Financing patterns of European Buy-Outs
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Sascha Kaumann
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Financing patterns of European Buy-Outs
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Diplomica Verlag GmbH
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9783836625654
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1
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CHF 47.20
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Management
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English
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92
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kein Kopierschutz/DRM
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PC/MAC/eReader/Tablet
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PDF
As Buy-Outs became larger and more levered in the mid 2000’s the European Leveraged Finance market experienced a wave of innovations. This research is concentrating on the capitalisation process of leveraged Buy-Outs in Europe, taking the perspective of an equity investor.
We embark on the quest for the optimal capital structure by constructing an integrated model based on traditionalist (irrelevance hypothesis) and modernist (tax, risky debt and costly contracting hypothesis) views. In a second step we review common terms of financing instruments used in European Buy-Outs (ie. Senior debt, Mezzanine, High Yield, Preferred Equity, Equity) in the light of these theoretical insights. Finally the capitalisation process is embedded in a broader framework for value levers in Buy-Out transactions and an outlook on further research is given.
This research provides a solid review of relevant literature on capital structure (eg. Modigliani&, Miller, Agency Theory) and can be used as an introduction for the inexperienced reader. The consistent mapping of common financing terms against relevant theoretical hypothesis is unique among related literature.
Chapter 3.1.2.1, Senior debt
The most debt like element in an LBO capitalisation is senior debt. It is provided by banks and financial institutions in the form of term loans. To cover a wide spectrum of risk and return trade-offs, senior loans are available in three different tranches. Tranche A is the most secured tranche with B&,C senior loans ranking lower in a company’s capital structure.
The financial terms of the different tranches are distinguished by interest rate, repayment mode and maturity. Typically, senior debt is provided at a floating cash rate with a mark-up over LIBOR increasing in maturity and security. Repayment terms also vary with amortising repayment preferred by A loan investors and bullet repayment preferred by B&,C loan investors. Maturity of senior debt is relatively short compared to hybrid instruments. Normally, no call premium is imposed on shareholders in the case of repayment before maturity. Senior debt loans are essentially privately placed bonds that enjoy the advantages of lower distribution cost and avoidance of public registration cost. Banks and Financial institutions are the main players in senior debt provision. After this short wrap-up of general terms we will now see how senior debt can alter asset induced firm problems through its contractual feature.
Tax hypothesis
The tax effect of senior debt is threefold: Interest payments are tax deductible, assets financed with senior debt are depreciable, and placement costs can be amortised over the life of the issue. Therefore, contractual prerequisites exist to realise the full value creation potential of debt and non-debt tax shields. Latest empirical evidence seems to support these findings. Senior debt consequently is an efficient means to lower a company’s tax burden.
Risky debt hypothesis
Interest charged is essentially a function of the loans’ security features. We can broadly distinguish between asset based and cash flow based lending. In an asset based lending scheme, the company’s assets will serve as collateral, whereas the company’s projected future cash flow will serve as collateral in a cash flow based lending scheme. Asset based lending schemes are less risky as lenders have direct access to the company’s assets whose value is less subject to volatility than a company’s cash flow. Senior A loans are provided through an asset based lending scheme, whereas Senior B&,C loans are provided through a cash flow lending scheme.
To further reduce their exposure to single transactions, senior debt investors can pass default risk on to other banks. This technique, known as syndication, is quite common with over 60% of senior Buy-Out related debt being syndicated. The global coordinator of the bond issue originates the transaction and then passes on part of the default risk to other banks for a fee.
The limited number of counterparties in senior debt loans results in easier renegotiation in the case of default which can substantially decrease direct and indirect costs associated with financial distress.
Another means of risk reduction can be found in the comparatively short maturity of senior debt loans. Merton and later Ho and Singer demonstrate that a reduction in the time to maturity of debt outstanding will reduce the elasticity of the value of the bonds with respect to the value of the firm, i.e. reduce the risk of these bonds.
