What we're gonna be having a looking at, having a look at for today's session is we're gonna be thinking about a number of different elements with regards to our financing instruments in relation to, uh, private equity debts.

The first thing we're gonna be thinking about is what a capital structure might look like, what different kind of debt instruments might be available.

We're not gonna go into, um, huge amount of detail in relation to each one, but some of the key elements in terms of, uh, what might be part of the financing structure for an LBO transaction.

We'll then have a think about who might be providing that financing, so who the actual lenders are within a transaction.

And there's maybe more of a range there than you might be anticipating.

We'll then get into a lot of other content, somewhat more in high level towards the end of the session, thinking about the role of equity financing within an LBO transaction, the use of covenants within that transaction as well.

And then finally, we'll think about collateral financing fees and just some high level concepts in terms of what factors are gonna influence the overall structuring of an LBO capital stack and the debt side of things for an LBO transaction.

Otherwise, we're gonna dive into our content.

Thinking about how you might look to finance an LBO transaction.

We really are thinking here about the leverage buyout side of the private equity marketplace.

Trying to think about how you might be able to borrow money as a private equity fund to invest alongside your funds, your clients, your investors' own money to finance the acquisition of a target company.

So, uh, we're imagining ourselves as a private equity fund. We've gone out and we've found a target company.

We've done all the modeling that says this might be a great company to invest in 'cause they're operating model.

But now what we've thought about is we've don't wanna acquire this company just with our own money as the name leveraged. Buyout suggests we're gonna go out and borrow a lot of money to go alongside our fund's own money to invest into this target company.

But typically that financing won't come from a single source.

There's often a very wide range of different lenders that will actually lend into an LBO transaction, as you can see on this slide here.

So let's start off with the top end of things.

At the top end of things, we're looking at regular commercial banks lending money into a LBO transaction.

Now, these banks, because they're governed by pretty, uh, strict, uh, capital requirements, may not want to take on a lot of risk and be lower down in the risk profile for this capital structure.

Typically, what you'll find then is banks will only lend at the more senior end of the structure, and normally we'll refer to that as a term loan.

A nothing more sophisticated than that name other than the a means that they're the more most senior term loan.

So learn loan with a particular timeframe, uh, banks may be willing to do that.

And, um, as you can also see, this may well be done on a syndicated basis.

So it might not just be one single bank lending, uh, this term loan a it might be a group of banks altogether lending, uh, within that capital structure.

So, you know, it might be the leave bank that's taking 40% of the overall loan and got two more banks lending 30% each.

Okay? So that's our term loan, a structure.

The other element of the structure where banks may no guarantee here but may be providing financing into an LBO structure is with regards to a revolving credit facility or an RCF.

The issue here is that the target company might require some short-term financing once the transaction's finished.

So once the private equity fund's gone out and acquired this target company, it's now a portfolio company, we then need to think about its ongoing financing needs, and maybe it's short on cash, maybe it needs to spend money to, um, beef up its inventory levels before our peak selling season.

Uh, we might want that RCF.

Now it's banks typically that lend this RCF because the banks are more comfortable lending and receiving money back on a more flexible basis.

Further down this structure, the further down the structure we go, we'll typically find that the lenders are more institutional lenders, which means that they're not really fully fledged banks. They're just looking to make a loan and maybe receive some interest and then get their money back at some point in the future.

They don't wanna be investing around with short term lending.

Uh, that might come along with an RC.

So typically the bank that's gonna provide the RC, okay, so those prorata that's like linked between a number of different banks, um, at the senior end of our capital structure.

Now, you might potentially say, well, that's great. We can go to a bank and we can raise some debt financing, but maybe that's not enough debt financing to make the transaction attractive to us as the private equity fund.

From an IRR perspective, if we only borrow money from a bank, there might be restrictions on how much banks are willing to lend in a particular transaction.

And as a result, if we take just that term loan, a money and our money that we are willing to put in as the private equity fund, we might not be able to get enough capital together to go out and buy that target company.

So what we might do is look to other lenders to see if there are other people out there that might be willing to lend us money.

And this is maybe the biggest driver within the LBO market over the last 15, um, or so years, is that the LBO market is not just driven by bank lending.

There's a lot more institutional lending.

So we're thinking about hedge funds getting involved in here.

We're thinking about private credit funds maybe being set up as well, and we're thinking about maybe insurance companies and pension funds looking to lend money within an LBO structure.

Typically, the way that those loans are gonna work is there'll be more junior term loan.

