Financing instruments. In this section, we will cover types of debt, debt providers and holders, equities, covenants, collateral, financing fees, debt structure consideration. In leverage financing, many types of debt instruments are utilized. In every deal, a financial sponsor such as a private equity firm and a strategic buyer negotiate with banks on the best capital structure. Leverage finance can be classified into three types, pro rata, seller, and institutional. The pro rata portion consists of the revolving credit facility in term loan A, which are packaged together and distributed among participating banks. For example, if three banks participate in a deal, each bank will own a proportioned amount of a revolving credit facility and term loan A. It would be about 40% for the lead bank and 30% for the other two banks. A seller loan is another way of financing a leveraged buyout. The existing owners of a target company provide the loans. Institutional debt consists of some of the term loans such as term loan B, bonds, mezzanine, and preferred shares. Those are generally arranged by investment banks and taken by institutional investors, which is the reason why the industry calls this debt institutional debt. Banks sometimes take this portion as well. In leverage finance, the expected ratings of notes are high yield, which are BB+ or below. This is due to the high leverage. In this section, we'll focus on several types of loans that are frequently used in leverage finance. Those are the revolving credit facility, the term loan A, the term loans B, C, and D, notes or bonds, and mezzanine debt. This table navigates you through the different characteristics of each type of debt. The table is somewhat simplified, but that helps give better guidance. In many cases, senior debt or specifically bank debt is the cheapest and most available option of all the financing instruments used to purchase the company through a leverage buyout. It is a lower cost of capital than the other charges of the capital structure because it is senior and most of the time secured as first lean in the capital structure to receive residual value during a liquidation process of the company. Here, we will look at the typical lenders and investors in leverage finance by facility type. General players in the leverage finance buyout markets are banks and institutional investors such as credit funds and insurance companies. A notable recent trend is the liquidity in the leverage market provided by the resurgence of the CLO or collateralized loan obligation market. This is a special purpose vehicle set up to manage a pool of loans. Due to the increased presence of CLOs in the market, banks are able to syndicate deals widely and hold less on their balance sheets, enabling a greater volume of deals to be done. The growth in private lending and business development companies, or BDCs, also add the momentum to this trend by providing dedicated capital for other junior capital solutions such as second lean loans and mezzanine. BDCs are publicly traded companies that invest in finance small to medium-sized businesses, or SMBs. BDCs are playing an essential role in giving retail investors access to private investment opportunities. Also, recently, some private equity firms have been investing in term loans B, C, and D or even high yield bonds by using their credit investment funds which expands their ability to take risks because they do not need to rely on bank distribution network and third-party institutional investor appetite.

One last significant debt product is unitranche. Basically, private lenders looking for return in the market looked at all of these trends such as cov-lite, sponsors looking for speed and flexibility in raising funds, and came up with an idea. They created a financing option called unitranche, which merges senior and subordinated debt provided by multiple lenders into one tranche arranged entirely by one fund. These unitranche direct lenders are invested in by hedge funds, private debt funds, private equity funds, et cetera. They offer one blended rate to the issuer for all of the tranches, which are then carved out between first out or priority and last out, which are second priority. Unitranche loans do not amortize generally and offer the same features of the covenant-lite loans. Pricing is slightly higher than would be achieved via separate tranches, but the execution risk is much lower. Revolvers are the tricky part of these loans and they can either be carved out from the fund and given super priority status or provided by traditional banks. These are, as mentioned, generally arranged as super senior or super priority to all other borrowings. Here, we will look at some practical insights relating to equity arrangement in a leverage buyout. The equity package is as important as the debt structure because it affects the probability of success of the deal. Acquirers ponder how much equity should be injected and also the components of the equity and capital structure. Typical equity investment is 20 to 30% of the proforma enterprise value of the target company. When deciding the amount, you need to be careful to consider the management portion that the management of the target company will invest post-transaction. Management involvement is key to the success of a private equity leverage buy-out transaction so a PE fund will invite the target company's management team to roll a portion of their current equity stake into the post-closing company. This is often referred to as skin in the game. Management equity is often referred to as rollover equity. It provides them with an opportunity to achieve additional economic compensation by increasing the stock value. Also, management equity may be attractive to the sellers from a tax perspective. The scale and implementation of management equity may vary from transaction to transaction depending on the company valuation, capabilities of seller's management team, and so on. In the example here, we are assuming a 5% rollover. This means that the management team owns at least 5% of the existing equity and agrees to keep 5% invested alongside the