Securitisation and

Private Equity

slaughter and may

October 2004

contents
Securitisation and Private Equity

1.

Renancing an Acquisition

2.

Providing Debt Financing for an Acquisition

3.

Realising Private Equity Investments

4.

Conclusion

Uses of Securitisation in Private Equity Transactions

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securitisation and private equity

For many years securitisation has been seen as an attractive (but complex) tool for nancing
assets in the consumer and trade receivables businesses. It is only relatively recently that the use
of securitisation in a corporate context has become evident. This development (primarily driven
by a series of U.K. whole business securitisations), together with the more recent arrival of CDOs
(securitisations of underlying corporate loans and bonds), has given rise to a tool which can be
used in a variety of ways in the private equity arena. Whilst much of the activity to date has
been in the U.K. and the U.S., it has good prospects in Europe, particularly with the passage of
pro-securitisation legislation in a number of European jurisdictions.
Three of those potential applications are outlined in this note:
>

Securitisation as a means of renancing an acquisition

>

Securitisation as a means of funding the debt component of a private equity acquisition

>

Securitisation as a means of realising private equity interests

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1.

renancing an acquisition

Short term bridging loans are commonly used to provide the debt nancing for the acquisition of
a company in a private equity transaction. Following the acquisition, the bridging loans need to
be renanced.
1.1

Alternative Funding Methods

High yield bonds and/or longer term bank debt are often used to take out the original bridge
nancing.
1.2 Securitisation Methods
Whole Business Securitisation: A special purpose vehicle (SPV) is established to lend to
a business or group of companies within the target group (the Borrower Group). The SPV
nances the loan by the issue of rated debt securities in the capital markets. The loan is secured
over the assets of the Borrower Group and further protected by a package of operational and
nancial covenants imposed on the Borrower Group. Cashows generated by the Borrower
Group are used to repay the loan. Working capital is made available under separate bank facilities
which will (normally) be subordinated to the securitised debt.
Hybrid Structure: As above, except that the securitisation renances the senior portion of the
bridging nance and a high yield issue simultaneously renances the junior portion. Possible in
theory, but has not yet happened in practice.
Receivables Financing: Alternatively, a homogeneous pool of assets in the target company is sold
to an SPV, which nances the purchase by the issue of rated debt securities in the capital markets.
The target company continues to service the assets and extracts any prots relating to the assets
after the SPV meets its debt service obligations.
1.3 Advantages and Disadvantages
>

Higher debt proceeds levels, lower cost of funding and longer maturities may be achieved
using a securitisation than through high yield bonds or bank nancing. The equity value is
thereby increased. It has also been said that the covenant package (which will usually be
driven by rating agency requirements) may be more exible than that required for high yield
or bank debt. However, the costs of putting a securitisation in place, and the constraints
which apply whilst it is in place, must be weighed against the funding advantages.

>

In particular, these types of securitisations require businesses with stable cash ows and
a strong market position (e.g. high barriers to entry). Credit enhancement and liquidity
support will usually be required in order to obtain the rating. The rating achievable will
usually not be much higher than the normal corporate bond rating. Securitisations also
have signicant start up costs in terms of documentation and systems for servicing the
assets and reporting by the target company. The Borrower Group will also be restricted
in its operations (through operational covenants relating to acquisitions and disposals
and minimum and maximum capex requirements) and will be required to achieve certain
nancial benchmarks (e.g. debt service coverage ratios) throughout the securitisation.

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>

It may be harder to oat a company that has a signicant level of securitised debt,
but it has been done and experience also shows that exits through trade sales or
secondaries to other private equity houses should be less affected by having
securitised debt in the business.

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2. providing debt nancing for an acquisition

A private equity house will provide the equity component of the funding package necessary
for the acquisition of a company. The debt nancing is usually provided by other nancial
institutions.
2.1 Existing Methods
The debt nancing will usually be provided by banks or specialist lenders. The private equity
investor will need to involve those nancial institutions in the negotiation of a combined debt and
equity package.
2.2 Securitisation Methods
The private equity investor establishes an SPV in advance of any particular transaction. The
SPV raises money by borrowing under a warehouse facility from one or more banks, builds a
portfolio of private-equity related (leveraged) loans and then renances that debt by issuing rated
debt securities in the capital markets (the warehouse facility and then the debt securities being
collateralised by the underlying loan portfolio). Whether during the warehousing phase or the
capital markets phase the SPV provides, directly or indirectly (through the private equity house
or a bank afliate), the debt nancing for the transaction; the private equity investor continues
to provide the equity alongside that debt. The private equity house (or an afliate) manages the
loan portfolio of the SPV and earns management fees. If it wishes to have access to the excess
spread between the income on the underlying leveraged loans and the debt service costs of the
SPV, it can (and usually does) invest in some of the junior debt securities issued by the SPV in the
securitisation.
2.3 Advantages and Disadvantages
>

The private equity investor is able to provide a one stop funding source for the acquisition
and thereby participate in larger private equity transactions (than might otherwise be
the case) without having to use its own balance sheet for the debt component of the
funding package. It can control the process without having to involve other lenders in the
negotiations, and probably execute the transaction more quickly. It can also earn fees on
the management of the underlying portfolio and get the benet of the excess spread
arbitrage between the income on the underlying loans and the SPVs funding costs.