BC d just means that they are gonna be ranked lower down the list of priority if default were to occur.

So these lenders are taking on more risk than the bank is taking on.

But like everything in finance, the more risk you take on, the more return you're gonna get.

So the interest rate on these loans, as you go down through this capital structure, you're gonna be earning higher levels of interest.

So as long as there's no default, you've got the opportunity for earning higher levels of return.

If you are lending lower down this capital structure.

What it does allow for the private equity fund is to take on more debt financing to put less money in themselves, and as a result, hopefully generate a high level of IRR for the fund and for the investors in their fund.

So we are opening up the pool of potential lenders here to people that are willing to take on a more risky position than just banks on their own.

And as a result, we can raise more debt finance.

Again, as we go further down the list.

These are people that are not quite a strict linear, but, um, we'll see a bit more on this on the next slide.

Uh, when we're looking at notes, uh, a note is an instrument that is set up to be tradable, somewhat like a bond, uh, but just slightly, um, you know, not issued by a company being a corporate bond, but just within an individual structure potentially.

Here for these notes, um, now these notes are set up to be tradable so you could exit. You don't have to wait to maturity so long as you can find a buyer for them, but they're, they're designed to be tradable.

And when we're looking down at subordinated notes, we're looking at, uh, again, lenders that are agreeing to be subordinated, which means that they will be ranked after all of the other senior lenders if there were to be a default event. So more risk here again, but higher returns to cover that risk off.

Um, again, just to be clear here, when we're looking at these senior notes, typically we're gonna be assuming that these notes are high yield notes, that they are riskier investments.

If things go great, great, you're gonna get a fantastic return from them.

But there's an increased risk of stuff going wrong here as well.

Further down the list, we've got mezzanine financing. Mezzanine finance is a pretty broad catchall term.

Mezzanine gives us an indication that this is somewhere between debt and equity.

What you'll typically find is that it is structured as a loan with a fixed interest rate attached to it, but where there is what's referred to as some degree of equity participation.

So they're gonna take some degree of share ownership at exit.

So if the company that they've, um, helped to finance the acquisition of through a debt instrument, earning themselves some sort of fixed rate of return.

But if that company does amazing during the private equity ownership time period, they get to participate in that upside as well.

Great. And then finally on the bottom here, we've got preference shares. So these are shares, they're not getting paid a, um, interest rates.

They're getting paid a dividend.

It's expressed typically as an interest rate as well, but their dividends, they don't have to be paid and against ranked further down in terms of priority.

Often these preference shares are used, um, by the actual private equity fund itself as a way of managing the payoffs under a range of different circumstances between themselves and, um, the management rollover.

So we'll see a little, little bit more on this later on, but typically what you'll find is that the equity investment into a private equity acquisition is financed in part, or at least the former shareholders of the target company, if they were management will become shareholders in the new transaction as well, but they may not be acquired at the same, or may not be valued at the same rate on the way in, uh, at the same price effectively.

So just to ensure that there is alignment of incentives and alignments of payouts to the private equity fund and to management of the acquired company, uh, it may well be that the private equity fund wants to have some investment through preference shares, which are gonna get paid out first in a liquidation before any ordinary or common stockholders would get their money back, which is where the management rollover would sit.

Okay. Skipped over one thing here as we went through, which was the seller.

Now this is the former shareholder of the target company, and you're gonna say, well, why would you as a seller? So you've, maybe you're a founder of a business, you set the company up, it's it's grown. Fantastic. Lynn, you've maybe been able to sell it off to a private equity investor.

Why would you then want to lend money to the, uh, essentially to the private equity fund to help them finance the acquisition of your company? Because that's what this is. Okay? This is the seller of the acquired business agreeing to effectively lend money to the acquirer to help them with the acquisition of their business.

What this essentially does is it again, tries to tie together to bind together, if you like the buyer and the seller.

It can sometimes help overcome valuation mismatches where the acquirer might say, well, sure, we're willing to buy a company at let's say 10 times ebitda.

But, uh, if you wanna get 11 times EBITDA, we'll give you one more times in five year as time the maturity of a loan. So it's effectively deferring acquisition payments.

It also provides an income stream for the seller.

So there might be a taxation benefit potentially here from receiving your receipts from selling your company, not as all cash, but as essentially transformed into debt, which gives you an interest payment.

So there's a range of different reasons why this might be beneficial for the seller of the target company, uh, but also to align incentives with the acquirer as well.

