So what we should be able to see now is our title slide.

We're going to be looking at some financing instruments throughout the course of this session. What we're going to be thinking about here is the different ways in which we can go about financing a private equity transaction.

Obviously, within a private equity transaction, there's going to be equity paid in by the private equity fund or the sponsor of the transaction that's arranging the transaction. But with most private equity transactions in a leveraged buyout context, they're also going to be taking on a lot of debt financing as the leveraged element of the leveraged buyout suggests.

So we're going to see the different ways in which that debt financing might work.

So that's going to be our main focus for this session.

So have a look at the slides if you want to, that PDF download on the right-hand side, or we can just dive straight into the content itself.

So in terms of financing instruments, what we're going to be having a look at is the different types of debt instruments, firstly, that can be used within a LBO-type structure.

We're then also going to think about, well, who's actually providing the financing here? Because within an LBO structure, it's definitely not just going to be banks who might be providing this financing.

There's a range of different sources that we might have for this financing, and we're going to touch on who those people might be.

We'll also have a look at the equity side of things.

The equity side of things might feel like it's straightforward because it's just going to be the sponsor, the private equity fund, who's putting money into this transaction. But there's a wrinkle or two that we'll have a look at here in terms of how that might work for us to just scratch the surface a little bit on how different types of equity might work.

And then to wrap things up towards the end of the session, we'll have a look at what features we might need to be careful with around debt instruments themselves.

So covenants, collateral that might be attached to the debt instruments. And we'll have a quick think about some fees and how these different factors all come together to give us the overall debt package that private equity funds will look to put in place with regards to their private equity transactions with their acquisitions.

Okay. So that's where we're going to be going in terms of all of this content.

If you have just joined, don't forget there's a download on the right-hand side, and you can also get in contact with me via the Q&A or via the chat function.

Either work perfectly well for me. Thanks very much.

So let's dive into the content itself then.

Let's have a look at what we're talking about in relation to the different types of debt instruments that you might find within a private equity transaction.

So what we've got on the slide here is a list essentially in descending order of riskiness. So as you go down, there's more riskiness, ascending quality of riskiness, I guess we could say.

So ascending riskiness as we go down through this list of the range of different providers that might be involved in this transaction.

So at the very beginning, we've got bank financing.

You definitely might get some bank financing within an LBO transaction, but you don't always have to have bank financing.

It might be within a transaction.

In terms of bank financing, those banks will typically only want to be lending at the most senior element of the transaction, and we might call that a term loan A. That term loan A just going to be provided by banks generally.

Banks looking to get the most secure form of lending, the best protection, if you like, against default.

And this term loan A is just saying that it's going to rank more seniorly, be more senior than any other type of debt instrument that might be within the structure as well.

The reason for that is that banks are obviously heavily regulated and have high levels of capital requirements. And as you go down through the capital structure, the increase in riskiness outweighs any additional interest that they might get.

Or in other words, the interest that they would have to charge to make it worthwhile lending at these lower levels.

There might be other people that we can see lower down this list who might be willing to lend at a lower interest rate at those more risky levels.

So we tend to get banks only involved at the more senior levels.

Also, depending on the size of the LBO transaction, it might be a number of banks that are involved in this transaction, and as a result, we might say that the loan will be syndicated or split up amongst a number of different lenders.

Also from the banking side of things, we've got a revolving credit facility, also sometimes referred to as an RCF or a revolver.

This essentially will always typically be part of a transaction, but this may well not actually be used.

It might well just be set up as a facility which would allow a company to borrow at some point in the future, but where they're not necessarily using it on the actual date of the acquisition when they're acquired.

So key thing to note here about this revolving credit facility is it's typically going to be used for seasonal financing needs.

Might be used as emergency liquidity insurance, essentially, but it's like a corporate credit card. Okay? The company can borrow up to a limit, borrow and repay, borrow and repay as many times as they like within a predefined maturity date.

So that's what we mean by the revolving side of it.

Okay. So that typically is provided by a bank because that borrowing and repayment nature of a revolver doesn't sit typically too well with the nature of the institutional investors here, which might be private credit funds, it might be insurance companies, it might be other types of investment vehicles that don't really want to be dealing with the hassle of, on an ongoing basis, having money flowing in and flowing out of their businesses.

It's much more of a common featureOf just regular banking activities. So that's why the banks are going to be providing that.

