1. THEORY
1.2. I NVESTMENT BANKS AND ADVISORS
Second part of this chapter of the thesis will be dedicated to description of investment banks and their role in transactions. In order to do so we will focus on transaction process as such and role of other advisors in it. We will elaborate also on theory of moral hazard and adverse selection theory as they are main reason for usage of advisory services by buyers. Investment banks in their strictest definition are institutions raising funds for their clients both in debt and equity. In accordance with this definition we will dedicate part of this subchapter to High Yield bonds – an investment banks specialty.
On the other hand today due to their expansion into other areas of finance, investment banks are providing also services of M&A advisory, corporate finance, trading of fixed income, commodity, foreign exchange and equity securities. With repeal of barriers imposed by Glass-Steagall Act and subsequent Banking Act in 1932 and 1933 (respectively) by Gramm-Leach-Bliley Act from 1999 we can see them entering other areas of banking and introduction of new service lines (e.g. private banking offered by Morgan Stanley etc.). With their role in securities trading diversified they become known as “sell side” to the contrary of “buy side” represented today by institutional investors (insurance companies, pension funds, mutual funds etc.).
Advisory roles are more important for non-private equity M&As. In such transactions investment banks can stand on either of sides (buyer as well as seller) and are responsible for facilitation of transaction process, coordination of advisory teams, evaluation and sales and purchase agreement negotiation. Very often, especially in Central and Eastern Europe region, investment banks are used as privatization advisors of governments. This is done mostly due to their experience with transactions, emerging countries governments’ (eventually national property funds’) desire to increase credibility of the privatization process and to woe investors who would not consider their participation otherwise.
Transaction process
In order to show investment bankers involvement and role we will now describe stages of transaction of typical two round transaction process. Length and number of stages of transactions depend on its size, structure, sophistication, number of participants etc.
Besides our example transaction can be conducted as a one round process, direct acquisition, takeover (hostile or friendly), merger, carve out of assets etc. Roles and activities of advisors depend on structure of transaction process. For purpose of our thesis we will focus solely on buy side advisory activities as sell side is not imminently involved in LBO transactions as we look at it.
Graph 2: Two round transaction process and roles of advisors
- appointment by the buyer
- negotiation with seller
- submitting indicative offer on behalf of buyer
- appointment of other advisors - appointment by the lead advisor
- facilitation of information flow - performance of due diligence
- preparation of valuation model
- information for valuation model - valuation of the target
- presentation of findings to lead advisor and buyer - submitting binding bid on behalf of buyer
- negotiation with seller and its advisors
- preparation of sales and purchase agreement
- optimal tax set up for the transaction - closing of the transaction
After appointment by the buyer as official transaction lead advisor (appointed, in most of the cases, based on selection process with main criteria the proposed fees), he is responsible for early negotiation with seller and submission of initial bids. At this stage prime goal is to stay competitive and to be selected for second round.
Upon commencement of second round lead advisor after consultations with buyer appoints other advisors who will be responsible for information gathering and due diligence reviews. Due diligence is a process of finding and providing information for
investment decision16. The number of advisors performing respective due diligence reviews depends on capacity of lead advisor and needs of buyer. In some cases only simple financial due diligence would suffice. In other transactions all possible reviews will be necessary.
In order to perform due diligence properly advisors need access to information. These are made available in the “data-room” which can be defined as a place at which information regarding target are stored. Information can be stored in hard copies in particular room (either at premises of target company or at third party premises or at premises of sellers advisor) or in electronic form (e.g. dvd, server etc.) or simply given away buy sellers to the buyers. Most common form of the data-room is combination of the above stated possibilities. In bilateral transactions so called full access is given to the buyer, which enables him to meet target’s management, auditors and so on. The most difficult access to information is in case of hostile take over attempt. There is no willing seller and therefore company has to use extraordinary measures in order to get access to information.
At this point lead advisor (investment bank) is responsible for coordination of advisory teams, proper distribution of information provided and management of data flow between both transaction sides. It is usually him who communicates with opposing side during the access to the data room and takes care that all questions and request are properly answered.