Okay. Hopefully that gives us some insight in terms of the capital structure here.

The whole point here is to raise as much money as possible, and as we go down this, uh, list to less senior debt, there's more risk for the lender.

So they want more return to compensate 'em for that.

But that means that out of the acquired company, more of its profits are gonna be going to pay interest.

So long as that trade off is working for us as the private equity fund, then we can take on these more junior forms of debt financing that are more expensive.

But if we have to pay less money in ourselves to finance the acquisition, then that should give us a net benefit.

That's part of the modeling and debt profiling, the debt structuring that, uh, private equity funds go through in structuring a transaction.

Okay. So that's what the debt instruments themselves look like to help finance this acquisition of our target company.

Um, what are the instruments look like themselves in a bit more detail? Well, this slide is quite busy and I'm not gonna go through every single word 'cause we do cover some of it in later slides.

Generally what we're saying though is that on the left hand side, we've got less risky forms of debt financing, and on the right hand side we've got more risky forms of debt financing.

So maybe not a huge surprise then, but as you go left to right, you can see that the interest rate increases as we go across.

We've been quite broad there when we get to the subordinated notes in mezzanine finance, because there's a huge range of possible outcomes here in terms of what those interest rates might look like, you're definitely looking at a double digit, uh, you know, into your teens percentages in terms of those interest rates for those more junior forms of debt financing.

In terms of the interest rate itself, well, uh, loans generally from banks are gonna be variable interest rate, whereas pick coupon bonds, essentially what those notes are, are gonna have a fixed interest rate assigned to them.

Uh, interest type generally you only see pick interest, uh, which stands for payment in kind at the very bottom end of a structure.

Uh, what this means is that the target company doesn't have to make interest payments to cover this, uh, debt element.

Instead, what you get back rather than cash every year is more principle back at the maturity of this debt instrument.

So you're essentially, it's not too dissimilar from a zero coupon bond really in that you're making an investment today and you're getting some money back in the future.

You're getting more money back in the future than you initially invested.

So rather than getting return every year, it's all kind of compounded up and you get it as one big lump sum at the end In terms of the tenor, well, hopefully it's not a huge surprise that as you go down the, the capital table, the risk profile, as you move left to right, then there's a longer time to maturity because that's the whole point.

We said that in liquidation, the more senior debt holders, so term loan A paid back before term loan B, but that also applies if the company isn't in liquidation as well.

So term loan A needs to be paid off before term loan B can start to be paid off.

And that's why we can see that the amortization here exists typically on a straight line basis.

So an equal amount every year for, let's say each one of those five years, you're gonna pay back 20% of the money borrowed every year.

That's term loan A, and you've gotta pay all of it off before you can start paying back on term loan B.

And then the same for term loan C, term loan D, and whatever else might, we might have further down in the structure there as well, which is why we're saying that the amortization amount here is typically pretty minimal for a term loan.

B, it effectively just operates as a bullet repayment from a legal perspective that all of the money borrowed needs to be repaid at the maturity of that particular debt instrument.

And the same for all of the bonds, uh, the notes like you would see for any other, uh, standard kind of a bond.

Again, the difference for the prepayment and the um, ability, the preprint ability really is no different from loans and bonds generally, but you can repay loans early, you can't repay bonds early typically.

Um, and then seniority who said, okay, as we go left to right, we are becoming more risky, so less senior in the capital structure and equally more risky means less security, less collateral.

So, uh, hopefully most of that makes sense as we go. We'll talk a bit more about, uh, covenants a little bit later on, uh, as we get down this list as well. But the maintenance covenants you have to maintain all of the time, whereas the incurrence covenants, you only have to match at certain points in time, like taken on new debt financing.

At that point, you would measure those incurrence covenants.

And again, you might imagine that you get more protection from those covenants that have to be complied with all of the time, but they take more monitoring compared to the incurrence covenants that you only have to look at when something specific actually happens.

Okay, so hopefully that's given you a bit of a background in relation to the actual debt instruments themselves.

What things might look like from the borrower's perspective.

The private equity fund, if you like, uh, in terms of what the, uh, different kinds of, uh, facilities might look like, that they can raise financing, uh, for their transactions.

The question then becomes, well, who's actually providing this money? And we've talked a little bit about this already and that there might well be banks no surprise, uh, on those term loan as and the revolving credit facilities.

And just while we're talking about it, uh, there's no guarantee you will have a term loan.

A, there are a lot of, um, LBO transactions that don't have any term loan as at all.

