Buy now, finance later: equity backstops boost buying power in scramble to close deals — PE Review

13 October 2017
Competitive bidding and pressure to put record cash raises to work have created an aggressive new paradigm in deal-making—one in which private equity firms rush to close acquisitions before they even nail down committed financing, according to multiple buyout industry sources.
 
Several recent LBOs by firms including Thoma Bravo and CCMP were closed solely with equity backstops from the sponsor. This strategy of forging ahead without finalized debt underwriting commitments allows PE shoppers to sweeten their bid in a competitive market where enterprise value multiples are at multi-year highs, the sources noted.
 
“It’s such a hot seller’s market that timing between the signing of the deal and the closing of the deal is getting shorter and shorter,” said an M&A adviser. “Sellers and their bankers are greedy in terms of certainty of closing and getting the price they want. This way they can guarantee you a close quickly.”
 
In some recent cases, the period between signing and closing has shrunk to about 20 days from the usual 45, as sponsors seek to outbid competitors.
 
“This is what you get when you are at the top end of a market,” said Steve Kaplan, a professor at Chicago Booth School of Business specializing in private equity research.
 
However, even during the heady days before the global financial crisis, equity backstopping was uncommon, said an M&A lawyer. “Full backstops without protection in the contracts are a very new thing,” the lawyer said.
 
While backstops “guarantee the speed and certainty of closing” a deal, sponsors could get stuck holding giant equity checks if credit markets seize up before a PE firm can eventually get a debt deal in place to offset its exposure, the lawyer added.
 
Recent examples of deals that were backstopped include Thoma Bravo’s winning bid for educational software company Frontline Education and CCMP’s purchase of eating disorder treatment provider Eating Recovery Center, several sources noted.
 
Both deals were struck at higher-than-expected EBTIDA multiples, with Thoma Bravo paying more than 19x for Frontline (compared to expectations of 14x-16x) and CCMP forking out over 13x for Eating Recovery (compared to expectations of 10x-12x).
 
Vista Equity Partners is another large PE sponsor that has used equity backstopping extensively in the past, multiple sources said.
 
The new gold rush
 
Backstopping is becoming more common as investors increasingly turn to the higher returns offered by private equity amid the global search for yield.
 
Global private equity firms were sitting on a record USD 963bn equivalent of unused cash as of July, with that figure expected to reach a trillion by the end of the year, according to research firm Preqin.
 
Some of those recently raised funds have included equity backstopping capabilities as a new feature, according to a senior portfolio manager at a leading private equity firm.
 
“In our fund documentation, one of the recent evolutions has been the sponsors building that language into PE funds to increase their flexibility and deal-making ability,” said the PE source. “Our guys can do that. They don’t want to do it, but they can.”
 
As funds scramble to put this cash to work, competition is becoming especially intense in middle market deals, with half the respondents in Preqin’s mid-year survey saying that was where they saw the best opportunities.
 
Given this increased interest and the smaller size of companies—which makes the upfront equity check more manageable—backstopping has become particularly popular in middle market buyouts, with the eventual debt financing often provided by alternative lenders such as Antares, Golub Capital and Ares, sources said.
 
The sweet spot for equity backstopping is among companies valued at around USD 500m – USD 600m, said two M&A lawyers, adding that around 25%-30% of the deals they have worked on recently include some form of backstop.
 
Recent examples
 
San Francisco-based Thoma Bravo first announced its plan to acquire Frontline on 4 August. Multiple sources told Debtwire that the firm got the deal signed by equity backstopping the purchase without pre-arranging a debt package.
 
The transaction closed a month and a half later on 18 September, with Thoma Bravo announcing financing from alternative lenders including the Ares Capital Corporation BDC, TPG Sixth Street Partners and KKR Capital Markets.
 
The size of the financing was not disclosed, although sources said the deal was around 8x levered on USD 70m of EBITDA, implying a debt package of around USD 560m.
 
Likewise, when New York-headquartered CCMP Capital announced it was buying Eating Recovery Center on 30 August, the sponsor provided a full equity backstop for roughly UD 600m, said a source close to the transaction.
 
The deal closed about 25 days later, with lead arrangers Antares and Golub syndicating the USD 325m credit facility after the close.
 
The first lien facility included a USD 190m first lien term loan, a USD 30m delayed-draw term loan and a USD 30m revolver, which are expected to allocate early next week, according to a source close to the deal. The USD 75m second lien was privately placed, according to the source close.
 
Bring out your banker
 
Another way that private equity firms are closing deals faster is by having the lead bank provide funds ahead of syndication, in exchange for additional compensation.
 
Jefferies was the sell-side bank when CCMP acquired Truck Hero this April. In order to get the transaction closed faster (in about 20 days), the bank’s leveraged finance group wrote a USD 1bn check for the acquisition before syndicating the debt, according to a source close to the transaction.
 
Jefferies later brought in Antares Capital, Golub Capital, Citizens Financial Group, Natixis and SunTrust to syndicate the deal, according to Debtwire data. The credit facility eventually allocated in May and included a USD 675m first lien loan, a USD 250m second lien and a USD 100m revolver.
 
Sources said New Mountain-backed Avantor’s purchase of VWR and KKR’s and Caisse de Depot’s purchase of USI Insurance Services were also conducted in a similar manner, according to two sources familiar with the situations.
 
In Avantor’s case Goldman Sachs put up the commitment for the financing, whereas KKR’s own Capital Markets unit did so for USI, the sources said.
 
Banks usually earn extra fees for taking on this extra risk, said one of the M&A lawyers—typically an extra 25-50bps on top of the 2-3% fees they normally take home for underwriting an LBO.
 
Limits and risks
 
Backstopping has its limits. For one, the sponsor has to be large enough to be able to commit to the whole size of the financing should they have to, said one of the M&A lawyers. Secondly, many of these firms have concentration limits on how much they can invest in any one sector in their portfolio.
 
“If it’s a USD 3bn fund and you have a 20% concentration limit, there is only so much you can commit to equity backstopping a deal,” an M&A advisor said.
 
It also puts an incredible amount of pressure on sponsors to complete debt financing before the equity commitment eats up too much of their IRR, said the private equity source.
 
“The second they use that capability, the clock starts ticking on what they owe to their investors,” the source said.
 
If a sponsor cannot syndicate the debt to fund a backstopped deal, they will likely try to find a way to pull out of the commitment, the source added.
 
“Have no doubt that a PE shop will try to weasel out of that,” the source said. “If they can’t, they’ll just take it down and have to ride it out, and at some point over the lifetime of that fund, they’ll come back to make when the debt is desirable again.”
 
The speed of closing with a backstop is also a potential hazard. In their haste to close deals, sponsors and underwriters also risk not giving enough attention to due diligence, one of the lawyers cautioned.

But despite these dangers, backstopping is set to increase as sellers demand ever more aggressive terms, said a leveraged finance lawyer.
 
“Of course, as a seller you want to close and want certainty of funding, so if sellers see it as market practice, it’s probably is perpetuating itself,” the lawyer said. “It’s helping them when they sell but hurting them when they buy,” she added.