There are significantly different due diligence reviews which can be conduct by advisors of the buyer or by buyer himself (only if he has capacities to do so) such as:
i. Financial due diligence, which is performed in order to find all potential and present threats to operations of the company from financial point of view. In particular it looks on trends in margins, sales, working capital trends, commitment of future CAPEX, and sources of funds for the company etc.
ii. Tax due diligence aims to eliminate issues affecting investment decision on tax side (e.g. unpaid taxes, transfer pricing etc.)
iii. Commercial due diligence has goal to map past and present state of market for company’s products and services as well as company’s share on it. If possible and information make it available it also should dedicate some time to analysis
16 Deloitte (2006a)
of trends and future developments of market. Main concern of this review process is not on the company but on the market on which company operates.
An analysis focuses on competitors, key products and distribution channels, main customers (their concentration) and quality of the management (via benchmarking).
iv. Environmental due diligence looks at operations of the company and their compliance with safety and environmental regulations. It aims to eliminate any possible contingencies arising due to environmental contamination and focuses on investments needed to comply with present as well as eventually future legislation.
v. Technical due diligence concentrates on machinery and equipment capacity as well as their usage and remaining capacity / useful life and future need of CAPEX.
vi. IT due diligence pays attention to the development and operations of company’s information technology and software. Theirs reliability, simplicity of operation, cost (both cost of maintenance and upgrading) and last but not least quality of outputs.
vii. Legal due diligence which are together with financial due diligence the most important parts of due diligence process. It focuses on legal status of contracts, company’s incorporation etc.
Main conclusion and finding of due diligence have impact on; (i) valuation and deal model (if purchase price is based on multiples of EBITDA or EBIT any decrease or change in normal level of EBITDA alters price substantially), (ii) actions of the potential buyers (discovering a “deal breaker”), (iii) sales and purchase agreement preparation and negotiation (buyer can ask for indemnities), (iv) deal financing (previous loan agreements can exclude certain financing options)17.
Principally due diligence process is conducted in order to provide investors with as much information as possible for their investment decision. Information gathered and analyzed by due diligence advisory teams, are incorporated into valuation model upon which is based valuation of the target by bidder. Responsible for its preparation is lead
17 Deloitte (2006b)
advisor who in post due diligence phase assumes biggest responsibility for successful conclusion of the transaction.
After submitting biding bid lead advisor prepares contract and negotiates its terms as well as purchase price mechanism with seller and his advisors. In order to increase his motivation advisory contracts put so called success fee options for lead advisors. They are triggered by successful negotiation and lowering of purchase price (on seller side is the situation exactly opposite). If the negotiations are successfully concluded, lead advisor usually assumes the role of provider of finance for buyer and attempts to negotiate best terms at the market. Of course we are now referring to normal two round bidding process but in most of the LBO cases buyer is gathering finances even prior to the acquisitions, as soon as he is granted exclusivity in negotiations. In hostile takeover situations no exclusivity is granted and therefore funds needs to be ready prior to any actions of buyer. Funds assembled are mostly via issue of high yield debt which is placed by investment banks acting on behalf of issuer.
Last stage of transaction process is deal tax structuring in order to obtain the most advantageous tax position.
High Yield
Although presence of High Yield bonds was very well established throughout US, Europe got to know them well only towards the end of twentieth century. Slow acceptance was due to different institutional composition of the financial markets as banks have dominant position over the capital market, opposite to US. As will be later showed, European HY developed into significantly diverse product from US HY. Main differences will be brought to lime light throughout the thesis.
As we already mentioned HY bonds are defined today as bonds rated bellow investment grade (BB+ or Ba1 and lower). Ratings are assigned usually by at least two rating agencies with dominant position of Moody’s and S&P. In order to achieve position as liquid as possible they are issued in US dollars or Euros as both currencies have the strongest positions in investors’ portfolios. To narrow the definition we can consider HI only those bonds rated BB or B grade (all sub-grades included) as bonds rated below those levels are one step from default (CCC rated bonds). Comparison of
selected characteristics / rating criteria of bonds of companies rated in certain categories. Besides those ratios and numbers, there are plenty other qualitative criteria taken into account while assigning rating (e.g. management and its quality, operating trends, shareholders etc.).
