By Malcolm Wattman, Matthew Feig and James Langston, Cadwalader, Wickersham & Taft LLP
Many investors this summer began rejecting the fast and loose financing packages that ruled yesterday’s credit environment. So where can buyout firms turn to for financing that reduces risks while preserving financial flexibility? One relatively new financial technology to consider is securitization.
Imagine a hypothetical target of a leveraged buyout. The buyer would like to finance an acquisition by causing the target to issue debt; however, the target is a high-yield issuer and the expense of such an issuance in a traditional structure may make a competitive bid difficult. In the current investment climate, there may be limited appetite for the high-yield debt of certain issuers. Even in the best investment climate, a high-yield issuer will necessarily pay more for a given amount of financing than a highly-rated issuer. Since improving the credit rating of a target issuer is not a short-term option, the prospective buyer may face unappealing alternatives. However, through the technology of securitization, you can in fact change the credit rating of the issuer—by creating a new issuer.
How It’s Done
Business securitization simply involves isolating the assets and cash flows of the private or public target company in a special purpose vehicle (SPV) owned by thte target parent, usually newly formed specifically for such purpose. For flexibility and convenience, several SPVs may be created if many assets or assets of a different type are involved or are located in various jurisdictions. For purposes of this article assume one SPV is used. The SPV is limited, by its organizational documents and contractual agreements, in purpose and activities and required to observe formalities intended to isolate it and its assets from the credit and bankruptcy risk of the parent and its affiliates. It is generally limited in its ability to enter into other businesses and incur debt outside the securitization. However, these restrictions will not apply to the parent. Whether or not the parent will be able to issue other debt ultimately depends on how much of its assets and cash flow have been securitized.
Most significantly, the securitization need not be a single financing, thereby exhausting the leverage capacity of the SPV in one issuance. The SPV can be designed to be able to continue to borrow as long as its assets and cash flow will support the credit rating of its existing and new debt, usually subject to a debt service coverage ratio test. In many facilities, an option exists for the parent to contribute additional assets and SPVs to the structure to support additional issuances of debt at interest rates corresponding to the high credit ratings of the SPV issuer. Standard formalities protect the integrity of the SPV structure and, apart from the costs of any underlying acquisition and reorganization itself, such additional issuances can be consummated in a fraction of the time and expense of the original issuance. Thus, with an appropriately designed SPV structure the parent may be able to determine on an ongoing basis whether or not to use the structure to seek additional financing, depending on its needs and capital market conditions at the relevant time, and allocate assets inside or outside of the structure accordingly. This provides maximum flexibility without compromising the high credit quality of the SPV and corresponding savings.
The assets of the SPV will be subjected to a security interest in favor of the lender—in other words, the loan to the SPV is secured by a lien on its assets. Depending on the structure, the lender may be a trust (issuing pass-through certificates) or the secured holders of notes issued by the SPV itself. This security interest may take the form of a combination of liens on intellectual property, mortgages on real property, or UCC filings against its contract rights. Generally, a legally enforceable, or perfected, security interest in the equity of the asset holding SPV is also obtained. For assets located outside the United States, a security interest in the assets of the SPV would be perfected in accordance with the laws of the applicable jurisdiction. As the SPV has essentially no obligations other than the debt issued in the securitization, and the lender has a first-priority security interest in valuable assets and cash flows, the high credit quality of the SPV issuer has substance—the legal structure creates real value security for its lender, isolating it from the credit risk of the parent.
Revenue streams payable to the SPV—whether in respect to royalty payments, lease payments, payments from sales of products or other contract rights—are paid directly into a lock box controlled typically by a third-party servicer and a trustee. Such revenue is applied according to a pre-determined waterfall, most often giving a priority to the payment of interest and expenditures necessary to preserve the collateral. However, all expenses necessary in the operation of the SPV’s business are accounted for, including operating expenses and the payment of a management fee to the parent or, more typically, its designated subsidiary. Through its ownership of the manager, the parent retains virtually all other day-to-day control over the operation of its business. As all funds in excess of the required allocations are released back to the SPV—and ultimately to the parent—the parent has little incentive to maximize the management fee. However, the provision of a management fee is required to ensure that the business will be truly severable from the parent; as discussed further below, a third-party manager wouldn’t work for free. Typically, the waterfall will also provide for the trapping of such excess funds in the event of a default or upon an early amortization (repayment of principal) triggered by the occurrence of certain events, including the failure to meet certain minimum financial or operating requirements.
