Hello everybody. My name's Ollie or Oliver, you can call me either.

One of the instructors, and today what I'm going to do is this private equity financing, which is quite a broad topic.

We've got this website, which I will put into the chat, and you can get all of the downloads from today from that website.

Okay, I'll probably end up pasting that in a couple of times because as people join, they don't see the history of the chat.

All right. Now, we've got about an hour.

When I did this this morning, we overran slightly, but that was because there were lots of questions.

I envisage going for about 45 minutes, okay? I want you to ask questions. I don't mind overrunning.

Okay.

I had a really nice time this morning answering lots of questions about debt, and speculating a bit about the ones I didn't know the answer to.

All right. So I'm going to open up this slide deck.

Okay. Normally in these kind of sessions I don't use a slide deck as often, but today it works really well. Okay. Just give a bit of structure to the session.

And then what I'll do is I'll bounce out and look principally-- Okay.

So I'll bounce out and look principally, let me get rid of that, at this one. It's called Public and Private.

Okay. So I'll download that as well, just in anticipation.

And get it open because it takes a little while to open.

I'm going to copy that into the chat again, so you've got access to this.

All right, so here we go. We're going to have a look at a variety of topics, and then you can ask me whatever you like, and if I don't know the answer, we can speculate together and help each other out.

We're going to take a look at it from a PE point of view.

So I'm often going to talk about doing an LBO.

We're going to see what types of debt might be available to funds when they're organizing an LBO or a PE transaction.

We're going to look at something which you might not have looked at as often, which is who are the eventual holders of the debt.

So where does the debt end up? Okay. And that is going to help us to understand the kind of ecosystem of lenders and some recent developments which are quite interesting.

We're then going to have a look at equities, so the management roll, and we'll have a look at preference shares as well and talk about the motivations behind them.

The last bit, this morning went quite quick, okay, covenants.

We'll have a look at bank rules.

Collateral, we'll have a look at the security attached to debt, and financing fees, I don't really intend on doing too much on.

They're very diverse.

This is supposed to pull it all together, but if we do a good job of chatting things through as we go, okay, the debt structure consideration, we won't need to do specifically.

All right, so here we go.

Okay. We've got a number of types of debt on this slide.

Let's talk them through from top to bottom.

You can see on the next slide, there's more detail, and so I'm not going to get into too much detail now.

So let's say I'm putting together a deal, right? Okay. Let's say here's the model I made for Morrisons. Okay, so Morrisons was LBO'd in 2021 by a fund or a firm called CD&R, which is quite an interesting deal because it was done at a time of very low interest rates.

You can see SOFR's at an all-time low.

It was done at a time when it was unclear what was going to happen with COVID or how long it would continue and what sort of impacts it would have on the UK supermarket industry, and it didn't go particularly well for CD&R.

We're imagining we're in 2021, and we're putting together this debt package, right? I mean, debt and other funding package.

We've worked out that to make the deal attractive, we need to pay about £7 billion to the target shareholders, and we need to pay about two-ish, 1.7, to get rid of the target's debt, so we can replace it with our own.

We've got some fees to pay, and so we need about £9 billion, and I've run this in US.

Now we've got two proposals from me. Okay.

This is what was intended to happen, and this is my kind of what if, I think.

Right? And what we've got is a situation where we either go more towards bank debt or we go more towards bonds, notes, what you could call public debt.

And the question that we're addressing in this session is why would you want one or the other? What are the qualities of this debt, and what are the aspects that we need to be aware of? Okay. I'm just going to copy in the link one more time.

Okay. That's where I'm getting all the resources in case you just joined.

All right, so let's start at the top.

Normally what will happen is, if a deal involves banks, which it doesn't necessarily have to, it will organize a term loan, maybe a TLA or a TLB, and then that term loan will probably be packaged with a revolver.

Okay. Even if there's no banks involved in the major part of the lending, you probably need a revolver anyway, which the banks are best placed to provide.

Now most deals these days, as far as I can tell, have a TLB in them.

And that'll be a bunch of banks coming together and saying, "We'd like to share out this TLB in a syndicate because taking it on ourselves is high risk, and we don't have enough contacts to get rid of the loan and sell it on." Okay, so they syndicate the loan, be it an A or a B, and then they'll split that loan up and also split up the RCF, which will be an ongoing commitment to provide, say, $500 million into the structure should the need arise for things like working capital.

So you can see here the deal itself doesn't lean on a revolver.

It's not the smartest move to lean on the revolver, and the lenders don't love it, I don't think, because this is supposed to be short-term funding.

Okay? What it's supposed to do is support the working capital needs of Morrisons going forward, say they have to stock up in anticipation of Christmas or something, okay, and they need short-term debt to do that.

All right, so the RCF is super common but doesn't actually get used very often in deals. It can do, okay, and has done, but I don't think it's your classic deal debt package.

So then we're left with TLA versus TLB. Well, what's the difference? Well, we'll find out later. The difference on this slide is that TLA generally stays in the bank, okay, so on the bank's balance sheet, and TLB generally ends up in the hands of institutions such as pensions, insurers.

Now, this helps us to understand a major shift in leveraged finance, which is that TLAs have somewhat faded in debt packages.

And that's because the banks since '08 are subject to such stringent capital ratio requirements.

