The banks have won the first big show down with private equity.
Last night several news outlets, including the Wall Street Journal, reported that private equity giant Kohlberg Kravis Roberts has signaled a willingness to include a financial covenant for the bank loan portion of the $24 billion of debt needed to finance its purchase of First Data.
First Data was largely viewed as a test case for some of the biggest, and riskiest, of the highly leveraged buyout deals that are scheduled to close in the next few weeks and months. The banks had been asking the private equity sponsors of the deals for concessions on the terms of the financing, saying it was having trouble syndicating the debt due to recent concerns about debt levels by many investors.
For the past several years, giant buyout firms have succeeded in getting banks to commit to financing without financial covenants and without some of the traditional flexibility that would allow banks to raise interest rates or back out of a deal altogether if the prospects of the target company or the market for acquisition loans changed dramatically. These so called “flex” and material adverse change—or MAC—clauses were stripped from bank commitment letters in recent years, leaving the banks in the risky position of having to fund loans they would then have to sell to investors at a discount or keep on their books until the market for the loans became more favorable.
The apparent concession by KKR is intended to make the loans more marketable by assuring investors that First Data will meet a financial performance test. Specifically, it seems that KKR agreed to a minimum EBITDA covenant for the company. If First Data’s EBITDA falls below the levels specified by the covenant, the company would be in breach of its credit agreement. If that breach persists, the company could be held in default on the debt. Neither the covenant levels nor the cure-period—the time in which the company may attempt to recover from breaching the minimum EBITDA requirements—have been disclosed.
Despite earlier reports in the Financial Times that KKR might cave in on interest rates, KKR reportedly continues to resist any interest rate increases, something some investors had said would make the debt more attractive. But since this would increase the cost of servicing the debt, an increased interest rate might put the company in a more precarious position and make it harder to market the high-yield bonds that make up the other part of the financing for the acquisition. What’s more, it would likely make it harder for the company to generate the returns KKR seeks in the acquisition.
The banks—Credit Suisse, Citigroup, Deutsche Bank, Goldman Sachs, HSBC, Lehman Brothers and Merrill Lynch—have been in a difficult position on First Data. They have long depended on the leveraged buyouts to generate fees to pump up their earnings, and there is some trepidation about alienating KKR by taking too hard of a line or attempt to walk away from the deal altogether. In the First Data acquisition alone, the banks stand to pocket as much as $600 million in fees.
On the other hand, the market for syndicating these loans to hedge funds and other investors has been much more difficult in recent months. The banks would likely have to sell the loans at a discount—perhaps at 96 or 95 cents on the dollar—which would mean suffering permanent losses. The banks say those losses could add up to as much as $1.5 billion. Banks loathe carrying the full amount of debt that finance these deals on their books.
One option that has been mooted—and reportedly is under serious consideration at Goldman Sachs—is funding off balance sheet special investment vehicles that would buy the debt with money from investors and the banks themselves. This temporary patch would keep the loans off the books of the banks, essentially converting the loan into an equity investment in the special investment vehicle. This has the added advantage of allowing banks to participate in the upside should the bull market for syndicated loans return. This kind of financial engineering, however, has raised some eyebrows on Wall Street among those who wonder if the banks wouldn’t be better off reducing their overall exposure to the risky loans rather than moving them off-balance sheet.
KKR Allows First Data Covenant [Wall Street Journal]