The next one in orange, again, isn't always there.

It's in the dotted lines here to indicate that it doesn't have to be part of a transaction at all. And the idea here is that we might get to a stage within transactions and negotiations where the existing shareholders of a target company are not quite willing to sell at a low enough price to match the maximum that the private equity fund is willing to pay from an acquisition perspective.

So one way that that last hurdle can be kind of breached or gone over is through this vendor loan or seller loan.

And this essentially is where we agree a purchase price, but immediately as the transaction takes place, the previous acquirer, owner, founder of the selling company lends money back to the acquirer. It's essentially just a form of deferral of a purchase price with some interest attached to it as well.

These definitely won't always be there, but it might be a mechanism that can be used to get a transaction over the line when there's a slight mismatch in terms of pricing between the acquirer and the current shareholders.

So it ties them in for a bit longer. They've got to wait a bit longer to get their money, but it gets the transaction done, and it costs the acquirer less cash upfront.

Okay.

Then we move into the more of the red blocks here that are coming from on the right. On the left-hand side there, the institutional investors. So these institutional investors are people that have money that they want to invest.

So these are more investors who are looking to generate a rate of return.

It's not their sort of general business activity like it would be the case for a bank. But these are investors who are looking to earn that rate of return.

And because they're looking to get better rates of return, they're often more happy to lend lower down the capital structure.

Okay, so the term loan B, C, and D is just people who are ranked at lower levels of seniority, and as a result, they're getting higher interest potentially because there's more risk. They've got to wait for the other levels to be paid back first, higher up the structure. But as a result of that more risk they take on, they get a higher interest payment.

So if no defaults occur, they're going to get higher levels of return.

So it allows for one LBO structure to provide a range of different risk and return profiles for different investors to maybe participate in that transaction.

You don't have to have all component parts.

A lot of LBO transactions may well not have bank loans, the term loan A. It may be more common just to dive straight into that leverage loan market and borrow from a private credit fund to finance, or an insurance company, to finance the majority of the debt financing. And you might have just term loan Bs and no Cs or Ds. There are broad characteristics of these different loan types that we'll see in a second on the next slide.

But it's not just that the most senior lender is always lending on term loan A basis.

We also have further down the structure some notes.

Thing about notes is they're equivalent to bonds.

Even though they might not be traded, they are mechanically the same in that they have a fixed maturity date, and they have fixed interest rates typically as well.

The subordinated notes, these are people who are willing to come lower down the capital structure. So they're saying, "Well, everybody else can be paid off first if stuff goes wrong with this company, and it goes into liquidation maybe as a worst-case scenario. I'm happy to come lower down that structure and run the risk of not getting all of your money back.

But because I'm taking more risk," again, they get better rates of return.

Mezzanine financing is an interesting one because mezzanine financing, like a mezzanine floor of a house, it's somewhere between debt and equity.

So it's got some features of debt investing, some features of equity financing. Typically as a fixed rate of interest applied to it, will have a fixed maturity date. But it may well be the case that they get some equity participation in an exit.

So even though they don't own any of the shares of the private equity sponsor does, they may well get some of the value from those shares at exit. So maybe if returns are above a certain level, they'll get 5% of the exit proceed values from the equity share sales.

So there's that equity kicker, equity upside. There's a benefit here where the mezzanine investors participate in the performance of the common equity stock at exit.

So again, more risk. You're low down the structure.

If default occurs, you're not getting as much back.

But better levels of return for providing that financing there.

And then finally, we've got preferred shares.

Preferred shares sit within the equity category.

They don't get paid interest. They get paid dividends and therefore might not receive these along the way. They might only get paid dividends at the end, at exit as well.

The preferred shares may be a way of the private equity fund sponsors ensuring that they align their interests with other equity investors.

So they get maybe paid out in advance in certain poor-performing circumstances.

Okay. So hopefully this gives you just an insight that there's a massive range of different ways in which the debt element of a private equity LBO transaction could be structured. Okay? This would also sit within things like infrastructure projects.

So project finance structures may well have this range of seniority of debt elements as well.

Okay.

Good stuff. In terms of the actual features themselves, we've got a bit more detail here on this next slide as to what actually goes into these slides. I'm not going to go through every single data point here because we've mentioned some of them already in a little bit of detail.