The opportunity cost of keeping so much equity around as the buffer means that their TLAs have become comparatively expensive compared to institutional debt, which isn't subject to such stringent regulations.

So I think if you're looking for a reason why TLAs have fallen out of favor a little bit, an oft-cited reason is the regulatory pressure put on banks making their TLA slightly less competitive.

All right, so we've got institutional debt, and we've talked about the B.

Cs and Ds might just be other term loans with more subordinated relationship, so lower in the stack, but they're probably still very senior to the others.

All right, next, we've got senior notes.

These will probably be low rated.

Okay, this means they'll be high yield or what they used to be called is junk bonds.

You'll issue these eventually into a bunch of stakeholders' hands, and they'll need to be marketed probably via a bank, via their debt capital markets or leveraged finance desks.

And then they'll end up in the hands of a variety of investors.

And then when they're in those hands, they can be traded, okay, because notes are generally very liquid.

We'll see later that the TLB has become quite liquid as well.

I don't want to do that just yet.

Now, why would you want senior notes instead of just more senior bank or institutional debt? It's because the idea is for gigantic deals, mega deals. And I think this is getting towards a mega deal, right? It's like $8 billion.

Okay, the idea is that private debt, okay, not private credit, but bank debt might run out of steam and not have deep enough pockets to fund the level of gearing or leverage that you want in your debt package. So the idea is that public markets, bonds, have deeper reserves of capital that are more accessible, and so you can achieve greater leverage.

It comes with downsides that we'll talk about later.

All right, then we've got private credit, alternative lenders, your Ares, maybe Apollo. Don't actually know if they do that.

I imagine they do.

Credit funds, that kind of thing. And they'll be offering mezzanine debt, which are usually these hybrid instruments that we'll look at later.

Okay? They're somewhere between debt and equity and often have qualities of both.

The preferred shares are probably going to come from the fund.

We'll talk about that later again.

There's a special thing that they can achieve with the preferred shares.

And by the time you're down here, you're stretching the definition of debt, really.

I don't think many people would call preferred shares debt.

They're certainly legally not debt. They're equity.

The final type of debt just to be aware of is a vendor loan.

This is often used if, let's say we look at Morrisons.

Let's say the acquisition equity value is just a bit higher, so like 7,200 or something.

Okay, can you see that falls straight onto the lap of the fund through the preference shares? Now, let's say the fund can't afford that ticket and make their IRR, or they just can't fund that equity ticket.

It's possible that you could lean on the vendor itself to provide the last 200.

Okay? And the two ways that are generally, well, three really, that are generally used to cross a line in these small last hurdles, okay, are number one, a shareholder, excuse me, a vendor loan, okay, which is actually usually much more subordinated than this slide would suggest.

They're usually right down here with mezzanine.

The second way you could do it is the management role, okay? Which is where you ask your management or other owners to stick around in common stock and pay for some of the common stock themselves, and then participate in the exit.

And the third way is something like an earn-out or deferred consideration.

Okay, so that's this slide here. There's a lot going on there, so you might have questions, and so I'll pause there and just see if there's anything anybody wants to talk through.

Okay, you can put your questions into the chat box or the Q&A if that makes you happy, or I think I've allowed everybody to talk, so you could, excuse me, unmute yourself.

Don't know what's going on with me.

There's not that many of you. There's about 20 of you, which is pretty good for Felix Live, but it's fine. So you can unmute if you want.

All right. I'm going to assume that people are okay.

If you are typing, just keep typing.

All right. Now, this slide's a bit busy, right? So if I just talk broad strokes, clearly the most safe type of lending is on the left, and that's because it's really senior.

It's really short.

Okay. It's got a kind of built-in hedge against interest rate risk, and it has quite stringent covenants in some cases.

And then the most risky lending is on the right.

Okay. It often doesn't get any cash at all until the end.

It's deeply subordinated and there's no security, and often it doesn't really have that many covenants, although we'll see that's not always the case.

And that means there's a spectrum of low to high cost available to the fund.

You might think then, "Well, we should just fund the whole thing from RCF.

It's the cheapest." Okay, well, that's not going to work because that's just not allowed. It's short-term debt.

So then you might say, "Well, let's go for the whole thing on a TLA basis," right? At a certain point, the lenders that are kind of lining up to give the LBO a TLA are going to run out of patience, I guess, or you might call it debt capacity.

They're going to look at the structure and say, "At this point, we're uncomfortable lending any more." And then you may have to go to, say, subordinated notes to make up the rest of your debt because they've got much looser view of debt capacity as part of their higher risk-reward strategy.

Okay, so generally, if we go back to Morrisons, this 2,800 is not there just for fun, okay? It's trying to get the cheapest debt.

There's other considerations as well, but where perhaps a TLB runs out of debt capacity, we might have to go for a subordinated loan or mezzanine to make up the rest to lift up our IRR.

Now, it's a balancing act.

Okay. Clearly, the TLB is a better idea just from an earnings and even a cash flow point of view.

Okay, so if we could jam the whole LBO into that TLB line, it would be a better LBO.

I don't think there's any arguments there, really.

The question becomes, is it worth paying 12% to get extra debt? Why would you pay 12%? That's an enormous amount of money.

The more mezzanine you load into this thing, okay, what's going to happen is you're going to have less cash for sweeps, and that means more debt at exit.