But if a bank were to lend money into an LBO transaction, it would be at that most senior level.

You may well find that your debt capital structure starts with term loan B in one of these other structures.

Okay. Um, so just something to be aware of.

Um, so who else might be providing financing for a transaction? Well, as you mentioned, hedge funds might be looking to lend money into a transaction depending on the hedge fund's specific risk and return profile depends on where they might end up. Further down that capital structure.

Insurance companies and pension plans are still quite low risk. They're quite heavily regulated and do need to make sure that they do have enough money to meet their repayments or to actually make any, um, payouts on their insurance premiums, uh, in relation to those transactions.

Okay.

Uh, so Gabrielle, thanks for your question and saying where does the nav, uh, where does the navone, where would be classified in this transaction? Well, uh, uh, and Navone is really just thinking about the, um, what net asset value loan.

Thinking about that coming from a fund perspective.

I don't have any specific detail to add to that, unfortunately.

Um, uh, at this time, unfortunately, apologies, Gabrielle.

Okay, good.

Um, so let's go back into what we have here.

Um, so, um, great pensions plans and insurance companies, um, lower risk, heavily regulated need to have cash to meet, um, claims settlements or pension payments.

So the lower end of the risk scale, so the more senior debt instruments on the right hand side here, we've got CLOs. So collateralized loan obligations, uh, are very similar to what you might have seen or read about in relation to thousand eight. Financial crisis being in relation to, uh, collateralized mortgage obligations, maybe been part of the, um, problems that we faced during 2008, global financial crisis.

Um, what this enables banks to potentially do is to issue a loan into a transaction, but then not to retain it on their balance sheet, but to sell it into a obligation, a essentially an SPVA structure, um, which is buying the loans up from banks and then what it's doing with those loans is it is, or to afford to finance, to acquire those loans.

It's gonna go out and have to actually, um, raise some financing. And we do that by issuing these CLO securities, allowing smaller investors to own a small part of effectively a portfolio of loans, diversifying risk, and, uh, earning the return from the leveraged loan marketplace without actually making loans themselves directly.

So beneficial for issuers banks potentially, and that they don't have to hold onto these loans over time so they can get the origination fees, but don't maintain the ongoing credit risk in relation to them and capital requirements in relation to them.

Uh, but also allows investors that want exposure to leverage loans to get that exposure as well.

Uh, BDCs do the same thing.

BDCs, uh, standing for business development companies.

Okay, good.

Uh, so business development companies, these are very specific us, uh, instruments, uh, and they are listed companies, okay? So they're listed, which means that any investor could potentially own shares in a business development company.

But the only thing that this, uh, business development company's gonna do is go out and invest into small and medium sized companies, either directly into shares, but equally commonly through debt financing. So it's providing capital to small and medium entities typically, or may well be through the form of term loans or mezzanine financing into an LBO structure as well. And this also gives, uh, average everyday retail investors access to that leverage loan marketplace.

Again, it's gonna be a portfolio of loans through each of these BDCs and it, um, will have some diversification as a result of that portfolio of loans, but it gives you exposure, exposure without having to have all of the money to be able to make that direct loan yourself over on the right hand side, we may also find that a private equity fund might invest into the debt structure of a private equity transaction.

Couple of ways is good work.

We mentioned the preferred stock, um, being a way of aligning incentives between management and the private equity fund, potentially allowing the private fund to get their money back earlier, uh, and, and also potentially end to cash, cash return as well.

Uh, the other issue here is that this might be capital that is being provided, uh, by a private equity fund.

Private equity funds typically give themself license within their mandates to go out and invest in the debt element of other LBO transactions led by other PE funds.

It allows smaller private equity funds to get exposure to bigger private equity deals, not by being locked into the equity investing, but by invested into the debt element of that transaction.

So it gives them that exposure.

Also, they can rely on the work that is being done by the bigger private equity equity investor in the transaction, and they don't have to develop all of their own models. They can just review the models produced by the private equity fund leading the transaction itself.

So again, giving them that exposure to the private equity deal without being the equity investor in the transaction itself.

Okay. So private equity sponsors private equity funds, potentially within private equity, uh, houses.

They might have a private credit fund, so that might be where this is coming from as well, but to equally can be private equity funds themselves.

Okay, good stuff. So what does that mean for us? Well, it means that if you are thinking about, uh, if you work for a private equity fund and you're gonna go out and you found a target company, okay, you've looked at an operating model, you think they're a great company to go and invest in, and you then turn around and start having to think about, well, how much money do I want to invest myself in this transaction? Uh, we then might have an upper limit on how much we wanna invest as a private equity fund.

