Only the Strong Shall Thrive

Financially sound companies find gold in credit mayhem even as weaker players fear the game is up.

The return of vigilance is evident in the commitment letters banks give buyers to finance acquisitions. During the buyout frenzy, private-equity buyers often committed to purchasing companies without financing contingencies (like buying a house without the assurance you will be approved for a mortgage). In turn, private-equity firms pressed banks for firm financing commitments. Banks issued commitment letters without strong escape clauses and, as a result, were stuck with billions in debt they were unable to unload. Banks are now inserting tighter terms, including market clauses, which give them an out if market conditions worsen.

Covenants, once a staple, were removed in the frenzy, hence covenant-light deals. Omitting these agreements, which protect investors, enabled issuers to sell debt without obligating them to meet performance benchmarks. Covenant-light deals are now gone and traditional covenants are back. Also gone are PIK clauses. These toggle-like features enabled issuers to pay investors in bonds instead of cash at their choosing.

Financial buyers will also have to do without dividend recaps, which allowed buyers to reap a windfall long before exiting an investment by loading companies with extra debt. (Think Hertz and the $1 billion in additional debt that Clayton, Dubilier & Rice Inc., Merrill Lynch, and The Carlyle Group paid themselves just six months after acquiring the company in September 2005.) Ditto for refinancing. With debt tighter, companies on the edge may not be able to refinance with new cheap debt and instead may have to be sold. Gone too is unsecured debt such as second-lien loans.

With banks retrenching, buyers and sellers in M&A deals can expect more negotiations about bridging financing gaps. Helping close such gaps are earnouts and sellers’ notes. Earnouts are benchmarks a company has to meet after it is sold, while sellers’ notes mean a seller agrees to hold part of the debt. For example, to complete the sale of its wholesale unit in August, Home Depot had to agree to finance $1 billion of the deal price. — A.L.H.

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