But the key point is thatWe're going left to right with increasing risk generally.

So key points to note is that loans generally have that floating interest rate, whereas the notes will have a fixed interest rate.

And you can see there for the term loan A, it's going to be SOFR plus 200 to 275 basis points. Obviously, that changes over time as well, depending on market conditions. Whereas the term loan B, higher interest rate, higher credit spread attached to SOFR because there's a greater risk attached to it with potentially that longer maturity.

Coming lower down this list, yeah, tenor matters, that the lower down you are in seniority, also typically the farther away your maturity date is. But the amortization I think is the relevant point here.

If you're lending money as a bank, if you're borrowing money from a bank as a term loan A, there will typically be some degree of amortization of that loan. So you need to replay some of the principal as things progress through the life of the LBO investment from the sponsor's perspective. Okay? Whereas for everything else, you can prepay on a term loan B, but there's probably less in terms of structured required principal repayments. Whereas when you get into the notes world, like bonds, they only can be repaid at maturity.

So term loan Bs do give that flexibility to be able to repay early if you want to, whereas the notes are much more structured products.

And as a result, you can only repay at maturity, typically.

Okay. So that covers off the next line there as well.

In terms of seniority, it just really moves in terms of the credit risk, generally, in that as you move further to the right, we're getting more risky, and part of that risk profile is to do with the fact there's typically less security as you move left to right.

Term loan A will typically require security from the bank to allow them to take ownership of assets if default does occur.

The term loan B may well have a second lien, so a second charge on some of those assets that have been secured on a first lien basis, maybe by term loan A.

But as you go down into the subordinated notes, they're so far down that capital structure, there's typically no security down there.

The final point to pick up on our slide here, though, is just around covenants. And we will mention a little bit more about covenants in a little while. But the main difference is that with loans, given that it's coming typically from a small group, maybe even a single source with a single bank, maybe, there tends to be the ability to monitor covenants more closely.

So you do tend to get more demand from banks to have financial maintenance covenants in place, which means that there are ongoing requirements to meet certain requirements, maybe interest coverage ratios, maybe debt service coverage ratios, maybe debt to EBITDA ratios that you need to demonstrate your compliance with on a quarterly basis on an ongoing basis.

So the target company, company involved in the LBO transaction will have to produce those financial statements on a quarterly basis to present to the lenders here, and then they'll verify them to make sure that they are in compliance with any of these maintenance covenants.

On the other hand, if we're looking more at the leverage financing world, so subordinate notes or mezzanine financing and even some of those senior notes, they typically will only have incurrence covenants. And what that means is that they are rules, terms and conditions within the loan documentation, bond documentation, that only need to be met if something happens.

So the maintenance covenants need to be met on an ongoing basis. You need to demonstrate ongoing compliance with these. But the incurrence covenants only need to be met if something happens. Okay? Only under certain circumstances.

So only if something is taking place, potentially like an exit.

So if there's an exit point here for the transaction, potentially something kicks in at that stage. It might also be maybe if we're looking to take on new debt financing, there might be a covenant that we've got to comply with in that instance only.

Okay, so we've had quite a bit of a look in terms of the different debt instruments that we might find within an LBO transaction.

We want to spend a bit of time though here just having a look at what the other side might look like. We've talked pretty generically so far that it may well be banks looking to lend, and that's definitely true. They may participate.

But also we said a lot of what's going down the bottom is going to be more around the investment marketplace, people looking to participate in an LBO transaction just to generate a rate of return.

So how does this work? Well, on the left-hand side, obviously we've covered the banks looking at the term loan A and the revolving credit facility.

Other types of people who might make loans, monitoring covenants on an ongoing basis, could include insurance companies, pension plans. They have big sums of money, so you could look at them as an investor, but they typically do also get involved in actually that loan marketplace to some degree.

Hedge funds. Hedge funds is a pretty broad range term, and as a result, pretty broad range mandates across the hedge fund sector and various different hedge funds with their very open mandates may well engage in different places across the risk spectrum, but generally looking to generate better levels of return.

So typically somewhere towards the lower end of this in terms of risk profile.

On the right-hand side of this diagram I think is where there may be potentially more interest, though, because we've got other people who might be participating within the leverage loan marketplace, providing debt financing to leverage transactions like leverage buyouts.And what we've got is three categories.

We've got collateralized loan obligations.