We can then go away and start, well, speaking to banks, maybe speaking to hedge funds, insurance company pension plans, BBCs other private equity funds trying to raise all this debt financing and trying to get from all these investors where they're happy to sit in the capital structure, how much risk they're willing to take on, uh, and also levels of return that they're interested in in relation to those transactions.

Also, maturity dates and any form of collateral they might want and whatever covenants they might want around that as well.

That starting to sound like it's gonna be a pretty all encompassing a heavy workload exercise.

Now, if you've got those debt partners that you have worked with over previous transactions for a number of years, then maybe it's not such an onerous perspective, but it can get quite involved.

And as a result, there is a alternative structure that may well achieve the same outcome for you, but with less administration.

So rather than having to go and find all of the individual separate lenders as we'd have to do for a typical transaction, what we might be able to do with a unitrans uh, transaction is to have one bank, maybe one lender that is overseeing the whole structure.

Okay? And that overall structure will, from the borrower's perspective, from the private equity funds perspective, look like a single debt instrument with a single interest rates attached to it.

Beyond that, the arranger of the tran structure will be going out and speaking to all the underlying lenders and trying to raise money and see where people wanna sit in the capital structure and what interest rate they want.

So essentially the administration of setting up your capital structure is taken on by the unitranche administration agent, probably the lead lender within the transaction.

This won't necessarily save you any money, it won't necessarily be easier, but for the private equity fund, the benefits of the unitranche structure is that it will reduce administration and as a result should lead to increased deal speeds.

You won't need to go round and actually arrange all the financing.

The uni tranche lender will have a range of structures that they already have in place, and they'll have a number of lenders that they probably got some arrangements with already.

So it typically ends up being able to increase deal speed, increase execution agility, and as a result can get more transactions done.

Also, just to be clear, there is just one single interest rates for the borrower, but within that, the actual underlying lenders within the structure will pay different interest rates.

And really the, uh, borrower rate is just the blended average of the underlying lender required rates of written.

Now this is typically not involving banks, but you may well still find that a bank might be involved, as we said earlier on the RCF, um, element of a transaction.

Uh, generally your institutional investors don't really wanna get involved in lending a bit and re receiving a bit back and worrying about all of that day-to-day administration.

And as a result, you may well get a bank involved in actually providing the RCF within the lending structure.

So there might still be a bank involved in here, but otherwise, generally it is more for the institutional lenders.

Okay, Good stuff.

So, one final bit bit then to have a look at in terms of the overall financing mix.

What we've got here is our, uh, capital structure as a whole.

Uh, we can see that we've got an RCF, we've got a term loan a, this repairable after six years term loan B repairable after eight years that the term loan A is described as well. At least we can talk about how much of that that makes up the overall structure.

Uh, we talk about in terms of a debt multiple. So typically there's a multiple of ebitda.

So three times EBITDA is what's sizing that term loan.

A term loan B is gonna be, um, two times our EBITDA.

And then as a result, uh, the remaining subordinated notes we've got are only one and a half times EBITDA. Now that in total gives us six and a half times EBITDA as a a debt capital amount.

That is not uncommon in terms of the size that you might find for a debt multiple of, uh, um, LBO transaction.

Okay? And as a result of that, um, we'll see that six and a half times is the amount ma most amount debt we can take on board here.

Um, got a couple of questions in that I'll deal with in a second if that's okay.

That gives us, given the EBITDA of this company, of one 20, uh, $780 million that we can raise as debt financing, but we think that we're gonna have to pay 980 to buy the company.

So we've gotta put in 200 of equity financing, but we're getting 10 million of that from the, uh, company themselves, from the management rollover, excuse me.

These are the former management that are now essentially bought in and we're aligning the interests of that management team with the new private equity investor. That's why they're, they're at the equity stake.

Okay, So numbers here, hopefully quite indicative of what you might find roughly equity making up 20% of the overall capital structure that is at the low end of what you might expect.

25 to 50% is more likely what you'll see in terms of the debt weighting in this overall capital structure.

Uh, so this is right at the bottom end of that scale just about, but the idea of the management incentive is to align the interests to say to management of this company we've just acquired.

Look, if you do a great job of running the company and boost the profits of the business and boost our exit valuation, then you're gonna boost the value of the shares that you own.

