As disruptive as the COVID-19 pandemic has been to the economy, its effects have not been evenly distributed. Financing markets, for example, continued to flourish. U.S. high-yield bond issuance had a blockbuster year in 2020, with volume increasing 60 percent from 2019 to $435 billion, according to LCD. The M&A market, on the other hand, was slower to rebound. While 2020 deal volumes fell 6 percent to $3.5 trillion, according to Bloomberg, $1.3 trillion of that amount signed in Q4 2020, and Q1 2021’s $1.1 trillion in deals represented the best start to a year since at least 1998. This temporary dislocation between the financing and M&A markets had a particular impact on private equity sponsors that had planned to exit portfolio company investments during 2020 and in some cases led to those plans being delayed.
At the same time, however, sponsors and companies took advantage of open financing markets to extend maturity profiles. These financings can serve as a bridge to a future exit while re-levering a business and returning capital to equity holders. Despite those immediate benefits, sponsors and companies need to take care that the new financing does not impede a successful exit once M&A markets have fully returned, such as by incurring debt with expensive call protection. Portability provisions play an important role in mitigating that risk.
The Role of Portability
An acquisition of a target company may constitute a “change of control” under its financing agreements, which usually either triggers an event of default or gives the lenders a put right for the target company to repurchase this debt. In either case, a buyer would need to allocate funds as of signing (whether in the form of committed financing or available working capital) to backstop or replace this existing debt. Instead, portability provisions allow, under certain conditions, for the buyer to step into the seller’s shoes in the target’s financing agreements, leaving the target company’s debt capital structure intact post-closing.
Including portability provisions in debt agreements brings sponsors three main benefits. First, portability features provide a sponsor with the ability to initiate a sale when difficult financing market conditions might impede prospective buyers from raising debt financing. Indeed, when an active M&A market occurs alongside a sub-par financing market, a company that previously obtained debt financing with portability features could become a more attractive acquisition target, since the buyer will inherit a debt capital structure that is likely better than what the market would provide. Second, portability features allow for a sponsor to pursue debt financing transactions based on strategy and opportunity, without having to worry about how the buyer’s ability to replace the debt might affect a future sale. Third, portability provisions can lead to fewer transaction costs overall, since a buyer will not have to pay commitment and other fees for the new debt financing (which are usually more expensive than fees for a best efforts refinancing) and the sponsor seller will not have to “pay” prepayment penalties or other breakage costs to refinance the company’s existing debt (which are often allocated as a deduct to the closing purchase price paid to a sponsor seller). Assuming a buyer prices in these lower transaction costs as part of the deal, the sponsor seller can negotiate to receive the benefit of these amounts in the form of additional purchase price.
The Five Customary Portability Conditions
Portability provisions customarily include five conditions that must be satisfied so that the buyer can assume the seller’s debt in an acquisition. These conditions are designed to provide comfort to the lenders regarding both the company’s health and the buyer’s reputation as an equity investor. First, the company must satisfy a leverage ratio requirement. This is often a total leverage ratio test; there may also be a separate leverage ratio test for secured debt. The leverage ratios tend to be set using the leverage levels as of the financing closing date, although sometimes there is a slight cushion added or a rounding upwards. These leverage ratio tests assure lenders that the amount of the company’s debt is in-line with lenders’ original credit determination.
Second, the buyer must provide sufficient equity financing to meet a pro forma equity-to-capitalization test, typically 30 percent. This demonstrates to the lenders the buyer has sufficient “skin in the game” so that the incentives of the buyer and lenders are aligned. Note if the purchase price paid to the seller is not enough to satisfy the minimum equity requirement, the buyer may need to fund additional equity to the company’s balance sheet (which can also be used to prepay a portion of the company’s debt, to further increase the equity capitalization percentage).
Third, the buyer must meet certain individual criteria. Financial sponsors typically must have a minimum amount of committed capital or assets under management (usually $1 billion). Similar to the minimum equity test, this provides lenders further comfort that the buyer is a reputable actor with a track record of substantial assets under management which can be provided as future equity capital to the company if necessary. Some debt agreements also allow for a strategic company to be the buyer (including the portfolio company of another sponsor), in which case there may be a requirement for this company to be in the same or related business. Additionally, some debt agreements allow for a SPAC to be the buyer, so long as any controlling shareholder would have been a permitted financial sponsor if acquiring the company directly.
Fourth, the company must provide lenders with the identity of the buyer, and subsequently provide any relevant “KYC” information requested by the lenders within a certain period prior to the closing date.
Finally, the sale transaction must occur within a certain period of time following the financing closing, typically two years. This represents a sufficiently long period for the company’s equity owners to arrange a sale process, while also acknowledging that investment considerations (and company performance) may deviate following that time.
Considerations When Negotiating Portability Provisions
There are two considerations sponsors should prioritize in negotiating portability provisions to help minimize risk factors that can occur between closing on the debt and closing on a deal.
First, avoid including conditions that are not fully within the control of a buyer and seller. For example, some debt agreements include a portability condition that rating agencies confirm that the company’s credit ratings meet certain agreed levels (often the rating given at the time of the financing). This type of condition introduces incremental risk that the acquisition may not be able to close due to a third party (in this case, a rating agency providing an adverse rating or ratings indication).
Second, make clear that certain conditions can be satisfied at signing using the “limited condition transaction” (LCT) technology already common in debt agreements.1 In particular for financial conditions, LCT technology provides certainty at signing that the calculations are satisfied based on the agreed debt and equity inputs, and ensures that any potential change in components of the calculation between signing and closing (such as a decrease in EBITDA) would not prevent the condition from being satisfied at closing. A related consideration is the role cash plays in leverage ratio calculations. Given that calculations made at signing will be based on estimated cash on the balance sheet at closing, sponsors should also include a rule that these calculations made at signing can be prepared based on estimated working capital and balance sheet items.
Risk Allocation in Purchase Agreements
Another set of considerations for sponsors is how the risk of failing to satisfy the portability provisions is allocated between the buyer and the seller in the purchase agreement. The following chart summarizes various risks for each of the five portability conditions and how they might be apportioned. Note that the risk allocation may be affected by a buyer’s planned capital structure.
|Leverage Ratio Condition
If Buyer is contemplating incurring any additional debt, Buyer may be in a better position to be responsible for the maximum incremental debt input.
Seller may be in a better position to satisfy this condition, since it can provide both the debt and EBITDA inputs at signing.
If Buyer is incurring additional debt, Buyer may be in a better position to be responsible for confirming the pro forma debt levels to be used for any ratio calculations.
If a debt agreement does not provide for this condition to be satisfied at signing using LCT technology, there is additional risk that this condition may not be satisfied at closing if the company’s EBITDA decreases between signing and closing.
|Buyer Identity Condition
(e.g., minimum AUM)
|Buyer primarily responsible.
Seller responsible to the extent within its control.
Seller responsible for providing the identity of the buyer.
|Buyer should want cooperation from Seller on KYC requests within its control (e.g., new beneficial ownership form is based on Buyer ownership but signed by target). Otherwise, Buyer may be in a better position to satisfy this condition since the sanctions/KYC requirements are specific to Buyer.
While the turbulence of the past year has lead to a rising number of financings that include portability features, we expect the use of portability to continue even after the pandemic ends. To be sure, portability may not be necessary for sponsors to include in all financing transactions, such as new LBO financings or for investments with longer holding periods. For astute sponsors, however, we anticipate that portability features will be closely considered in connection with future dividend recapitalization or refinancing transactions in advance of the sponsor’s eventual exit.