Boom in buying and building leads to rising debt | White & Case srl
Issuers are tapping into institutional loan markets to raise additional borrowing at a rapid pace as private equity firms turn to buy-and-build strategies to lower entry multiples and accelerate deployment
Debt issuances to fund follow-on acquisitions have soared in the past 12 months as private equity (PE) firms have turned to buy-and-build investment strategies to deploy capital at reasonable valuations in a highly competitive market.
According to McKinsey, buy-and-build strategies — where private equity firms buy a platform company and grow with a series of smaller follow-on acquisitions — historically accounted for 40% of private equity deal volume. investment, but have reached a 70% share in 2021.
The increase in ancillary activity followed record levels of investment from financial sponsors. Total value of global redemptions and secondary redemptions US$1.5 trillion in 2021, nearly double the previous record high of US$846.8 billion set in 2007. This in turn produced a record year for the issuance of leveraged finance for buyouts – for example, in America of the North and in Western and Southern Europe, funds for this purpose have reached US$328.1 billion at the end of last year.
The popularity of the buy-and-build approach has only grown as the global flow of private equity deals has accelerated. Financial sponsors recognize that small add-on deals carry less execution risk than large, stand-alone acquisitions, and are easier to fund and manage from a regulatory perspective. When done well, buy and build transactions can also improve profitability by unlocking synergies, introducing new products and services, and allowing the business to expand into adjacent geographies.
As private equity firms reached record levels of dry powder (over US$3 trillion according to Bain & Company), add-on deals also helped financial sponsors deploy capital to a wider range of targets and to achieve lower entry valuations, as smaller assets typically sell at lower multiples.
The increase in add-on activity was driven by the willingness of the leveraged finance and direct lending communities to provide financing packages for buy-and-build PE acquisitions.
According to By debtsNorth American issuers tapped institutional loan markets for record monthly issuances of US$13.6 billion in October 2021 and US$7.6 billion in November 2021, bringing the year’s total at US$68.3 billion, its highest level since 2017.
In Europe, meanwhile, Deloitte’s figures for the nine months to the third quarter of 2021 show that a fifth of direct loan deals at the time were for add-on acquisitions.
For example, UK software company Iris secured a top-up loan of £125m to repay draws on revolving credit facilities used to partly fund recent acquisitions. Platinum Equity’s French firm Biscuit International has raised an additional €205 million B term loan to finance its purchase of Continental Bakeries. Ardian-backed diagnostics firm Inovie, which announced six add-on deals worth around €600m in 2021, according to Fitch, has launched a €775m Term Loan B add-on end of 2021.
It has been extremely helpful for sponsors in competitive deal situations to provide evidence of committed funding to demonstrate the deliverability of their offer to vendors.
In terms of lending markets, sponsors have primarily financed follow-on acquisitions through fungible (debt treated as part of the same tranche of an original loan) or non-fungible term loan facilities. Sponsors can also raise funds outside of existing credit agreements, by arranging what is called additional matching debt in side-by-side credit facilities. However, fungible tranches were the preferred option. The financings of Biscuit International and Inovie, for example, were both fungible transactions.
Direct lenders, on the other hand, have structured many of their products so that buy-and-build platform loans have access to a committed line of acquisition financing. This typically takes the form of a deferred draw term loan facility that offers upfront commitments to provide debt to fund acquisitions over a set period of time, typically between 12 and 36 months after a debt package closes. Such deferred draw term loan facilities will generally include a leverage adjuster (fixed at closing date levels) as a drawing condition.
Borrowers have benefited from greater flexibility when it comes to meeting the debt thresholds and tests put in place when a set of debts is agreed. Most agreements will include a “free and clear basket” or “gift basket”, which allows sponsors to take on additional debt capacity in the form of additional loans or additional equivalent debt without having to satisfy any leverage test. In such a case, borrowers may increase leverage above closing date levels. In addition, generally in order to utilize the “outstanding-based” component of the additional lending facilities, borrowers would need to be in pro forma compliance with the applicable level of leverage at the closing date (disregarding, however, any use simultaneous and-clear”, which again allows borrowers to increase leverage above the applicable level on the closing date). Additionally, in many cases, sponsors have been able to negotiate “no worse than” tests, which allow companies to make acquisitions using additional debt capacity as long as the applicable leverage ratio is no worse than this leverage ratio immediately before the acquisition on a pro formal basis.
Liquid debt markets have allowed private equity firms to trade this flexibility into debt packages for platform companies. Sponsors are also making the most of the current tailwinds to broaden their lender bases and maximize the number of lenders they can turn to when raising additional funds for follow-on acquisitions.
Sponsors prefer to approach incumbent lenders as a first port of call to secure additional debt to fund acquisitions, which now also includes a broader pool of private debt providers for flexibility when planning follow-on deals. Access to a larger group of incumbent lenders who know credit reduces execution risk and the costs of raising funds for follow-on acquisitions.
McKinsey expects buy-and-build strategies to continue to gain momentum in 2022, which should in turn support a sustained pipeline of follow-on deals.
All financing options should remain open to private equity firms, on borrower-friendly terms, as they continue to pursue additional goals for their portfolio companies.