Yeah, so if we take a look, can you see over here, cash flow from operations is going to have interest in it, so the more we jack up the interest via mezzanine, the lower that number's going to get, and that means our sweeps won't be able to sweep away as much debt, which means the exit will be weaker. And so it begs the question, well, why bother with what we might scrape in the barrel a bit in terms of debt, or more positively, like levering up? Well, if I take a look at the IRR, here it's 23.9.

So if I just copy and paste that values.

Okay, so that's the original IRR, right? And that's not going to change if I play around with the model.

Now let's say I really jack up the mezzanine by another 2,000.

Okay, can you see that really means that I don't have to put barely any preference shares in as the fund.

Okay. I could even go 500 higher, and now I've almost eliminated my preference shares, which is very helpful.

Now, what's going to happen is, if we take a look, wow.

Okay. IRR's shot up, right? And that's not because the mezzanine is cheap. It's the opposite.

Mezzanine's super expensive. It's because the leverage effect is very strong now.

The B institution is putting less equity in, which amplifies the return.

And so there's a strong urge in financing packages to lever up. The name is a leveraged buyout.

And so when we're looking at this kind of thing, we might tolerate some of these very high costs if it means more leverage from lenders who are more generous with debt capacity.

Okay. What I want to do now is I want to just grab a workout just to play around a little bit.

So if we grab this debt products and PE workout empty.

It's possible you don't have access to that.

Maybe you've logged in late, and I didn't put the link in.

If that's the case, just let me know.

All right. Now opening it up, and you can just look at it on the screen as well.

A lender has the following needs, trying to decide which product to use or type.

They want six years low risk, and they want call protection, and that means they want it to be difficult to pay back the loan early.

And I mean, calling it loan is a bit...

Debt.

Okay, so in terms of call protection, why would you want call protection? If the borrower can sweep into your debt, that means they can reduce your debt, which might make you happy if you're a certain type of lender, but then you've got the money, and you need to redeploy it elsewhere, right? So if you're a certain type of lender, you might just be more into the idea of like, "Okay, you've got my money.

Now I don't want it back. In fact, you're not allowed to give it back to me, and if you try, you'll get penalties." That's called call protection, and it's quite common in certain types of debt.

Okay. So let's have a think, what would that lead to? And I'll just put this slide up again, and you can take a look.

Have a think to yourself.

Okay, I think what I was pushing you towards there when I wrote the workout was senior notes.

Okay, so they've got the right maturity, so they can be anywhere between about five to 10 years.

Okay.

They've got no prepayment, which means they've got call protection.

And they're senior, which means their risk should be relatively low.

You could argue that it's not low enough for this, but that's the idea. So a lender would position themselves, depending on their needs and wants, within this spectrum, and then they'd be effectively dancing around the fund, who'd be trying to position their own debt package for their needs and wants.

Do they want to delay payment? Okay, do they want to pay off early? Yeah. So would it be a negotiation between the fund and lenders? And it would settle on some sort of capital market, effectively.

Okay.

Let's move on.

Now, this is a fun slide, and you may never really thought about it this way before, so feel free to ask questions if you've got them.

All right. So what we've got here on the left is the things that most people are aware of, which is the lenders, who you could call the originators in a way.

Okay. And sometimes that doesn't quite work on this slide.

On the right, you've got investors, and it seems a bit odd because wait, hold on, are they lenders or investors? How does that work? Most people would use investor for a term like equity, so sometimes people get a bit confused with this slide.

All right. Now, we've said that normally the revolver and the TLA is organized by the bank and then is kept by the bank on their balance sheet.

Whereas a TLB might be organized by the bank but then sold on to a variety of stakeholders, some of which are probably quite familiar, like hedge funds, okay, insurers.

But you may not really have thought about CLOs and BDCs before, especially given BDCs are American, and I don't know if you're in America.

Okay.

You may never really thought about PE sponsors, so funds themselves being active in this area as well. So it's worth thinking through.

All right. The first thing we'll do is we'll take a look at this CLO situation.

And let's take a look at workout three.

A bank lends money as part of an LBO, and they've created a TLB.

So here's the bank, and right now they're holding a TLB, and they probably syndicate it.

Okay, so there's a group of banks, and they organize a TLB and maybe an RCF at the same time, okay, and then they syndicate it, and theoretically, it's now on their books forever.

Well, until redemption, at least.

And that's over here.

Okay.

Now, what's going to happen next is you've got this CLO, and it's a collateralized Loan obligation manager.

Okay. And that's an organization, a little bit like a fund.

I think they often are funds. And there'll be a manager, and they say, "Look, we're in the market for TLBs. We want to take a stake in TLBs. Not a whole TLB, and we don't want to lend into the LBO itself, but if you've got TLBs, we're interested in buying them from you." Okay? So what happens is the bank starts marketing the TLB, which hasn't even been properly lent yet, and it markets it to CLOs and actually to other investors who it could sell genuine slices of the TLB to.

Okay. Now, what's going to happen next is the bank will actually create the TLB, so it really will happen, and now the TLB really does exist.

And then what'll happen is the CLO is starting to think, "Oh, that's going to come my way.

I've already had conversations with the fund, and I reckon that is a certain thing now. So I'm going to start marketing to a variety of investors, and I'm going to market bonds to them." All right.