sponsor. Leverage finance entails covenants to protect lenders and bond holders by restricting how borrowers can operate and carry themselves financially. The size of covenants increases as lenders see more risks in borrowers or capital structures of deals. The size of covenants increases as lenders see more risks in the borrower structures or the capital structures of the deals. Covenants typically consist of three primary types; affirmative covenants, negative covenants, and financial covenants. Affirmative covenants stipulate what actions borrowers must take to be in compliance with debt. These covenants usually require a borrower to pay lenders, loan interest, and fees, provide audited financial statements, pay taxes, and so on. Negative covenants limit borrowers activities, and thus these covenants are carefully structured and customized to each borrower's specific situation. Prevalent negative covenants include limiting new acquisitions and investments, debt issuance, and so on. In some cases, borrowers are allowed to invest within a set range agreed with lenders. For example, a certain percent of free cash flow or net income. Financial covenants require borrowers to maintain healthy financial performance. Financial covenants consist of two types, maintenance and incurrence. Under maintenance covenants, lenders usually set a minimum cash flow coverage and leverage ratio. On the other hand, incurrence covenants force borrowers to test pro forma financials before taking actions such as investments and acquisitions. In the leverage finance market, covenant-lite loans, a.k.a. cov-lite, has been growing. Covenant-lite types of debt have no or fewer investor protections. These loans make it easy for companies to avoid bankruptcy in times of financial stress, but increase the risk for lenders who are less protected by strong contractual agreements. Before the global financial crisis, over 80% of the leveraged loans were considered covenant heavy. However, in the current market, over 80% of loans lack decent covenants because the market has shifted to more relaxing restrictions. In leverage buyouts, banks and bond holders usually ask for collateral to hedge credit risks associated with the deal. What is collateral? Collateral is an asset or property

as security for a loan. Collateral from the lender's perspective acts as protection against loss in bankruptcy and helps borrowers to get a portion of their funds back. Collateral varies a lot from properties to accounts receivable and inventory. But in the leverage loan market, collateral usually includes all the tangible and intangible assets of the borrower with a lien. A lien is a legal right acquired in one's property by a creditor. A lien generally stays in effect until the underlying obligation to the creditor is satisfied. If the underlying obligation is not satisfied, the creditor may be able to take possession of the property involved. Because of the higher risk of default, in most cases, leverage loans specifically for a revolving credit facility in term loan A are collateralized with a first lien. There are sometimes second lien loans which sit below first lien in the capital structure and are secured only if there is asset value left after securing first lien loans in a bankruptcy. There are several types of fees involved in financing. Here we will cover typical financing-related fees. Most often, fees are paid on a lender's final allocation. Therefore, the banks that are the arrangers of the loans, often called the lead arrangers or book runners, take the larger amount of fees. For bank loans, there is an interest rate that is charged annually or biannually on the amount of principal. In addition to interest rates, there are several one-time costs that borrowers are obliged to pay. First, the upfront fee is a fee paid to all bank lenders generally in exchange for the arrangement of the loans. The arrangement fee is also paid in exchange for the arrangement of loans, but only paid to the arrangement banks that led the transaction. The commitment fee is a fee for bank's commitment to lend money whenever borrowers need financing. The facility fee is another type of commitment fee paid on a facility's entire commitment amount regardless of usage. Lastly, prepayment fee is associated with the prepayment of the loan as a penalty. For bonds, registration fees are paid to a certain regulatory authority to register notes. Also, investment banks that underwrite bonds will be paid underwriting fees. The calculation of financing related fees is usually a fee percent times the initial principal amount of the loan or bonds. For example, if a private equity fund agreed on a capital structure, such as the one here, the revolving credit facility of 150 million, term loan A of 360 million, term loan B of 240 million, and subordinated notes of 180 million. In this case, the total financing fee would be 9.6 million. For revolving credit facilities, there are two components to the fee, the undrawn basis, so in this case that would be zero, but there's also a fee on the commitment amount to the facility, so in that case the fee would be the commitment amount multiplied by the associated financing fee. Debt structure is decided considering multiple elements. Key elements are the financing cost, the relationship, the certainty of financing, refinance opportunities, cash flow impact, and covenants. The optimal capital structure may vary deal to deal taken into account these components. For financing costs, generally bank loans are cheaper, but the cash flow impact is large because of the amortization of the loan. On the other hand, subordinated bonds typically have less restrictive covenants or limitations and coupon-only payments with pay down due upon the maturity of the debt. Thus, it is not as painful as bank loans for borrowers, but the certainty of financing is highly dependent on the capital market situation, and refinance of these bonds is costly because most of the bonds are non-callable. Therefore, in leverage finance, an acquirer will analyze each element and figure out what is positive or negative with a select capital structure.