So collateralized loan obligations, CLOs.

This is a securitization which operates similar to mortgage-backed securities but where the underlying asset is not a mortgage but a loan instead. So we might be taking some of those loans from the right-hand side that were originally issued by a bank.

Maybe it's part of a LBO transaction, and they are then packaged up and sold to potentially a broader range of different investors with different risk profiles.

It's a really important part of the leverage loan marketplace.

Loans being issued by an initiator but looking to sell them straight away into a CLO structure, which kind of separates out the risk profile within that transaction and allows different investors of different risk profiles to take different tranches of that structure.

So a securitization in another way.

Okay, so that's one form, typically looking at the loan side as their name would suggest.

Next we've got the BDCs. Okay, so BDCs, business developments corporations, business development companies, a US-specific product.

Okay? And what these BDCs do is they are essentially closed-ended funds that are listed on stock exchanges.

So as any retail investor, you can invest in these shares of a BDC, buying them over a regular exchange, and that gives you ownership of this company.

And the company's job is just to go away and invest its money into small and medium-sized companies in the US. Could be through the form of more risky type loans if we're looking at the small to medium-sized marketplace.

Also potentially mezzanine finance, also potentially equity financing in there as well, but that's not relevant on this debt side of things.

So when a BDC is set up, it will go through effectively an IPO, sell those shares for the first time, raising capital, and it's that initial capital that will be used to make investments.

So it's a company, sits within a limited liability company structure, but all it does is make investments, debt or equity, into small or medium-sized companies in the US.

It's a way of giving non-institutional investors, retail investors, access to this marketplace.

A really important part, again, of the leverage loan marketplace.

And then finally we've got our private equity sponsors. I guess we could also put in there private credit sponsors as well, that are funds that have raised capital from their investors and looking to invest it into LBO-type transactions.

It might feel a little bit odd to have private equity sponsors here as the starting point. Definitely we could have private credit funds over here as well. But the private equity funds, typically private equity funds do have remits that don't require them to invest only in the ordinary common stock of a private equity transaction than just buy the common stock of another company.

They can actually participate within LBO transactions on the debt side as well. It might enable a private equity sponsor, maybe a smaller private equity sponsor, to participate in a larger deal by providing some capital on a debt basis rather than on an equity basis and taking that ownership side of things. It allows smaller funds to participate and get exposure to a substantial deal without having to do all of the due diligence for themselves because the private equity sponsor, the primary private equity sponsor that will take the equity ownership of the target company is going to be doing all of the due diligence, all of the negotiations.

And it just allows these smaller funds to leverage all of that work to get exposure to be participating within a larger transaction.

So private equity funds can participate in debt within other transactions as well. Okay. So hope that gives us a bit of a decent background in terms of everything that's going on there from the providers of financing here. It's a pretty wide marketplace.

It's definitely not just banks.

There is one final point just to pick up here in terms of what a capital structure might look like.

There is a growing form of financing in the US. It's been prevalent across Europe the last 20 years in terms of the mid-market space at least, which is a uni tranche structure.

And the idea behind a uni tranche structure is just to increase the speed with which transactions can get done.

Essentially all a uni tranche structure is doing is it is pooling together all of the funds of all the different providers at different stages of that capital structure in terms of the priority on liquidation and the interest rates they might be getting.

We pool all that together to get one overall package deal, and then for the actual acquisition of the target company, there's essentially one debt instrument, the uni tranche structure.

The actual target company, once this debt gets loaded into their company following the transaction, they'll have to make one interest payment. There'll be a single interest rate for all of the money raised through the uni tranche structure.

That won't be paid equally pro rata to all of the component different sections of the uni tranche structure.

It will be paid based on the interest rate that they have demanded going into that structure itself. So it will be divvied up on a predefined basisTo the different lenders within that transaction. All this is doing, and it's not making anything cheaper from the private equity fund sponsor's perspective, all it does is because we can prepackage this, because we can have the unitranche structure set up in advance, it allows us to then say, "Well, if we're going into transaction, we've already got the debt package in place." It's just one instrument.

We can go along to the transaction, product transaction, and it's smoother, quicker, less negotiation to be done because there's essentially one debt instrument to be negotiated between the private equity sponsor and the debt financing to finance the acquisition.

There's not lots of separate component discussions here in terms of that debt element of the financing of the transaction.