Now, the bank then sells the TLB to the CLO, and there's lots of acronyms here, sorry.

And then what the CLO does is it effectively takes the TLB and it creates bonds of a variety of ratings.

And it even creates equity.

And it's effectively sort of created a capital structure stack out of the TLB. Okay? Now, what it then does is it splits the already split TLB down into little bits and it sells them. So here you might have a Japanese bank, and they kind of want exposure to this kind of thing, but they're very risk-averse, so they say, "I want to invest in your CLO on a triple A basis." And here you might have a very risky investor, okay, and they might say, "Do you know what? I'm happy to go with a bond B on this basis." Now, if the TLB fails because the port co can't pay it, then they're more protected than they are on the way out.

So what you've created is a collateralized or securitized asset that's split in terms of risk and size.

And what it does is it creates a much bigger market for TLBs to leave the balance sheet of banks.

And that means the banks are more willing to engage in TLB kind of organizing activities because let's say you didn't have CLOs, you'd be selling it just to the hedge funds and insurance.

And they may not have the appetite or the size in the area that you are. And so CLOs have created a lot of liquidity in this area, and they're a pretty big deal. Okay. They're seen as a really good thing.

I think some people kind of get them a little mixed up with the whole mortgage-backed security thing in '08.

The idea of the risk of these is actually quite low because it's such a well-understood product. I think the problem with the MBS or mortgage-backed security situation is nobody really understood the product.

Okay, so that's CLOs, which is quite a lot to take on.

I'm just going to pause there, see if anybody's got any questions before I move to BDCs.

Okay. If you are typing, just keep typing. It's all good. All right.

So BDCs are sort of the same idea. They're an America-specific phenomenon.

I think it was set up in the '80s or something to promote investment into small or slightly more distressed companies.

Okay. What'll happen is you'll have a BDC manager, business development company, and they'll take maybe a slice of the TLB or maybe some mezz onto their books from the bank, okay, or other thing.

I guess they could also lend directly into the LBO. I don't know how common that is, actually.

And now instead of creating bonds, they're just going to sell equity, okay? And investors can include retail investors.

And so this is like a gateway for retail investors in the US to invest in a wide variety of things.

And it's also tax efficient, okay, so it has some tax advantages.

So that's how a BDC works, a business development corporation.

Very big in the US. Not a big deal in Europe.

Doesn't really exist.

Okay, and that brings us to the end of this slide.

So just want to see if there's any questions here.

Yeah. They set up as companies and then they sell shares, so you own a stake in the company. And I think they kind of IPO and the idea is that the thing they sell is very liquid, very easy to understand. There's no tranching, which might confuse retail investors, like, "What am I buying here? What risk profile?" Just in case you're wondering, Aaron's asked, "Why do they only sell equity?" I think my impression is that it's just an easy-to-understand product, particularly for retail investors who might not like the idea of tranching the way that...

Oh, Aaron's asking, "Why not unitranche debt?" Remember, the BDC doesn't sell debt to investors, it sells equity.

You might get a BDC doing unitranche as a relationship with the port co, and I think they are actually quite common, unitranches, but that wouldn't be on the investor side, that would be on the borrower side.

Does that make sense, Aaron? So I think there are big players in the US on unitranche, but on the other side is what I'm saying.

You're welcome, and it's lovely to have a question.

So you can see I quite like them, and so if you've got questions, feel free to jump in. I have to repeat the question because I think they're hidden from other people.

Okay. I think last thing on this slide is increasingly PE firms are diversifying or looking to use their knowhow that they've built up doing things like leveraged buyouts, and so increasingly they're becoming themselves actors in the leveraged finance or debt space.

It's also quite useful if you're a small firm.

Okay, so let's say I'm not CD&R, but I'm some UK small LBO buyout fund. Now, I clearly can't afford the 9 billion ticket, nor am I big enough or have enough clout to co-invest with the fund and become part of the equity.

So if I think the Morrisons deal is a really good one, then maybe I could get some exposure to equity-like upside through perhaps issuing the mezzanine.

Okay? And so increasingly, funds themselves participate in deals in a variety of ways.

Okay, debt ways is what I'm talking about.

Okay, good.

On we go. And Aaron was asking about unitranche, and here it is.

People still call this new, but it's quite old now. I think it is still increasing and increasingly being used for larger and larger deals.

I think until relatively recently it was a mid-market phenomenon for funds in like tens to hundreds of millions.

I think billion-dollar unitranches are becoming more and more common, and so it wouldn't be totally crazy that a unitranche could cover Morrison's. It would be big and unusual, but it wouldn't be impossible in this day and age.

So let's talk about what a unitranche is.

Right. Now, if I just take some blank space.

So if I'm the borrower, and you can see it on the slide, so I'm effectively going to recreate the slide.

I could take a TLA and I could take maybe some mezz.

Okay, now that means two loan agreements.

Okay. And it means two sets of people to deal with, potentially two sets of covenants.

Okay, potentially some legal work in how these two relate to each other, especially if I put a third one in, it starts getting pretty wild.

And it might be quite slow because this needs to be syndicated.

If it were a TLB, probably the bank needs to be comfortable that it can sell it on, and so it needs to do some marketing themselves.

