Sponsors’ Role in Leveraged Debt FinancingsJames Roche Randy Szuch(212) 908-0776 (212) 908-0589jroche@fitchinv.com rszuch@fitchinv.com

SummaryRecord levels of equity and debt issuance in the high-yield market are significantly influencing capitalizationstructures and, in some cases, altering the creditworthi-ness of companies that have undergone leveraged buyouts(LBOs), recapitalizations, and other change-of-controlsituations. A much overlooked element of the creditprofile of debt issuers in this market segment is the roleof the private equity groups that often engineer thesetransactions. When rating bank loans of issuers thathave undergone or are contemplating leveraged buy-outs, Fitch targets the financial sponsor’s orientationand decision-making criteria, track record of providingpost-investment economic or qualitative support, andrelevant expertise to determine the sponsor’s effect on theissuer’s ability to service its debt. In addition, Fitch focuseson the type of transaction and the debt financing structure.

Market OverviewCompetition among banks and other financial institu-tions for loans has intensified to the point where Lon-

don Interbank Offered Rate (LIBOR) spreads on lever-aged loans have reached a mere 139–225 basis points, athree-year low, according to the LPC Gold Sheet’s broadlysyndicated loan grid. Loan syndications, which amountedto more than $888 billion in 1996, have risen at a 30.5%compounded annual growth rate (CAGR) over the pastfive years, driven largely by 22% growth in refinancingactivity and a 38% CAGR in leveraged lending.

A primary factor contributing to the pace of high-yielddebt origination has been the formation and expansionof private equity funds earmarked for leveraged buy-outs. LBO fundraising approximated $22.8 billion in1996. This represented an increase of 20% from 1995levels, which many market participants had viewed asunsustainably high. This momentum carried over intothe first half of 1997, when 49 new funds, constituting$16 billion, were closed.

Due to the growing supply of funds, an increasing per-centage of the LBO market can be characterized as an“auction” process, in which the highest bid generallyprevails. Competition among private equity firms for afinite number of buyout transactions has led manymarket participants to ask whether there is too muchmoney chasing too few deals. Additionally, the percent-age of equity supporting buyouts has declined.

These trends have increased the level of indebtedness.To mitigate the dilution caused by higher purchaseprices on expected equity returns, these groups haveraised the level of debt financing to leverage theirinvestments. Increasingly, LBO debt exceeds 6.0 times (x)earnings before interest, taxes, depreciation, and amor-tization (EBITDA) and 80% of total capitalization, versusmuch lower historical levels.

Structured Finance

Credit Facilities Special Report

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October 16, 1997

Preferred Characteristics of LBO Sponsor/ Issuer Relationships➢ Sponsor has a track record of providing

economic and operational assistance fol-lowing the initial investment.

➢ Sponsor’s investment horizon and exitstrategy is consistent with the company’s.

➢ Sponsor group has successfully completedor exited investments in the same industryas the company.

➢ Structure provides sufficient equity to ac-count for seasonal and industry cyclicality.

➢ Sponsor has substantial cash invested inrelation to its voting ownership position.

Types of Leveraged Transactions

The nature of a leveraged transaction(i.e. friendly or hostile, simple recapi-talization or change of control, auctionor private sale) can have as much effecton the likelihood of default as the issuer’screditworthiness and the strength of thefinancial sponsor. Sponsors play a largerole in defining the capital structures ofmost leveraged debt placements. Thus,a review of the final structure often revealsa great deal about the sponsor’s underly-ing motivations and likely future behavior.

The nature of the transaction has sev-eral implications. For example, there isa considerable distinction betweenbuyouts in which the sponsor acquiresa controlling ownership interest with alarge cash payment to existing manage-ment’s ownership control and involve aminimal cashout. It is critical in theformer structure that the sponsor hasthe ability to recruit successor manage-ment or structure strong incentive com-pensation arrangements. Fitch hasnoted that equity sponsors will morelikely devise incentive programs thatprovide for management succession.Additionally, sponsors with longer trackrecords tend to be more successful inavoiding auctions due to the depth of

their professional contact base and theperceived certainty of closure they of-fer to the buyout process. This abilityto avoid auctions often serves to lowerbuyout purchase prices, which, in turn,reduce leverage.

In assessing the structure of an LBO, ofparamount importance is the transac-tion’s effect on financial leverage(measured as total debt to total capitali-zation and total debt to EBITDA), atclosing and over the term of the debtFitch has been requested to rate. Fitchconsiders how the sponsor has tailoredthe capital structure to account for theinherent seasonality, cyclicality, or vola-tility of the business or to satisfy growthor working capital requirements. In thecase of sponsors pursuing growth-via-acquisition strategies, for example, higherinitial equity levels or formal provisionsfor equity replenishment may be re-quired to support future growth. If thisis not in place, the company is likely toend up far more leveraged than it wasat the buyout date.

