Surprise! With the availability of senior debt suddenly back to normal, middle-market LBO sponsors have the opportunity to profit more by using subordinated debt with warrants than by using coupon deals.
Coupon-only subordinated debt structures emerged to fill an important market need during the cash-flow senior-debt shortage of mid-2000 to mid-2003. But those days have passed. Today, warrant structures can often provide LBO sponsors with higher profits, higher IRR’s, greater financial flexibility and better alignment of interests between junior lenders and sponsors.
On first impression, this conclusion may seem surprising: How can giving up warrants increase IRR or reduce the risk of financial distress? The answer lies in the recently restored availability of cash flow senior debt for LBO’s. In the past six months, the credit cycle has matured from recessionary tight money to looser money typically found in the “middle age” of a cycle. Debt service coverage levels and cash interest rates now set the limits on total debt, not artificially low total debt leverage multiples.
When senior lenders required sponsors to keep total leverage ratios at unusually low levels, debt service coverage ratios were automatically strong as a result. During this tight money period, senior lenders (especially cash flow senior lenders) often limited the ratio of total debt to EBITDA to 3.5x or lower. With such low leverage, the higher interest costs of all coupon subordinated debt deals did not limit total debt availability. And the absence of warrants left sponsors with greater flexibility to refinance. Therefore, all coupon structures worked particularly well for LBO’s with plenty of free cash flow. Although sponsors still had to put up extra equity, a quick refinancing allowed many of them to cut interest costs and make dividend distributions, all with no equity dilution.
In today’s improved credit market, the advantages and disadvantages of warrant versus no-warrant deals are reversing. With amazing swiftness, the limiting factor on total leverage in many deals has become the fixed charge coverage ratio, rather than the total debt to EBITDA ratio. “Cash interest rates matter again,” said William Kosis, president and chief executive officer of PNC Business Credit, a unit of Pittsburgh’s PNC Financial Services Group Inc. “Most recently, lenders have relaxed the total debt to EBITDA ratio as long as the borrowers have good fixed charge coverage,” he said.
This change provides sponsors with compelling reasons to prefer warrant deals to all-coupon structures in many instances. Sponsors can get higher IRR’s with more total debt at lower average interest rates. Lower cash coupons in warrant deals encourage cash flow senior lenders to advance a greater amount of low cost senior debt. Even asset based lenders can increase the size of their “air ball” term loans since amortization can be higher, lowering the average interest rate on the deal. Lower cash interest also leads to better debt service coverage ratios in warrant deals, which in turn enables senior lenders to allow more subordinated debt and higher total debt to EBITDA levels.
“We can usually provide some additional senior debt and some relief on the total leverage covenant in transactions where the subordinated debt has a meaningfully lower cash pay rate,” said Steve Robinson, a director of Antares Capital Corp., a Chicago-based provider of leveraged finance capital to equity sponsors and middle market companies.
More debt availability allows the sponsor to reduce the amount of equity required for the deal. Together, the lower blended interest rates and lower equity investments create higher IRR’s.
As an example, take a typical LBO where expected post-closing performance is achieved and where a warrant structure allows senior and subordinated debt to be increased by 0.25 to 0.50 times EBITDA. The added leverage can improve the sponsor’s IRR by 300 basis points or more. The improvement can be even more important if the target company’s post closing results are somewhat disappointing. The lower total coupon in a warrant deal can be the difference between the sponsor achieving an adequate return on equity and virtually no profit at all.
Further, subordinated lenders who hold warrants have dramatically better alignment of economic interests with sponsors. Warrant holders care about growth and enterprise value. This alignment plays out everywhere from fewer documentation issues on intercreditor agreements to an improved sense of partnership at board meetings. Alignment of interests can be especially critical if a deal requires an amendment or waiver due to an acquisition or a performance bump. Lenders who hold warrants are likely to be more flexible and to make changes at a lower cost. Some all coupon subordinated lenders who get no tangible benefit from improved enterprise values have developed a reputation for high consent fees and big interest rate increases when changes are needed.
As an added benefit, lower cash interest costs increase financial flexibility and reduce the chances of financial distress. In good times, higher free cash flow can be used for capital expenditures, working capital or amortization of restrictive senior debt. In weak performance periods, the large cushion against fixed charges makes a liquidity crunch less likely.
Modestly leveraged, sponsor-driven mezzanine providers are best suited to provide sponsors with highly flexible subordinated debt structures with warrants. Such lenders specialize in underwriting enterprise value and have a track record of working well with equity investors and senior lenders. Partnership minded subordinated debt providers can provide flexibility for the companies, even in tough times, in return for a long term relationship with like-minded sponsors.
Golub Associates Incorporated provides subordinated debt and equity capital to middle market companies on a national basis. With offices in Atlanta, New York and Chicago, Golub Associates completed a record 14 financings in 2003.