So it's not cheaper, meant to be quicker, meant to be less administratively burdensome for the target company following the acquisition, because they've only got one debt instrument.

Within the unitranche structure, though, everything operates in exactly the same way as we would have if this didn't exist.

The risk profile still is different within the structure, different interest rates for the different component parts.

So that all still sits there. It is just that it is making things easier for the acquired company and a bit quicker to get the transaction done in the first place.

Okay. Great stuff. So I hope that gives us a bit of oversight on the unitranche structure. Definitely growing in terms of importance and prominence within the US marketplace.

Okay, good stuff. We did say there was one final element to have a look at in relation to the financing of a LBO transaction, and that was on the equity side. Now, obviously, the private equity fund, the fund sponsor, is going to be putting a good amount of cash into a transaction.

But there might be somebody else that ends up getting shares, essentially, in the newly acquired company, and that would be existing management of the acquired business.

The idea here is that if we have management that either was the founders and shareholders of the acquired business or had just been given stock grants, potentially as part of their performance packages over time, they may well still be the management team of the company on an ongoing basis. And as a result, to align their incentives with that of the rest of the acquirer, the private equity fund, we might want to make those people who are going to be running this company shareholders as well, who will benefit from an increase in the value of the company and better exit proceeds by making them shareholders of that company post-acquisition.

So some of the selling of their existing shares won't be in the form of cash, it'll be in the form of new shares of the acquired entity.

Now, maybe that also helps out with the second point here, that it helps to reduce the cash burden on the private equity fund because they don't need to pay cash to the sellers of the shares. There instead, it's essentially a stock swap, that they get new shares in the new BitCo rather than the existing shares they had in the target company.

Good. Now, over on the left-hand side, we can see the substructure that might end up giving us. So we've got some senior secured debt here.

So there's some security. The term loan A is for three times EBITDA and term loan B for two times EBITDA, so that's three hundred and sixty and two hundred and forty respectively. So six hundred of senior debt.

We've then got only one and a half times the subordinated debt here to get us up to seven hundred and eighty. And then there's two hundred of remaining equity financing that we need to get up to the purchase price, the cash that we need to go out and buy the target company and maybe refinancing any debt that they've got of nine hundred and eighty. Okay.

Now, rather than needing to find nine hundred and eighty of cash, we're giving ten of that...

Sorry, rather than having to find two hundred million of cash as the sponsor to get all of that residual equity piece financed, in this instance, we're only having to find $190 of equity, $190 million of equity ourselves, because rather than paying ten million in cash to the former shareholders of the management team of that target company, we're giving them shares in the new entity following the acquisition.

And those shares are going to be worth ten million.

So it just saves having to, as a private equity fund, the transaction sponsor, pay in all of the equity value themselves.

It's a rollover. The existing shares they had roll into those new shares of this new entity. Typically, this is only done where there's a significant stake that those shareholders have in the selling company. Otherwise, it's less meaningful.

If they are the founders and shareholders, maybe a small number of shareholders that are owner-operators of that business, then this is going to be much more common because the cash proceeds will be substantially higher then.

But the idea here is that we tie in management.

We also align them to the goals of the private equity fund as well.

Okay, great. So hope that gives us a bit of insight then in terms of all the different elements we might have within the debt side of things, but also the equity side of things as well.

We're going to have a bit more of a dive back into some of the debt content to get us through the next 15, 20 minutes or so.

And the first one we're going to look at is around covenants.

Now, you'd expect to find that most loan documentation would have covenants within it. Covenants are terms and conditions, contractual clauses that the borrower has to comply with. Okay.

Some of these, like the affirmative covenants, are things the borrower is going to doLike provide quarterly statements, financial statements to the lender.

Like have insurance in place so that if there's a fire at the warehouse, then this is protected.

And also ensuring they're going to promise to replace.

So this is just essentially protecting the interests of the lender.

We might also have negative covenants.

These are things that the borrower says they won't do, like selling off their key assets that could be used to regain some cash in the event of a bankruptcy. Maybe not make significant or dispositions to shareholders above a certain level. Okay? Or maybe on the, as it says here, the risk of the projects themselves. Also, there might be a negative covenant here saying, "Please don't issue," or not please don't, but you cannot issue. You are not allowed to issue new debt without coming and asking me first as a lender.