Volumes of issues are today only approximately above EUR 100m as below this level placement of bonds will be difficult and investors would not be interested (although in markets flooded by liquidity we can experience issues of lower amounts). Below EUR 100m are very rare in Europe but can be seen in US fairly often. This is due to unwillingness of companies to undergo bank financing as capital markets are much more effective sources of capital and have incomparably higher appetite. It should be also mentioned that low volume issues are difficult and illiquid for trading on secondary markets and thus not interesting for general investors.
Tenor is from seven years up, on average about 10 years. Of course longer issues of up to 16 years are also fairly common. To protect investors they have incorporated call protections which attributes to their dislike by private equity funds which desire to refinance loans of their portfolio firms as soon as possible after the deal in so called recapitalization or shortly recap. Further to this bonds can be called only at premium as compensation for shortening of investments18.
Fixed rate (defined as spread over benchmark) coupons still completely dominate today’s market and floating rate HY are especially in Europe very rare occasion with only around 2-3 percent of the global total volume outstanding and about 10 percent of
18 Usually half of the coupon. In Monaghan (November 2005)
new issuance. HY floaters can be seen as attempt to blur the lines between HY and loans in order to cut of the loans slice of LBO market.
Main investors into HY are various mutual funds, pension funds, asset management funds, insurance companies and other financial institutions. As these are found mostly in US, issuers accommodate it with identical issues at US capital markets. Issuance under Security and Exchange Commission rules requires much more administrative work and incorporation of other issues (disclosure of risk factors in prospect or opinions from council and translation into US GAAP).
Approximate timeline of HY bond issue is in the Gantt chart below. As can be seen whole process is effective today with average length of 10-12 weeks. Investment bank acts as mandate representative on behalf of issuer with leading due diligence process, preparing presentation and running road show, ultimately printing prospectus and leading the issue. concerned mainly with business, legal and accounting issues, therefore it consists only from financial, tax and legal due diligence usually. Throughout whole process abbreviated prospectus (offering circular) is distributed in order to rise awareness among potential investors about issue. Meetings with rating agencies are very important due to the fact that rating determines interest rates / coupons HY bond will bear. Investment bank advising on bonds issue fulfills usually role of rating advisor as
well. As such she takes proactive approach to position the credit as near as possible o investment grade. Roadshow is basically when the bond is being sold. Issuer with his advisor (investment bank) is meeting with potential investors and is trying to “sell”
them HY. Printing means issue of “Red Herring” (preliminary prospectus filed with exchange commission regarding bonds offering) and later final prospectus for regulator and investors.
Depending of issued volume lead bank is also lead underwriter and thus it leads whole transaction. If there are other members of underwriting group they can participate on particular phase of the process as they see fit. On the other hand lead underwriter runs the book and controls allocation of the bonds according to book building exercise.
Investors can enter the process until the offering circular is printed.
There are two main characteristics followed with HY bonds. These are default and recovery rates of issuers and issues. Rates can significantly differ depending on industry issuer’s enterprise operates and are followed for these industries. In the thesis we will focus only on general rates as this is not in scope of the paper.
Default as defined by Moody’s includes three types of default event19:
i. missed or delayed disbursement of interest and / or principal, including delayed payments made within a grace period;
ii. an issuer filed for bankruptcy (e.g. Chapter 11 protection in US) or legal receivership occurs; or
iii. a distressed exchange occurs where; (i) the issuer offers bondholders a new security or package of securities that amount to a diminished financial obligation, or (ii) the exchange had the apparent purpose of helping the borrower avoid default.
Default as per definition is viewed of any action or circumstance putting lender into disadvantageous position and causing loss to him. Points (i) and (ii) are clear but point (iii) is based on subjective measures. It is in order to capture not only obvious but also defaults being hidden or masked by other actions but still causing substantial harm / loss to the lender.