So instead, what we could do is we could say, all right, let's take a unitranche.

It's got one loan agreement, and then behind the veil, like a curtain, is a bunch of investors who take different risk profiles.

If these had a kind of, let's say, I don't know, this is like 6%, and this one, just to keep things simple, is like 12%, and they were like 50/50, then you might expect the unitranche to run as the average of those two, right? So you might say average, if they were 50/50, which is incredibly unlikely, okay, but just go with it.

And so you might say, "Well, the unitranche should run between them because it replicates these two." And that's what's so good about it, is it replicates the kind of relationship that you might have with these and the kind of cost profile that you would achieve with them.

The good thing is this is going to be really fast because usually there's a club of lenders who've done this before.

It'll be like Oaktree and Ares or the BDCs in the US, and this is what they do. And so they'll have a club of lenders ready.

They've done this before, and so they'll just deploy the cash very quickly.

Okay. It's more private.

Now let's say we had some notes here, then those notes require quite a lot of disclosures, which as the borrower, for some reason, you just may not want out there.

One of the benefits of an LBO is that you get to go private and get to draw a veil of your own over your activities.

Well, with the unitranche, there's less disclosure, which is helpful.

So why don't we use unitranche for everything? It's usually more expensive.

When I build models, I tend to put an extra 2% on.

Okay? So it's effectively charging for that benefit.

For funds that don't have the kind of relationships or know-how to do this quickly, unitranche is very popular and drives many deals now.

Okay, so I'll pause now and just see if there's any questions on the way unitranche works or anything about it.

Okay, if you're typing, keep typing. Now we're onto equity.

This is, for me, one of the most interesting bits of an LBO.

Right? We can have effectively three or more types of equity in a deal.

Okay. If we take a look at Morrisons again, you can see we've got common stock, and that's split into the role, the management role, which is management keeping a stake of the company, which then the fund doesn't need to pay for, and then the PE institution, which has put a bulk in.

But actually the common stock is relatively small in this deal.

And preference shares, which is still equity coming from the fund, is making up the bulk of equity in package one.

And there's a question which is: how does management equity work? Why do funds issue prefs? Why don't funds just issue all equity? That kind of thing.

And that's what we'll do now.

Okay. If we take a look at the IRRs, you can see that management is making a better IRR than the fund right now, which is again making a better IRR than the mezz.

Actually, that's quite helpful to do, so I'm going to do that here as well.

Okay. Then here.

Right. So if we now grab the originals here and play around with the model.

If I chuck in a really bad exit, you can see here it says exit, and I exit at eight, which would be really terrible. You've bought in at 14 and you're going to exit at eight.

That's a defeat, really.

Now what happens to who? Can you see the mezzanine? Blimey, they're doing well.

And this is because what they've got is debt and gets paid out ahead of equity, right? So it gets paid out ahead of potentially the preference shares and the sweet equity here.

Now this means that effectively the management get wiped out.

That haven't actually-- It's not worked. Interesting.

Boo.

Okay. So, the management get wiped out and that's because they've got all equity which has disappeared down the plughole.

So the PE is actually relatively resistant, and that's because of the prefs.

The prefs create a debt-like.

Okay? So the prefs create a debt-like, and here they are. They're running at 12.

And all they create is a hurdle for the fund, okay? And management are very unlikely to get any real return until that says 12% or something like it. The numbers are a bit more complicated now.

The other reason prefs are so useful is they concentrate risk and upside.

Can you see management, if they do a bad job, are suffering the most here.

Whereas if I create a really good exit, so we exit at 16, management are the ones who create the most benefit, and that's because they've just got upside, whereas some of the PE return is a debt-like.

And so it's interesting to see prefs in these structures.

They create a kind of debt-like without actually doing debt.

Now funds can issue debt like shareholder loans.

A lot of the benefit of those has gone away in many economies because of tax evasion rules like base erosion prevention, BEPS, as they call it.

So if you're wondering why it says prefs here, not something like shareholder loans, buyer loan, that kind of thing- It's because the benefit of having this as genuine debt has disappeared a bit because tax authorities tend to deem that kind of thing increasingly to be non-debt anyway.

Okay, we're starting to get towards the end of our time.

That's quite a lot to take on, and for me, one of the most interesting bits of the source and uses table.

I'll just see if there's any questions there.

Okay, so we've got about 10 minutes left or so, and so we'll do a light touch. Okay. And then if people have got questions, I'll hang out afterwards.

Now, covenants come in a number of sizes and shapes.

Okay. Some of them stop you doing things.

You're not allowed to pay a dividend until we've got a certain leverage.

Some of them make you do things, like our secured assets must be insured, and some of them are financial.

Okay. And they fall into the same kind of bracket, like onward ongoing monitoring or things you must or must not do.

Now, on the whole, within the more senior debt, covenants have really nosedived after '08.

Okay. Most covenants, or excuse me, loans or debt is now what you might call cov-light, which might just have very few or no covenants.

Now, why is that? It's because the perceived risk after GFC, '08, really fell away, and so lenders became more comfortable issuing easier to monitor loans.

There was also an element of competition. Okay.

If you're offered a loan with ongoing admin versus a loan with no ongoing admin, and they've got the exact same cost, well, of course, you're going to go with the one that's cov-light because there's less work, which means you need less admin headcount, which saves real money.

