Bridge loans are a key way to finance large acquisitions, but their terms are very specialized. In "The Basics of Bridge Loans", the White & Case team explains the key terms of bridge loans and discusses some challenges faced in the current market.
Bridge loans serve as an essential way that a potential acquirer demonstrates its ability to fund an acquisition. Certainty of funds is required both for regulatory reasons for financing the acquisition of listed companies in Europe (i.e., under the UK takeover code cash consideration should be available to proceed with a bid), as well as practical considerations, such as providing assurance that both private equity buyers and corporate buyers can raise the necessary funds to support their bids during an auction process.
Traditional bridge loans are temporary loans with an initial maturity of one year or less, put in place to bridge a potential gap between the announcement of an acquisition until a company can secure permanent financing. However, bridge loans carry significant risk. The borrower would prefer to avoid certain expensive fees and pricing the permanent financing at the interest rate cap (discussed below) and lenders would prefer to be engaged as the initial purchasers on the permanent financing (usually high yield bond) rather than assume such a large balance sheet liability. The intent among all parties at the commitment stage is therefore not to fund a bridge loan, but to draw down the bridge loan only to remove funding risk from the M&A transaction. To this end, the fee and interest rate structure of the bridge commitment is set up to incentivize the borrower to launch a high yield bond offering or other permanent financing transaction ahead of the acquisition closing rather than funding the bridge, or if funding is necessary, to refinance the bridge as quickly as possible following the closing of the acquisition.
In recent years and during times of strong market conditions, it has been relatively straightforward for borrowers to then finalize the permanent financing transaction either before drawing the bridge or immediately after and quickly refinance bridge loans. However, recent changes and ongoing volatility in credit markets have delayed the permanent financing and put a damper on the ability to refinance the bridge facilities during the initial one year term. In such market conditions, banks need to consider whether to wait and stay in the bridge loan, or potentially price the high yield bond above the Cap (discussed below) and/or price with significant original issue discount, which would mean the banks might ultimately lose expected fees or more from the transaction.
The key parties to a typical bridge loan are the acquirer (typically a newly established company) in an M&A transaction (the borrower), the banks acting as arrangers and the administrative agent.
In a typical transaction, the bridge loan's maturity of one year will automatically be extended into long-term financing should the borrower fail to refinance the bridge loan at the end of its initial term. The bridge loan will convert into a tradeable loan instrument, typically with a fixed interest rate set at the "Cap" rate (see below).
As further discussed below, once a bridge loan "terms out" into an extended term loan, lenders have the right to exchange such loans for "exchange notes". Bridge loan documentation is drafted on the basis that at the time of conversion, lenders will want to exchange their extended term loans into "exchange notes". Such exchange notes are cleared through clearing systems and are freely tradeable, as opposed to extended term loans, which are less liquid and subject to certain transfer restrictions.
Typically, bridge loan commitments are documented by a commitment letter, bridge term sheet, bridge fee letter and high yield bond engagement letter.
Fees, interest rates and various rebates are typically structured to incentivize the borrower to refinance the bridge at the earliest possible opportunity. The fees in a typical bridge loan may include the following, all of which are payable only if the acquisition closes – known as "no deal, no fee":
The securities demand provisions in the bridge fee letter give the banks the right to demand that the borrower issue a high yield bond to refinance the unpaid bridge loan. Once the borrower and the banks satisfy the conditions of such demand, the banks in theory gain full control of the timing and structure of the long-term financing.
The securities demand provision is typically exercisable by the banks upon the expiry of a holiday period following the closing of the acquisition (or potentially prior to the closing date). Once available to exercise this provision, the banks can "force" the borrower to go to market with permanent high yield bonds at the Cap interest rate and on the terms set out in the bridge fee letter. If the borrower does not comply with the securities demand, then a "securities demand failure" will have occurred under the bridge loan, which results in the loan immediately "terming out" into an extended term loan (which will carry an interest rate at the Cap rate) which can be exchanged into exchange notes and the conversion fee will be due. A securities demand failure will however not constitute an event of default under the bridge facility agreement.
Key securities demand negotiating considerations from the lenders' perspective include:
One option that the banks can negotiate at the outset in the context of a securities demand is for certain "flex" in the bridge fee letter, which allows banks to "flex", or amend, certain terms of the securities offered under a securities demand to facilitate the issuance of permanent financing. Flex provisions could include, but are not limited to, forcing interest rate increases, restructuring low-cost senior secured loans to higher priced mezzanine loans or bonds, shortening or extending maturities of the loan tranches or tightening covenants. However, this type of flexibility is less commonly seen recently in the European leveraged finance market.
As noted above, if the initial bridge loan terms out either by reaching its one year maturity or upon a failed securities demand, the bridge loan automatically (subject to very limited exceptions such as non payment of fees) is refinanced into extended term loans, which have a maturity date equivalent to that proposed for the permanent financing (i.e., the tenor of the high yield bond take out financing). At certain regular intervals and subject to minimum issuance amounts, the lenders under the extended term loans can exchange their extended term loans for an equivalent amount of exchange notes, which are privately held securities that have typical features of long term financing, such as call protection and free transferability, and accrue interest at the Cap. The lenders also receive the conversion or rollover fee to compensate for the longer exposure to the credit.
In the European leveraged finance market, bridge loans are typically not syndicated to other institutions and there is a strict limitation on transferability of such bridge loans, which are relaxed for extended term loans and fall away for exchange notes. Therefore, the investment banks funding the loans will hold the commitments until the high yield bond offering is accomplished (either prior to the closing of the M&A transaction, in which case the bond is issued into escrow, or after the closing of the M&A transaction, in which case the underwriting banks will have funded the bridge loan and will be repaid with the proceeds of the bond).
Preparation for the high yield offering will therefore kick off as soon as possible following the signing of the sale and purchase agreement for the M&A transaction, to permit the bond offering to launch as soon as possible. high yield bonds are issued pursuant to Rule 144A / Regulation S under the US Securities Act, so three years of audited financials, applicable interim financials, pro forma financial information (if applicable), a fulsome offering memorandum and diligence of the target company will be necessary to launch the high yield bond offering. Pre-commitment, the underwriting banks will have considered the timing to market and availability of financials and should have factored additional timing constraints into their decision to underwrite by considering the issuer's readiness to market.
Bridge loans can, and are, funded. However, the intention is that they are outstanding for as short a time as possible.
If, due to market conditions, it is not possible to avoid drawing down on the bridge loan or, if the bridge loan is funded, a quick refinancing, underwriters will need to weigh whether to wait and stay in the loan, or potentially price the bond above the Cap, which would mean the banks may ultimately lose expected fees (or more) from the transaction. If the banks are unable to place the high yield bonds at an acceptable price, a hung bridge loan occurs. At this stage, the bridge loan has rolled over into an extended term loan and/or exchange notes with an interest rate set at the Cap. In the current market conditions, either of these options are possibilities.
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