Because those things all could potentially put at risk my position as someone who's lent money to you, and I've assessed you as you are at the moment, and I've assessed the risk of me getting my money back based on what you currently look like, and if anything substantial changes, well, I'm not going to be willing to lend anymore. So I don't want all of those things to change.

Down the bottom, though, which we have made slight mention of already, is these financial covenants. And the financial covenants we said for the loans side of the marketplace, term loan A, term loan B, et cetera, that there are probably going to be maintenance covenants in there, or at least that's where you might expect to find maintenance covenants.

The maintenance covenants, those financial ratios, typically, but it could just be having sufficient cash to make the next interest payment in a bank account at the beginning of a period.

Typically, ratios, though, they've got to be met on an ongoing basis.

That's what I mean by maintenance. Met on an ongoing basis.

Things like debt-to-EBITDA, that's our leverage ratio.

Typically, a leverage ratio comes in the form of debt to EBITDA.

It could be an interest coverage ratio, which typically comes in the form of the EBITDA, EBIT maybe, or EBITDA divided by the interest expense.

Okay? So debt-to-EBITDA thinks about the absolute amount of debt.

The EBITDA coverage ratio thinks about how easily a company is able to meet the interest payments.

So one's the servicing of the debt, the interest, one's the actual debt balance itself.

We might also have ratios around limiting how much CapEx there can be.

So all of these are things that you must maintain all the time, not let a ratio go above or below a certain level, to maintain your good standing. And the typical consequence of breaching this or any of these covenants is that you're in default of the debt, in default of the loan, and that results in it legally, potentially immediate repayment of the debt.

If you're in breach of the loan, you've got to repay it all in principle straight away, which might actually lead to bankruptcy.

So it's really important if we are signing up to these covenants to ensure that we are maintaining them on an ongoing basis, because there's pretty serious consequences if we don't.

Having said that, if companies do breach these covenants, it isn't always the case that they're going to go into immediate repayment straight away.

It is often just used by the lender really as an early warning signal, giving them an advance notice that the credit quality of the borrower is starting to decline and we might want to renegotiate some of the terms of the loan.

We might want to tip up the interest rate that we're charging.

We might want to think about negotiating repayment terms.

Because it would appear that the credit quality of the borrower has changed because they've breached these covenants.

Okay. The incurrence covenants, as we said, only need to be monitored under a specific event.

So the example here on the slide, if we're looking to borrow more debt as the existing borrower, we would need to ensure that we don't take our debt-to-EBITDA above a certain level, so five times here, once the new debt is taken out. So it's a bit of an add-on to the final negative covenant here, which says, "Don't take out new debt without asking me. But also, if you are going to take out new debt, then you can't take your debt-to-EBITDA above a certain level.

I just will say no flat out before you even ask me about that." So they're kind of going together in that instance.

Now, these are important because if you were, as a company, to go to a bank and look to take out a loan, they would want pretty substantial maintenance covenants within them to ensure that the bank is covered and understands all of its risk and knows how it's going to get its money back with some collateral maybe later on. However, you will find within the leverage loan marketplace, so loans going into leverage transactions like LBO transactions in the private equity space, that the amount of covenants, the depth of covenants within those loan documents has diminished substantially on average over the course of the last 15 years following the financial crisis. Okay? So what does that mean for us? Well, there's a number of reasons behind this that it's probably worth having a think about.

But essentially what we're saying here is that covenant light or cov light, what that means is there are less maintenance covenants within loan documents within the leverage loan marketplace than there would have been back in prior to 2008.

Over 90% of leverage loans have limited levels of maintenance covenants. Okay? So it's all around the maintenance covenantsOkay? So we might not require any maintenance covenants, might just have lower levels of maintenance covenants. We might only have the incurrence covenants in there within the loan marketplace.

Okay? And as a result of this, it means that there is less protection for the lender, for the investor. So definitely more risky here.

Okay? But on the flip side, what the positives might be, well, the positives might be that if there are less maintenance covenants, where the lender has to monitor them and maintain them on an ongoing basis.

There's less of an early warning sign for the lender, but also potentially more flexibility, more headroom, more, I guess, depth we can go down to if there are difficult financial times around without a breach of a covenant happening, allowing potentially more scope for companies to get through those difficult times.

Now, you can see two ways of looking at that.

