The ingenuity of lending banks is being put to the test by private equity firms these days. Firms looking to IPO their investments at a future date are forcing bankers to come up with ever more creative debt structures to help maximise transaction potential. Hence the birth of the Qualifying IPO concept, or QIPO, which aims to keep borrowing costs down to a minimum and smooth the financing path of a company post-IPO. Carol Dean reports.
Although IPOs have been few and far between over the last four years, the potential of an IPO as a possible exit route appears to be coming back into view as institutional investors show increasing interest in equity. In a recent report by law firm Lovells on the QIPO concept, Susan Whitehead gives the IPO of Umbro by Doughty Hanson and the flotation of Premier Foods by Hicks Muse as cases in point.
But while private equity would ideally like to exit a company through its flotation, in most cases firms are left with a significant shareholding in the business floated. This is partly because institutional investors are unlikely to take up shares in a company where the private equity firm is seen to make a hasty retreat from the investment.
This is evidenced by the flotation of both Umbro and Premier Foods. In May this year, Doughty Hanson sold a 30% stake in Umbro, the UK football products group, via an IPO. Doughty bought an 83% stake in Umbro five years ago and now retains a 53% stake in the company post-IPO. Umbro’s IPO was followed in July by the flotation of UK food conglomerate Premier Foods by Hicks Muse Tate & Furst in which the private equity house has retained a 30.4% stake.
Since a private equity firm is likely to retain a significant stake in the floated company, the debt financing of the company remains a concern to private houses after the IPO. Accordingly, sponsors are asking loan arrangers on LBO financings to sign a credit agreement that permits an IPO and allows for the terms of the financing to flip into more favourable terms suited to a less leveraged company following a flotation.
The benefits of such an agreement are many for private equity as well as the LBO business. As Lovells points out it avoids any arrangement fee for post-float facilities and avoids the administrative burden and legal costs of negotiating debt to refinance the original LBO facility. The borrower also has the certainty that it will keep its relationship banks and syndicate after flotation.
“Apart from avoiding the obvious disadvantages of having to arrange a refinancing in the run-up to a flotation, a QIPO represents a one-way bet for the sponsor; if credit markets have eased since the LBO they will have the option to refinance on even more favourable terms than would be available under the terms in the QIPO; conversely, if the market has tightened, they can enjoy the benefits offered by the [lower] margins in the QIPO,” says Michael Dance, finance specialist and managing director at Redcliffe Associates.
“The savings are large both in terms of the hassle factor and the absence of a post-float arrangement fee,” says Susan Whitehead of Lovells.
Raji Bartlett, partner in banking and finance at SJ Berwin, agrees with this view. He adds that the QIPO concept is increasingly being used by sponsors to allow for the change of ownership but without the pre-payment of credit facilities. Nevertheless, Stephen Gillespie, partner in the banking department at Allen & Overy, says that a form of the present day QIPO has been around for some years as a means of preventing the trigger of mandatory debt repayment once a company floats.
“Bankers are being asked to take a view on the expected nature of the company post-IPO although the original sponsors may not be the owners,” says Gillespie. “It’s basically the concept of an IPO without the trigger of debt repayment.”
Gillespie says that it depends on how strong a hand the sponsor holds and the strength of the credit whether banks are willing to agree to such an arrangement. “I don’t see equity sponsors pushing this hard,” he added. He believes that corporates are just as likely to pursue a QIPO agreement with a view to floating off a subsidiary in order to keep financing costs to a minimum and avoid the repayment of debt.
Crystal ball gazing
Nevertheless, the increasing use of the concept is a reflection of how much more friendly banks have become towards financing such deals. But while the concept sounds beneficial to private equity and their LBO companies, the credit agreements will also have to be attractive enough for the mandated lead arrangers to syndicate in terms of margin, covenants and security.
“It’s [QIPO] not so good for the banks since they lose out on potential arrangement fees although there are obvious advantages for the company and private equity sponsors,” says Jerry Moore, director in corporate and investment banking at SG based in London. “In some instances there is mandatory repayment of debt if the company IPOs,” Moore says, referring to the use of equity to repay more costly LBO financing. “It’s a point of negotiation on each deal,” he adds. “It will depend how comfortable the banks are with what the company looks like in a few years time.”
“Some elements of it are like crystal ball gazing,” says Whitehead referring to the fact that banks will have to get to grips with what the company will look like in two to three years time when it has floated. “It’s part art and part science. It is quite difficult for bankers going into a highly leveraged deal to predict what lending to a less leveraged version of that business should look like in a few years time.”
“Companies going into such an agreement should bear in mind that it’s a quick fix arrangement whilst the sponsors retain control,” adds Whitehead.
Under a QIPO agreement, margins will typically be reduced by 25bp following an IPO subject to the margin not falling below a set floor, usually the bottom rung of the margin ratchet in the original loan agreement.
But Dance questions the effectiveness of using such a guideline. “By limiting the margin under the QIPO to the floor set at the original financing in the LBO (often the lowest step in the margin ratchet), the borrower may not be able to take full advantage of significantly lower leverage which may ensue after the IPO. Similarly, lender’s reluctance to agree carve-outs on their security package following the IPO may also be difficult to overcome.”
The key financial covenant in a QIPO agreement is the leverage test. The margin will only be reduced, and an easing of the covenant restrictions will only take place, if the company has significantly deleveraged as a result of the IPO.
Furthermore, the issue of security is a difficult one. While security such as cross guarantees is likely to remain in place, difficulties arise when security has been given over shares and assets.
“In the last couple of months we’ve seen no QIPO agreed which envisages that the original security will be released after an IPO,” says Whitehead. “It seems to be a step too far [for banks] to release security. Parties can re-open the debate on security if the company is performing well at the time.”
In addition, controls and restrictions on a company post-flotation will have to be considered on their own merit. These may involve restrictions on M&A and disposals, taking on additional debt from other lenders and the payment of dividends. On a number of transactions, the number of restrictions may move to a US-style incurrence test where, rather than prescribing a set allowance for these items, instead debt can be incurred post-QIPO provided it is covered by sufficient EBITDA.
“Most of the term sheets we’ve seen over the last few months [at Lovells’ London office] for larger deals have included the QIPO. As a concept it’s not new now, although we are not aware of a company floated with a QIPO agreement in place. That is likely to be at least a year off,” adds Whitehead.
Although QIPO agreements are becoming increasingly used in UK buyouts, another specialist commented that with a pan-European marketplace the QIPO is not solely for use in the UK and can be equally applied to European listings.
Indeed, a form of the QIPO agreement has been used in the financing of the directories business, Yellow Brick Road (YBR), which the sponsors plan to float during the second half of next year. 3i, the UK private equity firm, and Veronis Suhler Stevenson acquired three directories businesses over the past two years in deals worth an aggregate €850m that were merged to create a pan-European directories business, Yellow Brick Road. In March this year YBR raised €1bn of debt to refinance the business and repay in full the €280m of equity that was spent by 3i and VSS in acquiring the businesses. Allen & Overy acted as legal adviser in the consolidation process.