Default and default rates are by rule of thumb cyclical events as they correlate with macroeconomic activity. Correlation is caused by increases and decreases of operating
19 Moody’s (February 2001)
margins and cash flows during expansions and contractions (respectively). In 1960s change in lag-lead environment happened as default rate increases became leaders to downturns in economic activity20. Lead of default rates should not be viewed as cause of downturn but more as an indicator of it. It is much more likely that problems within economy are affecting the most levered companies first and only later they transform into GDP and industrial production statistics. Taking into account above mentioned and looking at this business cycle and ever increasing multiples (see later chapters) and leverage of companies, we should expect rise of default rate anytime soon (from 2007 onwards). Indicator of this can be downgrading trend by rating agencies.
Recovery rates of defaults are statistics measuring either; price of defaulted instrument upon attempt of investor to get out of it on secondary market or ability of investor to recover owed amount in bankruptcy proceedings. As second case depends more on administrative process and legal framework it is hard to measure (it takes too long).
Basically if we return to Graph 1: Providers of financing, we should envision downward sloping line of recovery rates from the highest point at secured debt portfolio to its lowest point at preferred stock. As usually collaterals are demanded in excess of loan / financing we should expect high recovery rate even though discounts are applied upon sale of pledged assets.
In order to ensure cash flow from bonds acquired, preserve the quality of the credit, ensure management actions and bondholders’ interests are in line, investors / lenders ask for covenant protection. Further more such protection is taken into account also by rating agencies (although it can not affect final rating). Covenants aim to protect and eliminate “potentially material deterioration in credit quality during the tenure of the bond”21. Their ability to do so strongly depends not only on regulatory issues (such as insolvency legislation, bankruptcy protection etc.) but also on extent of any contractual and / or structural subordination. There is no point in having strong covenant package while the debt is against holding company which does not have any recourse to operating assets or debt is of the most junior kind. Therefore it is wise to insert additional guarantees on such senior unsecured debt by operating companies of holding issuer.
their loans. These affirmative covenants would not be of greater use for HY issuers as they tend to be loss making (HY is issued in order to provide financing for restructuring besides LBO financing). From historical point of view we should underline that European HY market and thus covenants is an off-spring of US HY. As such it followed similar trend in loosening of covenants over past years. To the contrary although it adopted certain standardized package of covenants as in US covenants are still more tailored and differ from deal to deal.
Most commonly used covenants are22; (i) limitations of indebtedness (based upon debt to EBITDA ratio), (ii) limitations of indebtedness of subsidiaries, (iii) limitations on restricted payments (to prevent recapitalizations and payments to the benefits of junior bondholders), (iv) limitations on dividend and other payment restriction (in order to prevent negative effects of dividend pay outs on ability of company to repay its outstanding debt), (v) limits on sales of assets (protection of quality and quantity of assets), (vi) limits on sale and leaseback (to avoid sale of assets falling out of definition of previous one), (vii) limitation on creation of liens, (viii) change of control, (ix) provisions regarding M&A and transfers of assets (protecting bondholders positions pre and after merger and restructuring), (x) limitation of layering (preventing subordinated obligations from becoming senior to HY issue), (xi) limitations of transactions with affiliates (in order to avoid transfers of value within a group or related parties at the expense of bondholder), (xii) cross default and (xiii) information provision covenants
Most commonly used covenants are22; (i) limitations of indebtedness (based upon debt to EBITDA ratio), (ii) limitations of indebtedness of subsidiaries, (iii) limitations on restricted payments (to prevent recapitalizations and payments to the benefits of junior bondholders), (iv) limitations on dividend and other payment restriction (in order to prevent negative effects of dividend pay outs on ability of company to repay its outstanding debt), (v) limits on sales of assets (protection of quality and quantity of assets), (vi) limits on sale and leaseback (to avoid sale of assets falling out of definition of previous one), (vii) limitation on creation of liens, (viii) change of control, (ix) provisions regarding M&A and transfers of assets (protecting bondholders positions pre and after merger and restructuring), (x) limitation of layering (preventing subordinated obligations from becoming senior to HY issue), (xi) limitations of transactions with affiliates (in order to avoid transfers of value within a group or related parties at the expense of bondholder), (xii) cross default and (xiii) information provision covenants