You could say that the whole point of the covenants is to provide an early warning sign for lenders. And if we don't have that, we just wouldn't know about the increase in credit risk of the borrowers.

But also, if covenants aren't being breached, then there's no ability to put the companies into insolvency to get our money back early as a lender.

And as a result, there's a chance that there's more time for the company to get back on an even footing and continue over the long term.

Maybe. The risk with that, obviously, is that over more time, the company gets into further financial difficulty and does end up going bankrupt.

But just when it's got less assets left over and we get lower recovery rates in the end.

So it's not straightforward. Okay? That positive we might find at the bottom is a potential positive, but also has more risk from a lending perspective as well.

Okay? The other part of the reason for this movement is that, as we've alluded to a few times, the vast majority of loans that you see within a leverage loan marketplace are not term loan A anymore. They are much more likely to be term loan B, much more likely to be provided by private credit funds and by other sources of financing, those BDCs and CLO-sourced. And as a result, you're likely to see in those types of transactions, much lower levels of covenants. So if we have less term loan A involvement, less banks looking for and having the ability to monitor the covenants on an ongoing basis because banks have higher and more stringent capital requirements now than they had before the financial crisis.

You can see that the majority of this transition away from covenant-heavy leverage loans was in the immediate aftermath of the global financial crisis.

That is not necessarily people lending on a more risky basis, but just a move from banks lending to BDCs and other source of lending taking place in that marketplace.

So that switch essentially moves you out in this direction anyway.

So this is not only lenders willing to lend on a more attractive basis to the borrowers, it's just a change in the nature of the borrower themselves. So moving away from banks that would have wanted that higher level of covenants.

There is, however, there has, however, I'm sure you've been aware, growth in the level of private credit over this time period as well.

And private credit funds will definitely not want to be, or not require significant ongoing maintenance covenants, and as a result, that growth of the private credit marketplace will also lead to this or help explain this movement towards a greater level of leverage loans being on a cov-light basis.

Okay.

Good stuff.

One final factor here before we move on, just to wrap this up, there's definitely more competition in this marketplace as well.

There's more numbers of lenders, greater capital flowing into the private credit world, substantially more capital flowing into private credit over the course of the last 15 years. And that increase in competition might also drive this factor as well.

Okay, good stuff.

So what do we got next? Well, collateral. We've mentioned collateral a little bit as well.

Just to wrap up, though, on collateral, we said as we go down this list, we're looking at lower levels of seniority, lower levels of security, and more risk.

We also see that in the form of collateral. Okay? You'll typically say that the term loan A, the revolving credit facility, will have some form of collateral, typically secured against it.

So when talking about collateral, we're talking about assets, maybe an individual asset or a group of assets of the borrower that are pledged so that they can be taken ownership of by the lender if default occurs. It is the route or the primary route if there is security to the lender getting their money back, because those assets are going to be sold by the liquidator purely for the benefit of the people that have this asset as security or collateral. Okay? So it could be over an individual asset like property.

It could be something like for an airline, it could be their aircraft fleet that acts as the collateral. It could be a blanket claim.

Lien is just another word for claim.

It could be a blanket claim on all of the assets of the company. It could be on specific assets that we have a liquid market for and also a known value of that will help to increase the quality of that collateral, and as a result, lower the risk for the lender and lower the interest rate for the borrower. Okay? However, it could be more general forms of collateral.

So we might say this is specific collateral, but there might be also more general forms of collateral.

And this is where we're looking at a-Class of assets, like inventory or accounts receivable.

You have greater ability to control what the borrower does with specific collateral, like an airplane, because you can say as part of the loan documentation and collateral that we're taking here, security that we're taking here, that I don't want you to sell it unless you confirm with me first, because it's my main source of repayment if default occurs. Okay.

With general collateral here, inventory, accounts receivable, it's not really practical for the borrower to place restrictions on a company's ability to sell their inventory to their customers.

That's the whole point of their business.

And also to place restrictions on how much you can collect from your customers that they owe to you in terms of accounts receivable.

Just doesn't make sense to place restrictions on those.

So the risk with the general collateral types is that you don't know how much value there's going to be on these until default occurs. It could be with inventory that maybe the company's been having trouble with its suppliers, and as a result, they've been running down their inventory levels in the lead-up to bankruptcy. Okay.

It might be that they went bankrupt because they just built too much inventory, and they've got masses amounts of stuff in their warehouse.