So, you know, get on and work hard for the business, boost our profitability and you'll do well when the private equity fund reaches its exit point for this company as well.

Okay, fantastic stuff.

Uh, we'll talk a little bit about collateralized debt in a second.

Uh, so, uh, Guana will get onto that, uh, in a couple of slides time.

Okay. So, uh, what we've got so far is a range of different elements in the capital structure in terms of what the loans might look like or the notes might look like, the tradeable instruments.

We've then seen who the investors, the lenders might be in that structure.

And also a little bit of nuance here in terms of what the equity piece of that transaction might look like.

We're just gonna go back to have a look at a couple of other elements in relation to what the loans might look like.

The first issue is to do with covenants.

Now when we're talking about covenants, there's lots of different ways we can, uh, slice and dice them.

Firstly, we can talk about affirmative or positive covenants or negative covenants, the affirmative positive covenants, things you've got to do, which might be as simple as submitting financial statements might be as simple as maintaining insurance over the property, plant and equipment of the company.

Um, and really, uh, as you might well expect to pay the money back at maturity negative covenant things you can't do.

These are generally trying to protect the cash flows of the business for the benefit of the debt holders.

So there might be limits in terms of how much CapEx you can acquire.

Definitely limits in terms of how much dividends can be paid out and kind of circumventing the capital structure by getting cash out of the company into the equity holders at the bottom of the structure.

And also, uh, about not being able to issue new debt without permission of the actual existing lenders of the company.

So that's one way we can cut it, uh, affirmative or negative covenants.

The other way we can look at the, uh, covenants, uh, at least the financial covenants is whether they are maintenance covenants or incurrence covenants.

Now the maintenance covenants you've got to maintain all of the time.

Typically they're tested on a quarterly basis, but when you produce financial results.

But the idea is that you are on an ongoing basis in compliance with these, uh, covenants.

And because they're financial covenants, generally they're gonna be to do with things like, um, your debt holding.

So debt to ebitda, interest coverage ratios, maybe holding a certain amount of money in a bank account to cover the next two interest payments, something like that.

Okay? The incurrence covenants, as we alluded to earlier on, only need to be tested under certain circumstances, okay? So in this example here, we're only testing the debt capacity when the company's looking to take on new debt, okay? So if the target company wants to borrow more money, then the existing lenders to make sure that they aren't put at more risk of not having decent recovery rates by there being even more debt around, uh, if there were to be a subsequent bankruptcy, we're gonna say, well, if you wanna borrow more money, we're gonna be happy for you to do that as long as you come to us first and ask us to sign it off.

But you definitely can't take your debt to EBITDA multiple here in this example above five times.

Okay? So that's just a incurrence covenant only gonna be tested under certain circumstances.

And why is this all relevant? Why do we need to know about covenants? Well, you may well have heard about COV light or covenant like loans.

There's been a reasonable amount of, uh, talk about these in the financial press recently and for good reason because most loans in the leveraged loan market.

So that's thinking about collateralized, um, at least thinking about LBO transactions over the last 15 years, there's been a massive shift in terms of what this marketplace looks like.

Firstly, in terms of who the lenders are. So I move away from banks into, uh, more institutional investors.

And as a result of that, a significant move away from more traditional covenants that you might see on bank loans.

As you can see from this diagram, over 90% of leveraged loans are covenant like.

And what does covenant like mean? Well, essentially it means there are no financial maintenance covenants to worry about.

Now, there's a couple of drivers here.

The main issue is that banks are happy to, is in insist on if you like maintenance covenants.

'cause the biggest problem with maintenance covenants is checking them up.

Okay? So the, uh, borrower has got to submit data to the lenders, but then has got then check that those numbers against the, uh, covenants to make sure that everything's okay.

Now, there's something banks do all their time on regular corporate loans.

Uh, typically you will find maintenance covenants as a result. Banks have, um, loan management divisions that actually look at and ensure that covenants are maintained on an ongoing basis, right? However, for the leverage zone marketplace where it's a much more institutional driven marketplace, the hedge funds really wanna every quarter be checking up to CLOs that these other private equity funds really wanna be checking up, uh, on an ongoing basis with these covenants.

They're probably not so well set up to do it.

So as a result, we generally see, uh, the covenant like marketplace growing, uh, as a result.

Uh, and also though, not just because of that, it's just down to speed.

Uh, if you insist on having as a lender, significant covenants in place, then as a result it's gonna just slow down the transactions speed to ensure that the covenants are negotiated and agreed and both parties are happy with how they look.