I think arguably one type of loan has gone the other way.

Okay. We said that something like mezzanine, being private credit, is on the up.

And so things like unitranche have become more popular because mezzanine are right at the bottom of the stack.

Okay. And because a lot of what they're doing is very high risk, they might actually ask for more covenants than you would expect.

And so cov-light, I think, as a phenomenon, is slowing down and might even dip, I think, in future years.

And that's because private credit tends to have more covenants.

Okay.

Now we're next to done now. So we've got collateral left.

I'll just pause there to see if anybody's got any questions about covs, covenants.

Yeah. So somebody's asking, "Why has mezzanine debt been growing again?" I suppose taking it literally, I don't think mezzanine debt has been growing that much.

I think unitranche, which has qualities of mezzanine, has been growing a lot. And I'm willing to hear from others who are maybe in the industry and your country.

I'm always looking for input, so if you've got a comment here, feel free.

This is associated with private credit, which generally is increasing.

It's growing because LBO borrowers like the speed and the privacy.

It's also growing because the type of players that engage with it are holding more and more dry powder and are looking more attractive, and so have more and more funds flowing into them that they need to deploy, which they might deploy as debt instead of doing traditional buyouts.

And so there's a general kind of move towards private credit, and private credit is generally where mezz lives.

And so that's why maybe it's been growing the way I've been describing.

Okay, so potentially our last thing then. Now collateral.

Let's say I'm going to buy Morrisons. Okay.

I've been thinking about it the whole time, and now I'm like, "Yeah, I'm going to buy Morrisons." Then what I might do as the fund is I might start to look at the asset base of Morrisons as a way of collateralizing the loans that I intend.

I might look at some of the assets and say, "Well, these are basically worthless, right?" So if you're running a supermarket, Morrisons is a supermarket, well, you can't collateralize very many loans against this apart from maybe the revolver.

Okay. Nobody's going to put a long-term loan on inventories specifically because they move too much, and they don't sell well in liquidation.

Okay. What might be quite tasty is something like the PP&E, especially for a supermarket.

So you might have specific, often on property, collateral or security.

And something like a playbook in UK LBO of retail would be to take a good look at the books of the target and say, "Right, is there any value that we can release from this lot because it's all prime sites with supermarkets on there? Could we maybe do a sale and leaseback?" Which is what was intended to happen, I think, with Morrisons. I don't know if it did happen.

Okay? But the idea was that maybe you would end up with that PP&E being the same, but actually you would have a sale and leaseback, and you might find yourself two billion richer, which you could then put into your cash, and then you could say, "Well, we could either use that to reduce other debt," okay, because this might be quite cheap, what with it being secured against a high-quality asset.

Or what some funds do is they might release that as a dividend, okay, if the other lenders will allow them, okay? Because the sale and leaseback creates kind of windfall, and early payouts in an LBO do wonders.

Okay? Now, if I just say, "Let's release 2,000," well, the company will be worth a bit less.

But if I release that early, it actually has an elevating effect.

It's nowhere near that simple, but the idea is that some specialist borrowing can release funds early, things like div recaps, sale and leaseback, and that would rely on good security to give some comfort to the lenders.

Now, you may have never thought about a sale and leaseback before.

More general security would be covered with things like liens.

Okay, so let's say we issue a TLB, okay, into this structure.

Then the TLB may have rights over all of these assets before anybody else can get in there.

Let's say if five years down the line, Morrison collapses, and they're unable to service their debt and go into default.

Now, what you can have is these numbered liens, and once the first is done reaching into the assets, whatever's left, the second would reach into, and then generally the lower quality or the more subordinated debt would have no lien.

And so assuming there's anything left, they would then share it amongst themselves.

Okay, so this is how security works.

This is how you kind of model restructuring and distressed companies.

You have these kind of returns waterfall and asset recovery percentages, things like that. And all of that stuff would be in the minds of the lenders, and the more security they can create, the lower the cost to the fund.

Okay. I'll pause there to see if there's any questions.

I think there's a Q&A question. Cool.

Yeah, so there's a question, and it says, "For after the class." So I'll delay that one, and then I'll talk to you after the class.

Oh.

Yeah, I'll talk to you after the class. I'll just skim-read your question.

Okay, so we've talked about collateral.

Next, fees. I just don't want to deal with these too much.

I know it sounds like I'm evading, but they are important, and some models will make them quite complicated. Our models tend to keep it really simple.

Here's all of our legal and debt issuance fees, that kind of thing.

A more complicated model might do things like amortize that over time, so just be aware of that. The fees are usually such a small part of the overall financing, okay, that I think their treatment and whether you amortize them or not is not that critical, in my view. And so they're lower priority.

You obviously want to get them as accurate as possible, okay, within the time bounds that you've got, but I don't think they're that big a deal, and so I'm not going to labor them.

All right. Good stuff, everybody.

That's the end, and we've done this as we've gone.

Okay, we'll now say bye-bye if you're going to log off, and have a nice afternoon or evening. I've got a good question here, which I'm going to talk through. Okay? But I wouldn't be offended if you...

Well, I wouldn't be offended anyway, but you can log off now if you like.

And thanks, Aaron. Thanks for the questions.

Right. So let's go for it.

