multiples with increased leverage to maintain sponsor IRRs.  These instruments went dormant during the crisis, but have staged a remarkable return this year. Increased investor risk appetite in search for yield in a low rate environment underlies their return.

These instruments bear a strong resemblance to those used in the sub prime mortgage market. This is because they were developed by the same investment banks to solve the same problem; namely how to fund the fully priced deal. Note the comparison:

Private Equity and Subprime Affordability Products

Private Equity
Products Used
Yes – Collateralized
Mortgage obligations
Yes- Collateralized Loan Obligation
Interest Only
Yes- adjustable rate Mortgages

Tranche B Loans
Option Adjustable
Rate Mortgages
Second Mortgage
Equity Loans
Second Lien
Liberal Documentation
Alt A
Covenant Lite

These instruments, along with high yield debt (HYD) and asset based lending (ABL), were directed at identified investor bases, primarily non bank institutional investors, to expand internal debt capacity. Now for a discussion of some of their features:

             Tranche B term loans: They have a higher spread than revolvers and term loan A tranches held by banks. They amortize 1% p.a. with a balloon maturity after the A's are repaid. Spreads vary by debt rating and are currently in the LIBOR plus 350-400bp range.

             Second Lien Loans are designed to utilize any excess collateral value remaining after the first lien loans are fully covered. They are directed at investors requiring secured debt. They are priced at significant premiums to the first lien debt, and present serious inter creditor problems in a workout.

             Alt A is short for Alternative A-paper-alternatives to conforming GSE backed mortgages due lack of traditional financial information.  Cov lite loans have limited financial covenants like fixed charge coverage minimums and maximum debt levels. Debtors dislike the limits on their flexibility. When breached they must amended or waived.

Institutional investors, unlike banks, prefer to sell their loan exposure in the secondary market if the credit worsens rather than dealing with an amendment. Hence they are primary holders of Cov lite. The usage of Cov lite has returned to pre crisis level albeit at lower volumes.

One of the first mega transactions to use an array of these products was the $33B HCA transaction in 2006.This allowed a private equity group to bid an aggressive 7.7X EBITDA purchase price by incurring a high leverage level of funded debt to EBITDA of 6.5X. Using this template, deal structures became progressively more complex and aggressive as sponsors searched for ways to expand debt capacity to support rising purchase price multiples.

Debt instruments (like my ties) go in and out of fashion depending on market conditions. The key is to check their market availability and pricing. Their utilization can provide an inexpensive and flexible means of supplementing debt capacity. They are and will remain essential tools in your financial engineering toolbox.

joe prior Best Buy post was validated by the much weaker financial results released on November 20th.Especially concerning is the over $500MM drop in projected EBITDA. Even though the stock price drop makes the deal "cheaper" the ability to finance a highly leveraged capital structure becomes even more remote.


  1. From your perspective, what is the best schools which offers financial engineering programs?

  2. Dear Lizabaker,

    Sorry I missed this comment! Here is a recent ranking of schools. Rankings, like any opinion, can be quite subjective. Certainly Carnegie Mellon, Stanford, UCLA and MIT come to mind. Be sure you check out the short courses at Amsterdam Institute of Finance as well. It is a good way to get a handle on things.

    All the best,