So in the interest of speed of getting transactions done, then the cover light is a bit of a move in that direction to increase deal speed and execution speed.

Now, I would imagine, I wouldn't need to say this and I hopefully I don't need to say this, but the covenants are there for the protection of the lender.

The idea is that you are controlling the behavior of the borrowing company to reduce the risk of bankruptcy.

And if you have fewer covenants, you're giving the borrower more free range to do as they see fit, which might not be necessarily in the best interest of you as the lender.

And as a result, that may well lead to increased bankruptcy during times of financial stress.

So as we move into economic downturns, those cover light loans, which haven't been meeting the maintenance standards up until that point, are probably gonna be, or at least the borrowing companies probably gonna be in a situation where they're maybe not as well positioned moving into that economic downturn.

And as a result, there's a increased risk of default.

So speed of transaction, great to get the deal done, but if there's an economic downturn, there's a big risk here that actually companies won't be so well protected. They won't have been so disciplined in terms of running their businesses, uh, to meet the maintenance covenants on an ongoing basis so that if there is a downturn, they're more at risk, probably of d default.

Other thing to mention, and this is hopefully getting to grant question, is around collateral, okay? So when we're talking about a collateralized facility, what the collateral means is that if there is a default event, if the borrowing company goes into bankruptcy, then the lender doesn't just have to be wait and have to wait and be paid out of the general assets, general remaining assets of the company.

A collateral is where you have security or a charge or a lien over a specific asset or category of assets in that borrow company.

So it could be property, it could be which is an individual asset, it could be a category of assets like inventory or accounts receivable.

But the idea is that if you have a claim or a charge or later or security or means the same thing over a particular asset, then that becomes yours in the event of bankruptcy of the borrowing company.

And as a result of this, um, yeah, as a result of this, you are more likely to get back the money that you, okay? Um, first lien is more secure because you have the first charge on that assets value.

Second lien loans have a second claim on any residual value of that asset in a uh, transaction. So let's say you've got a hundred million dollars loan and the clo the charges over, uh, an office block, there's worth $120 million.

Okay? So in um, bankruptcy, the, uh, administrators sell the property off get 120 million that can cover all of the first lien loan here. Maybe a term loan, a there's 20 million left over that just doesn't go into the pot for everybody else.

If there's a, a second lien that will go directly to the term loan, let's say B here to pay off as much of their debt as you can.

And for the remaining that again then goes into the pot with everybody else, the remaining outstanding amount, Okay? Clearly the better the quality of the asset, the more fixed nature of the asset, the more likelihood there is of getting your money back in insolvency.

If you've got a claim over inventory, well you just dunno how much inventory is left in the warehouse until the default event occurs.

Okay? Good stuff.

Um, great.

Um, fees, uh, well there are fees that go along with all of these transactions.

Definitely worth not overlooking 'cause they can be quite substantial in terms of these fees.

Uh, for the actual, typically for the arrangement, for the ongoing administration of these fees, you'll definitely see this.

Uh, in relation to something like a unit tranche structure, um, things that are a little bit different in relation to what's on the right hand side.

The ones worth picking up in terms of just ongoing, other than ongoing fees.

A commitment fee is payable on an RCF whether you, uh, if you don't use it.

So if you've got a RCF or you can borrow if you need the money, uh, you've gotta pay a fee whether you borrow money or not.

Sorry, that's not quite true whether you on the undrawn amount of that facility.

If you borrow money, you've gotta pay interest.

If you don't borrow money, you've gotta pay this commitment fee.

Um, the facility fees are typically the kind of initial setup and you can see on the right hand side here, if we take all of these financing fees together, what the structure might look like and hopefully it's not a huge surprise that even for the RCF if no money is borrowed, there is still a cost to this because this financing cost amount is based on the committed amounts Applied to the facility.

Excuse me, apply to that facility B.

Okay, good stuff.

Uh, good. One last final thing before I, uh, try and answer that question one in more detail if I can for you.

Uh, just in terms of setting up a deal structure, okay, we've seen that there are lots of different elements potentially of an LBO structure and the key balancing act here is between how much money you can borrow, how far down the structure you want to go.

The further down, the more you can borrow.

But the offsetting factor is the increase in interest cost as you go further down the structure.

So it's a balancing act between taking on more debt financing at increasing ever increasing interest rates as opposed to what that saves you is having to put your own money in from the private equity fund.