Now, I think everybody can see the question now in the Q&A.

Yeah, so we didn't talk about PIK that much.

So first off, PIK, payment in kind.

It avoids near-term cash flows, which can be helpful because you can use those near-term cash flows to make other lenders happy.

Okay? So what happens is, let's say here, can you see my cash flow for debt repayment? My last year is actually pretty good, right? Assuming that I hold the asset for eight years, which is pretty realistic, I think.

Now, if the TLB has its eyes on that lot, because they'll probably set up a sweep which demands cash during this, at least some of it.

And then let's say my notes need to be redeemed here, but are unwilling to lend beyond that.

If I can convince a PIK lender to lend on the basis of October 29, then I can unlock an entirely new debt level, which might increase my leverage.

Now, had this been a non-PIK lender, like a MEZ, then what you'd find is that because MEZs are sometimes, let's say, might make it simple.

Let's say that we've got the MEZ interest and it's cash, then it would reduce my borrowing capacity in all of these years.

The TLB would offer me less, the notes would offer me less, and I don't know if it would be worth it for the extra borrowing that I'd get over here. So instead, what I might do is say, "Okay, MEZ, I want you to be on a PIK basis. That way, the only interaction with you needs to be fulfilled from the 800.

So lend to me on that basis. And my TLB and my notes don't need to worry about you because you won't mess with them." Okay? By the time you come knocking, they will ideally have been repaid.

Let's have a look at the rest.

Okay.

Yeah. So if they have limited scope to grow operating earnings, why accept compounding debt that could become impossible to refinance? So, ideally the exit would take care of that, right? So whoever buys the entity would give enough money that you could get rid of this.

So ideally the exit would get rid of it the way it does here.

Can you see what's left for everybody else is post MEZ.

So we are assuming the MEZ is dealt with from the exit.

Now your point about compounding, if the exit's poor, then yeah, the MEZ is going to basically take everybody's lunch, and that would be tragic for the fund because that compounding, you're right, it is a big deal.

Sorry, I've got the wrong one here.

It almost doubles the amount owed over the hold period, right? So if you get it wrong, and fair enough, your point is good, PIKs can be very punishing. And so if you get it wrong and you hold longer and you keep holding, then it can damage the exit massively.

Okay? So it is a gamble, I'd say.

Can you hear me actually? Yes. Hello.

Oh, yeah. Thank you for answering the question. It's super helpful.

Very good session.

This question, actually I was thinking about in summer, which is why I brought it up towards the end because for this particular business that I was looking at, right? The operating earnings are just not there to ever cover it.

I think the owners currently are looking for appreciation in the scarcity value of the asset, which means that there is going to be multiple expansion, which is why they're probably going to sell it well, probably start of next decade. But still, it feels very interesting.

Why would an incoming investor accept paying down such a facility and installing a new facility on their own? This is a follow-up to your answer, basically.

How would the exit mechanics look like for the incoming investor? Yeah. Well, and should we talk about Chelsea? Is that the example? Yeah.

That's the example.

Yeah. And let's just say this is Chelsea.

I know it's not, but it just gives us something to talk about, right? Now the incoming investor will value Chelsea on an EV basis, right? So in a way, to them, the PIK is neither here nor there because look, they're going to say, "I value Chelsea at 20 billion pounds." And then whether this says two or five, in a way the incoming investor doesn't mind because they just send 20 billion to the fund, and it's the fund's business really how they get split amongst the existing lenders and themselves, right? Okay.

As long as there's enough oomph to cover the MEZ at all, then really any extra MEZ, can you see? That's not really the incoming investor's problem.

It just squashes the exit.

So let's say it really spirals out of control.

You can see the exit is shrinking to almost nothing now, right? Yeah.

But the next owner, in a way, they might look at that and say, "Well, gosh, that was a silly financing package." Or they might say, "Well, gosh, Chelsea's not particularly impressive on an earnings basis." But they'll just bid on those earnings, right? And- Yeah. No, I agree ... and the fund will take those earnings, or sorry, that EV, like the cash-free, debt-free basis, and they'll split it amongst themselves, the LPs, the management, existing lenders, and it's their problem if the PIKs got out of control in a way.

So by that admission, it also sort of makes it a very high probability event that the exit is going to be around that time.

Yeah.

Because if you hold onto that asset, how do you refinance that particular thing? Yeah. So that's the thing. So if I was that PIK lender- Yeah So if I were that PIK lender and I was looking at the ability to refinance, so let's say, this says more like minus 5,000, right? Yeah.

Okay. And there's a bunch of other debt here.

And you can see that the EBITDA has done quite well, but not that well, right? So if the fund can't exit, then your point kicks in, which is that the football club will need to refinance because they're out of runway with the PIK and potentially also, with the other debt, right? So at that point, they may be unable to get the same deal, in which case the whole thing collapses, or they get worse rates, right? Mm-hmm.

I think if I were the PIK lender, I'd be doing that maths now, like you say.

Yeah.

And I'd be saying, "Well, if it all goes wrong, am I going to come out of this okay? Or am I going to end up in a bruising round of renegotiation, right?" And clearly- No, yeah. I think Ares is fine.

I've looked at this a bit more in detail, but I feel that Ares in general is fine.

Yeah.

I think the owners should be a bit more worried, I would say.