Sponsor Background/Track Record

The record of the financial backer of aleveraged debt issuer can help deter-mine whether the involvement of a cer-

tain sponsor benefits the credit profile.Fitch considers the history of a spon-sor’s behavior with regard to previoustransactions to determine whether thesponsor has been a source of initial eq-uity or a resource to be relied on forshepherding the company’s develop-ment after the investment. This analy-sis is directed at understanding whetherthe sponsor is likely to provide financialor technical assistance following theclosure of its buyouts.

Arguably the most relevant aspect ofthe sponsor’s background is how long ithas been established and the numberof transactions it has completed. Spon-sors that have successfully completedand exited several transactions with in-dustry or other characteristics similar innature to the subject transaction areviewed most favorably. In the case ofequity sponsor groups that have recentlybeen formed, Fitch focuses on the trackrecord of the group’s principals and thedepth of its analytical team.

The background of the sponsor’s keydecision makers and professionals (i.e.financial, investment banking, lending,or operational) affects the type of buy-out they are best suited to support.Fitch examines whether the decisionmakers have specialized industry knowl-edge, turnaround expertise, or otherunique, value-added capabilities thatwill be useful to the issuer after the dateof investment. Fitch has observed, forexample that firms employing acquisi-tion-driven growth strategies oftenbenefit from association with sponsorshaving a financial orientation, given thelevel of financial re-engineering re-quired after closing. On the other hand,businesses with significant manage-ment turnover or that need product linerepositioning are usually better servedby sponsors employing professionalsfrom operational backgrounds.

When evaluating the performance of anLBO equity investor, Fitch considerswhether the firm has experienced sig-

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nificant turnover in personnel, espe-cially at the partner level. Lack of con-tinuity at the senior level can oftenserve as a red flag that the investmentfirm is either not unified or perceivedas unsuccessful by its insiders. If part-ners or professionals constituting toolarge a percentage of the firm have de-parted, extrapolating the firm’s histori-cal performance into future expectationsmay not be possible. In such cases, thesponsor’s involvement is, at best, con-sidered a neutral credit factor.

Certain sponsor groups have developedstrong reputations for their capabilitieswith regard to pre-investment due dili-gence and post-investment support.Experienced sponsors are often skilledin identifying competent managementteams, perhaps the most important ele-ment of evaluating an LBO candidate’sprofile. During this process, they areoften able to correct weaknesses in sen-ior or middle management by tappingtheir network of business and consult-ing contacts.

Sponsors can also provide post-closingfinancial support directly (through addi-tional equity investment) or indirectly(by negotiating with existing banks foradditional financing or the restructuring

of certain terms and conditions). Thisis especially important for cyclical orgrowth companies, as is the depth ofthe sponsor’s capital resources.

Sponsor Orientation/Decision-Making Criteria

Established financial sponsors have iden-tifiable investment preferences and be-havioral patterns. Many limit themselvesto investments within specified industries,and a large percentage target investmentcandidates within a defined size range(measured by revenue or market valu-ation). By understanding a sponsor’s cul-ture, Fitch is better able to gauge thesponsor’s motivation and rationale for sup-porting a given transaction and the level ofongoing support that can be expected.

Especially telling is whether the spon-sor typically employs an active or pas-sive investment strategy. In most cases,the post-closing support of a sponsorwill be in the form of financial advisoryservices, including the arrangement ofadditional capital and advice regardingadd-on acquisitions or restructurings.

Fitch considers whether the sponsorhas a short- or long-term investmenthorizon and whether it participates inauctions when making buyout offers.

These two areas directly affect thecompatibility of the equity sponsor andbanks lending to the same company inthat they influence the level of leverageand tenor of a given structure. The exitstrategy of LBO investment firms oftendictates their investment horizon and isoften relatively well known to the in-vestment community. Some firms tendto specialize in purchasing companiesthat represent strong initial public of-fering candidates, with an intention ofbringing them public as soon as possi-ble. Others look to make short-termoperating changes in their portfoliocompanies, with a goal of “flipping”these companies to other financial orstrategic buyers in a short time frame.

Another telling element of the spon-sor’s orientation is whether it has fa-vored industries or business types (i.e.whether the company avoids or favorscyclicals, technology-based companies,turnaround situations, or high growthprofiles). This orientation will not onlysignal how the sponsor views the issuer,but will also indicate whether the in-vestment is in line with the sponsor’sexperience or expertise. Fitch consid-ers how often the sponsor has investedwithin the same industry and with thesame primary underlying credit factorsas the company being rated.

Fund StructureA sponsor’s access to capital is of pri-mary interest in assessing the likeli-hood of its future financial support.Funds with a strong performance trackrecord are generally able to raise addi-tional funds more easily. Fitch evalu-ates the degree to which the totalamount of funds raised by a group ex-ceeds its deployed and committedcapital. Many funds will raise separatefunds for add-on acquisitions or for-mally carve out funds for such pur-poses.

After assessing a sponsor group’s dispo-sition toward providing incremental fi-

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nancial support to its portfolio companies,Fitch reviews the firm’s capital capacitywhen judging its ability to contribute.Investment behavior can be affectedand even limited by the composition ofthe fund’s investor base. Some fundsare restricted against making invest-ments in particular jurisdictions, in cer-tain industries, or with certainstructural components. The sponsoroften has strong policies regarding con-flicts of interest between its investorsand potential portfolio companies.