Other points to be careful of and aware of, um, LBO transactions can take a long time, could take six to nine months from maybe initially speaking to a target company to the transaction being finalized and over that time period, although you might have a, um, structure in mind and lenders in mind for that transaction, are they gonna stick around? Are they gonna be involved in the first couple of months and then with a month to go before the deal closes, just walk away? That might be a challenge for us. That's certainty of financing the investor relationship. Really important as well that as a private equity fund, you are not just gonna be acquiring a target company once you're gonna be doing it a number of times within each fund that you operate.

And to maintain good relationships with maybe other private equity funds that provide you with some debt financing or the banks that you're related to or any other lenders that you might be borrowing money from, you might need to think about maintaining that relationship and involving them in certain transactions to maintain that professional relationship on an ongoing basis for subsequent transactions.

Uh, refinancing is a really important point because, um, you might want to move into more long-term financing.

You might not just want to have financing in place for the next five or 10 years.

You might want to have security in terms of your capital structure and look to have more long-term debt Financing might be by maybe issuing a really a longer dated bond.

Issuing a bond is quite time consuming and, uh, pretty rigid and or less flexible in terms of when it's gonna be issued.

So you might want to take on all of this institutional debt financing to get the deal over the line.

And then maybe two years down the line, when you've proved your ability to meet interest payments on debt instruments and proved your credit worthiness as a company, you could maybe look to, uh, issue a more structured, more sizable bond, maybe given your better credit quality, a lower interest rate attached to that, but that might require early repayment of your existing debt instruments.

And as a result of that, you might need to think about that in the initial structuring to see whether you're putting break clauses in place to allow you to get out of bullet repayment loan instruments or debt instruments prior to maturity.

Talked about the covenants a bit, talked about the cash impact through interest payments and pick loans potentially as well.

But there's a lot of stuff that's in the mix here.

A lot of considerations you've gotta give thought to in terms of designing your capital structure.

Okay, uh, just in terms of grants question, sorry, I thought it, uh, we're talking about collateral, but we're talking about collateralized debts.

This is where we're looking at those CLOs.

So the CLOs that we had all the way back here, A CLO is a form of, uh, collateralized, uh, debt instrument. That's a collateralized loan obligation.

It's a special purpose vehicle, an entity whose only interest is to buy up loans from banks, sometimes referred to as collateralized debt obligation. Capitalized loan obligation is just a more, uh, specific name for it.

Um, so this SPV is just buying up loans maybe from banks, maybe from other lenders, whereas getting the money from, from doing that, well, it's issuing securities.

Um, these are what these CLOs are, and as a result, we're getting the cash in from a portfolio of loans and then distributing it to all of the investors in these securities that we've issued to actually get that cash coming in.

These were held out as being, or definitely were part of the contributors to the global financial crisis back in 2008.

Part of the issue there was, um, investors not having sufficient eyes or awareness on what the underlying portfolio or pool of, uh, loans look like.

Just taking them a bit too much at face value, uh, and not really appreciating that. The biggest issue here is not default, but maybe resale value at the end of the CLOs life.

So there's definitely more awareness of those issues, uh, today and as a result, hopefully if there are downturns, there aren't lots of investors who are, have significant holdings of CLOs where actually the underlying, uh, loans are not as credit worthy as might be hoped.

Hopefully that answers your question.

Okay, we're a little bit before the time that we had, uh, lined up here, but if you have any questions, I'm more than happy to take them. That's the end of things, what everything I've got, uh, uh, for you for this afternoon, hopefully that was useful and gave you some insight in terms of how the private equity market structures the debt element of a financial transaction of a leveraged buyout transaction.

Um, other than that, that's it for me today. Thanks very much. Hope you had a, a good time and um, maybe look forward to seeing you. Oh, definitely look forward to seeing you hopefully on one of these Felix live sessions.

Uh, later on. Have a great weekend and hopefully see you again soon. Thanks very much.

Uh, just in terms of answering your questions.

Um, so hopefully, uh, Jiao answered your question around the maximum debt leverage you might be able to take on board. Definitely depends on the, um, borrower, but also, um, lower than it was five years ago because of higher interest rate environment that we're in now.

Uh, LBM modeling and m and a modeling both have their complexities.

It depends on the nature of the transaction, but LBO modeling can get super complex in terms of the makeup of this capital structure.

Apologies not going there. Those questions sooner. Hopefully that, uh, provides you some answers.

Great. Thanks very much. Have a good rest of your day.