So they're being very optimistic about the exit.

Like it- Yeah ... added a better multiple is what you're saying, and fair enough.

Yeah.

Or they could have their own views about what the earnings are going to be.

It's possible.

Yeah.

I think that's the big gamble here, that they're going to grow earnings quite rapidly, succeed on and off the pitch, blah, blah, blah. I think that's the bet.

And then also scarcity value of the asset, which means they can- Yeah ... sell at a higher multiple than it was sold to them. So yeah, stuff like that.

But- The final thing I'll just maybe just add is that this Ares debt that you're talking about, it's possible that it might toggle onto cash interest after a while.

So a lot of these notes or instruments that look like PIK, in reality, what would happen is there'd be like a...

Where are we? In reality, there'd be like a PIK switch.

Yeah.

And you might find that it's PIK for a couple of years, and then when the business gets established, they start chiseling away at it and actually pay cash interest.

In which case, the problem would be nowhere near as bad as we think, right? True.

Because it wouldn't compound. So it could be- Yeah ... that it's going to switch mid-life into a cash instrument rather than a PIK instrument.

But it's so hard to understand these loans because a lot of the time the agreement just isn't anywhere where we can find it, right? Yeah.

No, thank you so much. I think that's a very good explanation and a very good session.

Last thing is, would you be able to share the presentation with the participants? Yeah, it's here.

Okay. If you came in a bit late, let me go for it with the link again.

Okay.

I've got a couple of questions.

All right. So choosing PIK puts you subordinate to other lenders in getting paid.

Not exactly. Choosing PIK, Aaron, means that you defer all cash until the end.

Okay? So if we have a look at the PIK interaction here, can you see that the term loan B is genuinely getting cash throughout its life, and then it ends up being paid off in full.

Okay? These are all genuine cash flows that would go to the lender, which de-risks it from the lender's point of view, which is part of the reason it's cheap, right? The PIK is very different.

Okay? So our mezzanine is a PIK interest.

Now, these are not cash flows.

The only cash flows that are experienced by the Port Co are the initial injection, which would be used for the acquisition, and then the pay-down, which would include all of the accrued interest.

So it's not exactly that being PIK puts you lower in terms of cash payout.

Well, but it would practically, right? Because if the company, say, were to go bankrupt- Yes ... midway through, they're not going to- Sorry. What I'm distinguishing is the ongoing maintenance of the debt. So here that is cash, isn't it? It's not that they're lower in line for that maintenance, it's just they've decided not to engage in it at all on a cash basis.

But you're right that the interaction with the principal would be subordinated. So if, for example, here, Morrison's still had 5 billion, I don't know how that would happen, but still had 5 billion of debt here, then the mezzanine would be stuffed, right? Because- Sorry, you lost me.

Even interest.

If the company went belly up halfway through the TLBs, if they've already received their cash interest payments, the PIK lender has not.

So the PIK lender is going to be holding the bag, and so therefore they've effectively, practical terms, made themselves subordinate.

Yes, and they genuinely are subordinate, right? But you're right.

So these people have made away with a bunch of money.

Everything goes south, and that doesn't happen, so boo-hoo.

The TLB loses some of its money but has walked away with a lot of the money already. And then the PIK, it loses everything because it hasn't extracted any value yet and won't.

Got it. Okay.

And then, so what was the question that Niharant was- Yeah ... was asking? Because we weren't able to see it.

That's okay. So his question was about Chelsea, which is engaged in a big old PIK loan.

Its owners, I don't actually know who they are, but they're some sort of PE player, and they're going to hold Chelsea, which is a football club in the UK, for say seven years, right? And his point was that if the mezzanine is growing in a frightening way, doesn't that put off the buyer? Because they've got this massive mezzanine to pay.

And then my counter to that was that actually the new buyer doesn't bid on the expanded mezzanine.

They bid on what they feel the earnings are worth, and then that value is shared by the fund amongst all of its obligations.

So the bigger the mezzanine, that's a problem, right? But not for the buyer.

The buyer just buys the club, and it buys it debt-free because the fund is going to, or everybody's going to refinance the debt, right? So if the PIK gets out of control for Chelsea, obviously it wouldn't look very good, but in a way it's not the buyer's problem because the buyer hands over 20 billion.

It just means less money for the fund.

See if I turn that into 10, just means less- Wait ... to the fund.

Sorry, isn't the fund buyer-- I guess I'm confused what the difference is between buyer and- So what Niharant did was place us to the next buyer.

Oh, okay.

So he's saying- After the exit.

Exactly. So at exit, wouldn't a PIK put off potential new buyers, say, I don't know, another fund or an IPO or something. Okay? But my point was that if it's well-managed and the exit is healthy, then the proceeds from the exit should cover that debt.

Got it. Okay. Yeah. That's kind of like, if you were to sell your house, the new buyer of the house doesn't care- Yeah ... yeah.

How mortgaged up you were, right? Correct. Exactly.

Yeah. That's a really nice way of saying it. Well done.

Okay. Thank you so much. I have to run, but thank you so much.

Have a nice weekend.

You too.

Okay. Bye.

Okay, I'm going to close off the session now.

If you want to get in there with a quick question, just say hello in the chat.

Okay, I'm going to be off then. Have a nice rest of the day.