By Dennis Lamont, Partner and Howard Sobel, Partner, Latham & Watkins LLP
Debt financing documents typically contain a change of control feature that triggers an event of default, or requires a mandatory prepayment or offer to purchase, upon the sale of the borrower or issuer of the debt (the “Company”) to a third party. As a result, the credit markets generally expect that all material existing debt will be refinanced in connection with a sale of the Company. In some cases, the need or obligation to prepay debt is coupled with call protection for particular tranches of debt, which adds a premium to the cost of refinancing the Company’s existing facilities. The total amount of this cost – underwriting fees for the new replacement facilities and call protection payments – is effectively borne by a seller, as a prospective buyer will factor these costs into its purchase price for the Company.
Private equity sponsors continually seek to optimize the capital structure of their portfolio companies. As a result, some sponsors have turned to so-called “debt portability” provisions which effectively waive the change of control provisions in connection with a sale of a portfolio company if certain criteria (including leverage ratios and ratings conditions) are satisfied. The principal financial advantages of debt portability are three-fold: they reduce transaction costs with the net savings flowing to the seller; they accelerate the time to closing as there is no need to arrange new replacement financing; and they eliminate uncertainty about the ability of the buyer to raise the debt financing for the acquisition on acceptable terms. In addition, portability features enable the sponsor to conduct an auction in an extremely efficient manner, as bidders do not need to communicate with numerous financing sources.
Debt portability, however, may not be equally effective in all cases. Sometimes, the prospective buyer wants greater flexibility (such as more debt incurrence capacity) or different terms (such as customized baskets based on sponsor precedent) than what the Company’s existing debt documents provide. In other cases, the buyer may desire to raise incremental debt to fund a higher purchase price, which means that some marketing effort will still be needed and which reduces the speed-to-closing advantage of portability. It is also worth noting that certain debt investors disfavor portability provisions, which means including those provisions in a syndicated financing could affect pricing or execution. Portability generally is most effective in opportunistic financings where market conditions are favorable and the expected exit is in the near term.
When negotiating debt portability provisions, the Company must anticipate how they will work in tandem with the expected sale process, so that they intersect seamlessly with the acquisition agreement’s conditions precedent. Because the Company negotiated the portability provisions and its equity holder stands to benefit the most from the feature, a buyer reasonably may expect seller to bear the risk that the portability feature works as expected at the closing. Therefore, sellers should pay close attention to when conditions related to portability (in both the debt and M&A documents) need to be satisfied, and identify which party is responsible for the satisfaction of each component of the conditions. From a seller’s point of view, ideally all conditions precedent to porting the debt that the seller or the Company must satisfy would be met at the time of signing the sale transaction in order to provide certainty that the debt will port at closing, or at least to ensure that seller is not responsible for any failure to port.