How It’s Been Used
In May of 2006, Dunkin’ Brands International went to market with a landmark $1.7 billion securitized financing package backed by royalty payments, other intellectual property and contractually-committed revenue streams. While Dunkin’ Brands International had a “B-” corporate credit rating from Standard & Poor’s at the time of the issuance, the Dunkin’ Donuts SPV was able to issue $1.6 billion in AAA debt, accounting for all but $100 million of the issuance. The securitization structure improved the credit of the SPV issuer to six levels higher than the parent, and reduced its interest payments by a reported $190 million over a comparable issuance by the parent over the expected life of the transaction (five years).
Dunkin’ Donuts is only one example of this type of securitization finance. In 2005, Crown Castle International, a provider of wireless infrastructure and, at the time, a high-yield issuer, went to market with a $1.9 billion debt package ($1 billion of which was rated in the highest category by both Moody’s and Fitch) backed solely by the equity of the SPV and the right to payments from tenants of its wireless towers. Crown Castle used the proceeds from the securitization to repay debt drawn pursuant to existing credit facilities, essentially swapping its high yield for AAA interest rates.
The Crown Castle transaction was a bellwether for the wireless tower sector in that Crown Castle’s repayment obligations were not secured by a mortgage on its interest in the underlying real property. This simplified the execution of the transaction tremendously, as thousands of mortgage filings were avoided. However, without a familiar security to deal with, the rating agency vetting process becomes more complex. It was also the first transaction in that sector to provide for multiple series of issuances and for the addition of further collateral. In the wake of this landmark securitization, each of the leading wireless tower operators followed suit by securitizing a portion of their wireless portfolio, suggesting that the securitization technology was essential to remain competitive.
Several of these securitizations were used to finance, or re-finance, leveraged acquisitions. In November of 2006, SBA Communications securitized the wireless towers it acquired when it purchased AAT Communications in April of 2006. SBA Communications used the funds it received from the securitization to repay a bridge loan facility that financed a portion of the cost of the AAT Communications acquisition. Both SBA and Crown Castle have gone on to successfully make additional issuances off of their securitization vehicles. In May 2007,
Limitations
Securitization is not appropriate for every business. Here are some of the main considerations:
* In order for the business to be securitizable, the assets and cash flows concerned must be capable of isolation, for legal purposes, from the parent and be “owned” by the SPV. Also, while the assets will be managed by the parent, they must be of a type that can be managed by a third party.
* To be bankruptcy-remote in the practical sense—in addition to the legal sense which is the raison d’être for the structure—the SPV’s business and cash flows would have to be able to survive the bankruptcy of the parent and its other affiliates.
* The ideal securitizable asset is one which can expect revenue growth with minimal additional investment. The severability of the SPV is fundamentally possible because its business doesn’t require a great deal of active, specialized or ongoing management. This makes intellectual property, royalty payments and contractual revenue streams ideal targets for securitization; additional applications are continuously being identified and the technology adapted accordingly.
* Given securitizable assets and cash flows, the process of setting up the structure is significantly more complex than many traditional financings.
Ultimately, as business securitization gains wider implementation, one can expect to achieve greater predictability and market acceptance. Given the significant advantages to borrowing levels, interest expense and borrowing flexibility, this technology should be fully explored as a financing or re-financing tool for appropriate leveraged buyouts.
Malcolm Wattman’s practice is concentrated in structured finance, risk-linked securities, corporate finance, securities, and general corporate law. He represents investment banks, insurance and reinsurance companies, public and private companies and institutional and individual investors in connection with public offerings and private placements of debt, equity and structured securities, credit agreements, business acquisitions and dispositions, contracts, and general corporate and commercial matters. Matthew Feig, is an ssociate in the Corporate/Mergers and Acquisitions Practice. James Langston is an associate in Corporate/Mergers and Acquisitions Practice.
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