>

The management fees will usually be available at different tranched levels in the SPVs
payment waterfall - the larger (more subordinated) fees will only be available once certain
IRR targets have been met. Equally, as holder of any junior (equity) securities, it would take
the risk of rst loss if the underlying loan assets default.

>

The private equity house must bear the initial expenditure of setting up the SPV.
Warehouse funding may not have signicant cost benets the pricing advantage is
probably only fully realised once the rated debt securities are issued into the capital
markets.

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3. realising private equity investments

Private equity investments are illiquid until the investee company is sold or oated.
3.1 Existing Methods
The private equity investor retains its investments until the companies in which it invests are sold
or oated. The investments are held on balance sheet.
3.2 Securitisation Methods
The private equity investor sells its equity investments to an SPV which nances itself by issuing,
directly or indirectly, rated debt securities in the capital markets. The SPV uses CDO techniques
to make the portfolio suitable for securitisation investors: these include tranching of the SPVs
debt securities, the availability of nancial insurance policies (known as insurance wraps) to
guarantee debt service on the securities and ensuring appropriate diversication of investments
through compliance with rating agency-approved portfolio guidelines. The private equity house
manages a dynamic portfolio (made up of primaries and secondaries) in return for management
fees.
3.3 Advantages and Disadvantages
>

Depending on the nature of the private equity investors investment in the SPV, the sale
either provides an exit from the investment or removes the investment from (or provides a
better treatment for) the investors accounting or regulatory balance sheet. It may also give
rise to benecial treatment in its income statement. It also provides an opportunity to earn
management fees, some elements of which will be dependent on achieving specied IRR
targets.

>

However, given the inherent nature of private equity interests, the cashows generated
by the investments will not be sufciently stable and regular for the purposes of obtaining
the requisite rating without the provision of credit enhancement (most commonly through
overcollateralisation of the underlying assets and the availability of unrated subordinated
tranches below the rated debt) and liquidity or an insurance wrap. A number of individual
private equity investments dating from different points in the economic cycle (vintages),
and from different industries and geographical areas, are necessary to address the
concentration risks. In practice, to date, most transactions have required nancial insurance
policies from rated insurers to be acceptable to investors.

>

The transaction may suffer from negative carry during an initial ramp up period. The SPV
will raise funds at closing but these cannot be immediately fully invested. During this time,
the portfolio will be less diversied and the uninvested portion will have a negative cost of
carry. Recent structures have minimised this by issuing partially funded notes, by using a
warehouse to accumulate investments until they reach a critical mass and by staggering
multiple issuances of notes. The structure will also usually allow the adoption of an
overcommitment strategy, but this will be subject to rating agency limits.

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4. conclusion
Securitisation can provide a tool for achieving higher levels of debt proceeds, lower cost of
funding and/or longer term funding than bank funding or the high yield market in the context
of acquisition renancing. In addition, it provides the private equity house with the ability to
provide the debt component of a funding package (as well as the traditional equity component)
thereby enabling it to participate in larger transactions and execute transactions more quickly.
It moreover allows it to increase funds under management and earn management fees.
Securitisation also provides a mechanism for realising its private equity investments through the
debt capital markets.
But, these benets must be weighed against the costs and operating constraints (the latter
usually imposed by the rating agencies). These may limit some of the desired exibility. Needless
to say, there are also some difcult legal and tax hurdles to be overcome, particularly on crossborder transactions. However, transactions have taken place in each of these areas, and this is an
interesting option for private equity houses to consider.

This note is intended to give general information only. It does not seek to be an exhaustive statement
of the law and readers should take specic legal advice on any matter which concerns them.
Slaughter and May
October 2004

slaugh ter and may

uses of securitisation in private equity transactions

Warehouse/
Securitisation
Vehicle

Private Equity
Investor

Sale of Equity
Debt

Private Equity
CDO

Equity

Target Company

Borrower
Group

Secured
Loan

Whole Business
Securitisation

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Target
Assets

Sale of Assets

Receivables
Financing

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