Okay, that could be the case. That they spent all their money building the inventory, manufacturing the inventory, and it's just got no customers to sell it to. In which case, actually, maybe it's not so bad at all.

If you were maybe a brick manufacturer in 2008 leading up to the financial crisis, then homeowners, home builders stop building homes, can't sell to any customers, and you still keep the factory open, you still keep building those bricks. There might be a significant amount of inventory left over. Or if it's those supplier problems that have led to your bankruptcy, you might just nothing left there at all. We just don't know.

That's the risk around the general form of collateral.

And accounts receivable, again, don't know how much is going to be there.

We might have been pushing our customers harder to pay early because we were short on cash, and eventually we still have gone bankrupt.

There might not be much left there at all.

Another consideration really in relation to this collateral is the level of claim that you have.

We've got the senior forms of collateral here, term loaner having a first lien.

Lien just means a charge or a claim on those assets.

With regards to a mortgage, for example, the house acts as a collateral for the loan, and that loan might not be the entire size of the asset.

But if you default on the loan, the lender, the bank, can still get ownership of your house, sell it to get cash to pay off the remaining amount on the loan. There might be cash left over.

Okay. And these second liens are a second claim on those underlying assets. Might not be worth very much if the assets aren't worth very much, but still might be better than just being an unsecured lender.

Okay.

Final points to pick up then. Fees, I'm not going to run through this slide in lots of detail. There are lots of fees that might be charged for setting up all of these transactions.

So there might be some upfront fees payable on loans for the actual provision of the loan, for the structuring of the loan.

There may well be some administration fees for the ongoing administration of those covenants and interest payments.

And there might be fees if you pay back early.

Those prepayment fees potentially could also be some fees on the bonds in terms of actually the initial issuance of the products. Okay.

But nothing too much interesting there.

To wrap things up for us for today, though, just to put this all together.

If we're looking at constructing a structure for the financing of an LBO transaction, then obviously the interest cost is of primary importance. If we can get more money borrowed at a more senior level with lower interest cost attached to it, that's fantastic. But if we think there would be benefits from taking on more junior forms of debt financing, which have a lower interest cost, but which requires the private equity fund sponsor to put less money in themselves, that might still be beneficial for the returns the private equity fund makes on an IRR basis at the end of the transaction's life. Okay. So the more debt financing there is, the less the sponsor has to put in, and the greater ease with which we have to magnify those returns over time to a benefit of leverage, right? But there's a trade-off here that if we go too far down that risk structure, the interest rates that we're going to be paying on some of that more lower credit quality financing further down the capital structure might be so high that it erodes a lot of the returns that we actually end up making as the private equity sponsor.

So that's the trade-off that we got to be careful with in terms of those two elements.

Other things to be careful with. This might be one transaction that we're thinking about structuring, but one private equity fund is going to be potentially engaging in lots of transactions and speaking to lots of banks and raising financing from lots of banks and BDCs and private credit funds on an ongoing basis.

So there might be a decision about including some people within a transaction to maintain relationships.

Also, certainty of financing might be an important factor here to ensure that while some people are definitely going to be investing, some people might be less willing to invest and might walk away at a later date.

Depends on what they might look like. The refinancing issue.

What's the ease of refinancing? Well, debt loans are definitely easier to refinance than more structured bond-type instruments. So notes much harder to restructure because they got a fixed maturity date, whereas loans with a prepayment option are always easier to refinance.

So if you think that the rates of interest you're being charged going into a transaction are unfairly high, then you might think you might be able to get a better deal refinancing maybe into a more structured loan, more structured bond in a couple of years' time. So having that ability to refinance might be important to a structure.

Cash flow impacts from things like the vendor loans and the management role might be an important consideration to think about, as well as potentially PIK interest lower down the structure on the subordinated notes and the level of covenants. But as we mentioned already, we're much more in a covenant-lite marketplace generally.

So maybe the covenants aren't such a consideration in terms of what they've been demanding.

Okay. Hope that gives a good summary in terms of the nature of the different types of financing that there might be within an LBO transaction or infrastructure transaction or real estate transaction maybe even.

But also the considerations that will impact on how you choose to structure a deal as well.

Hopefully, that was useful, and hopefully, I'll see you again on another one of these in the near future. Thanks very much, and have a great rest of your Friday.

Thanks.