The floating rate interest payments of senior loans are a major risk driver in Buy-Out transactions. Due to the high leverage, companies have huge exposure to interest rate shifts. However, instruments exist to limit that risk, e.g. swap contracts, 40% of Buy-Out debt in Europe remains un-hedged. We conclude that costs of financial distress do exist, but modern contractual specifications in senior debt loans allow for a significant reduction of those costs for banks. These lowered costs of financial distress should result in lower prices for senior loans and consequently benefit shareholders.
Costly contracting hypothesis
Agency costs of debt are being imposed on shareholders due to the existence of a discretionary freedom of action, induced by asymmetric information, which could be exploited to the detriment of bondholders, in the case of misaligned incentives. We will now examine the conditions being present in senior debt contracts that foster Agency costs.
As far as the informational aspect of senior debt is concerned, we find that documentation, both legal and marketing, are private documents. The private nature of these documents lowers the cost of information transfer, because managers can be sure that no sensitive information will be leaked to the market and information has to be provided on an informal basis. Banks seem to have a cost advantage in information production and transmittel. As with every good, lower price means higher consumption, thus implying that private debt holders will be better informed than public ones. Another important source of information is board seat representation. This superior information lets banks perform monitoring efforts more efficiently and thus reduces Agency costs of debt. On the incentive structure side we find a very debt focussed mindset. No warrants are being used in senior debt thus drawing a strict line between debt- and equityholders. To make up for the shortcomings of this divergence of incentives, covenants are used quite heavily.
Strong covenant protection is important for bondholders, as they might otherwise be subject to wealth expropriation by corporate decisions. In an LBO situation, however, the specific shareholder structure implies disincentives for bondholder wealth appropriation. Being the main holders of ordinary share capital, financial sponsors are repeated players in the debt markets with their reputation as good borrowers at stake. Hence, they are rather interested in doing good business with bondholders on a repeated basis then reaching one-off gains through bondholder wealth appropriation.
We conclude that tight informational control fosters an active monitoring of shareholders by bondholders, thus lowering Agency costs of debt. The impact of incentive structures on Agency costs of debt is twofold: The traditional Agency problems of debt are existent, but are ameliorated through Buy-Out specific ownership and contractual structures.
Agency costs of equity are being imposed on shareholders by managers that make inefficient use of free cash flow, either through over-investing or consuming of perquisites, or by under-leveraging the firm.
In this context, debt is an efficient means to fight the free cash flow problem, because interest payments reduce free cash flow available on manager’s discretion, thus curbing inefficient use of cash reserves. Additionally, debt gives shareholders the right to force the company into bankruptcy and thus pay out excess cash. As Glassman and Steward put it: ‘Equity is soft, debt hard. Equity is forgiving, debt insistent. Equity is a pillow, debt a sword’. Monitoring activities, either through informal information exchange or contractual covenants, help to fight both, the free cash flow and the under-leverage problem.
We conclude that senior debt is an efficient means to fight Agency costs of equity.
Mezzanine
Mezzanine is a hybrid instrument that shares characteristics of both, debt and equity. Its subordination (equity like) is compensated by higher interest payments (debt like).
Mezzanine facilities are usually provided for long-term financing (10 years), ar
Table of contents
2
List of Acronyms
4
List of Objects
8
1. Introduction
9
1.1. Definition of Buy-Outs
10
1.2. Relevance of Buy-Outs
12
1.3. Research focus
14
1.4. Methodology
14
15
14
2. The quest for a theory on optimal capital structure
17
2.1. Traditionalists
17
2.1.1. Assumptions made by traditionalists
18
2.1.2. Irrelevance hypothesis
19
2.2. Modernists
21
2.2.1. Tax hypothesis
21
2.2.2. Risky debt hypothesis
25
2.2.3. Costly contracting hypothesis
26
2.3. An integrated model of capital structure
40
2.3.1. The case of pure debt and equity
41
2.3.2. The case of hybrid financing instruments
43
3. Financing patterns of European Buy-Outs
46
3.1. Determinants of capital structure choice
47
3.1.1. Asset characteristics
48
3.1.2. Liability characteristics
49
3.1.3. Availability of funds
62
3.1.4. Summary
64
3.2. Evidence from European Buy-Out capitalisation
64
4. The capitalisation process and other sources of value
68
5. Summary and outlook
72
6. References
74
7. Appendix
89