Formal rate of return and time horizonstandards also have a significant bear-ing on the likely performance of a spon-sor. From a creditor’s perspective, it isusually preferable for the sponsor tohave a long investment horizon. Credi-tors are not necessarily adversely af-fected by the sponsor’s inclination toexit a transaction prior to the specifiedloan term. However, groups with theshortest time horizons may be lesslikely to support an issuer’s long-termstrategic decisions. A sponsor’s finan-cial commitment to a transaction canalso be affected by the frequency withwhich profits are proposed to be distrib-uted to investors.

ExampleThe theoretical example in the boxabove and table at right is provided to

illustrate how the growth objectives ofa leveraged buyout candidate might bemore readily achievable through alli-ance with one financial sponsor thananother. In this example, the LBO can-didate has two primary financing objec-tives — providing a certain amount ofliquidity to management while the pri-vate equity market remains favorable tosellers and obtaining sufficient externalfinancing to support the company’sgrowth expectations over the next fiveyears.

At first blush, it appears that the issueris better served by pursuing sponsor 2’sproposal. This proposal involves agreater up-front cash payment, allowsmanagement to participate in futureappreciation, and satisfies the company’sexternal financing requirements.

A further review of the proposals, how-ever, reveals significant qualitative dif-ferences in the proposals, many ofwhich would not be apparent unless theissuer was prepared to evaluate the

Case Example

Issuer Profile

➢ 20-year old niche retailer.➢ Founders in mid-40s, not ready

to retire.➢ Management is strong opera-

tionally, but in need of adminis-trative and financial expertise tomanage growth.

➢ $200 million in external financ-ing needed for expansion and re-modeling.

Background and Proposal of Sponsor No. 1➢ Long investment horizon; re-

cently closed second buyout fund.➢ Successfully exited five leveraged

roll-ups of specialty retailers.➢ Prefers to offer management less

up-front consideration to keep itincented.

Background and Proposal of Sponsor No. 2➢ Short investment horizon; ex-

pect to wind down fund withinthree years.

➢ Negligible experience with lev-eraged retail build-up strategies.

➢ Always acquires major voting in-terest; exercises significant con-trol over board-level decisions,including exit timing.

Case Example($ Mil.)

Proposal ofSponsor 1

Proposal of Sponsor 2

Total Purchase Price 300 350Purchase Price Multiple* 6 7Up-front Cash Payment 75 100Sponsor’s Acquired Ownership (%) 40 60Management’s Retained Ownership (%) 60 40Debt at Closing 225 250Debt as % of Buyout Price 75 71Debt/EBITDA (%) 4.5 5.0

ResultsFive-Year EBITDA Growth Rate (%) 10.0 7.5

Present Value of Management’s ReturnsUp-front Cash Consideration 75 100Five-Year Return on Equity Rolled Over** 217 122

Total Return 292 222

*Using earnings before interest, taxes, depreciation, and amortization (EBITDA) run rate of $50million. **Assuming exit multiple of six times EBITDA less outstanding debt.

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background or track record of the spon-sor. Sponsor 1’s proposal results in man-agement’s retention of a controllinginterest in the ongoing operation andalignment with a strategic partner withmore industry experience and contactsthat would prove useful in furthering itslonger term objectives. Sponsor 1 wouldplace this investment in a newly closedfund, and, thus has a longer investmenthorizon than that of sponsor 2, which islikely to wind down its fund in shortorder. Sponsor 1’s prior successes withretail roll-ups and its ability to augmentthe company’s board of directors withexecutives from its other retail portfoliocompanies add value to its proposal.

It is assumed that differences in theinvestment motivations and back-grounds of the two sponsors would re-

sult in different earnings growth ratesfor the company. This example as-sumes the company would achieve its10% earnings growth objective if thecompany selected sponsor 1 as its eq-uity partner. In contrast, it is assumedthat the short-term investment horizonand lack of industry familiarity of spon-sor 2 would have a negative impact onthe issuer’s earnings growth. Havingsubstantially achieved all its invest-ment objectives, this sponsor would be-come primarily focused on preservingthis economic return and on pursuingexit alternatives. This disposition, cou-pled with sponsor 2’s lack of hands-onexperience with retail growth strate-gies, would cause it to become moreconservative when voting on strategicinitiatives at board meetings, such ascapital expenditure proposals outside

of “maintenance level” outlays, propos-als regarding the number of new storeopenings, and growth related to adminis-trative and operational personnel addi-tions. In this scenario, sponsor 2’smotivations have become irreconcil-ably divergent from that of manage-ment, which has a vested interest infostering growth.

As reflected in the table on page 4, thepresent value of management’s five-yearreturn on equity would be 24% lower ifthe buyout proposal of sponsor 2 wereselected, despite the higher up-front cashpayment and larger overall purchaseprice. The company’s management wouldhave been better served to align itselfwith a knowledgeable, partner-like eq-uity source, such as sponsor 1.

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