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Whole business securitisations20/12/2006. Source: SJ Berwin. Brian Carne 
Recapitalisations have been a hallmark of 2006, says SJ Berwin. Not without some controversy, many funds have taken advantage of buoyant credit markets to refinance their portfolio companies and so take cash out before being ready to exit. Following an interesting development last month, next year could see more re-financing activity - but this time taking advantage of a different financing technique. The development came when Standard and Poor's announced last month an alternative, market value based approach to “whole business securitisation” which should increase the cost savings from re-financing, and broaden the range of businesses to which it is applicable. As a result of this change in policy, we can expect to see substantial whole business securitisation activity next year.
To explain briefly: whole business securitisation is a product most commonly used to refinance acquisition debt. A bond issuer is established in the target group. It issues rated, listed debt into the euromarkets and on-lends the proceeds to the target group's operating companies, which themselves on-lend the proceeds to the borrower under the acquisition finance facility. The operating companies borrow from the bond issuer on covenants very similar to an acquisition finance facility.
The new loans are secured on the target group's assets just like the acquisition debt it refinances. The bond issuer then grants a trustee for its bondholders security over all of its assets, including the benefit of that security over the target group's assets. This is in contrast to traditional asset backed securitisation, which raises finance against a portfolio of receivables rather than the future profit of a business.
The securitisation has to take place as a re-financing as there is neither the time to securitise during an acquisition, nor the access to data on the target required to carry out the transaction, but it will usually be envisaged from the outset of the acquisition.
Whole business securitisation, where it can be used, can offer substantial interest cost savings as against traditional bank facilities. These cost savings may, in the eyes of some private equity funds, outweigh the practical difficulty for management of living with the tight covenants that come with a securitisation. Unlike on a syndicated facility, where a facility agent will act as the borrower's commercial partner in determining which covenants have to be followed and which can be waived, the trustee will only look at the interests of the bondholders (in a very conservative way) when making similar decisions
Until now, whole business securitisation has been held back by raters' refusal to assign a value to the securitised business as a going concern. Instead, the amount companies can borrow has been limited by the underlying value of those of their assets which can be sold on an insolvency to repay the securitisation bonds.
Companies have had to pay interest and repay principal from operating profits, meaning that transactions have long terms, much longer than the private equity buyer intends to hold the target group, and that an extra cost is therefore incurred in terminating fixed rate funding (either some fixed rate bonds will be issued with a prepayment penalty known as a Spens clause and/or floating rate funding will be hedged with a fixed rate swap). A side effect has been that deals are only just investment grade, reducing cost savings, due to the stress placed on cashflows.
These disadvantages are substantially reduced by the new approach. S&P are willing to attribute a resale value to an underlying business in the right circumstances. This means that whole business securitisations can be five year, interest only transactions, as the raters will assume that the transaction can be refinanced at its maturity. Ratings will be higher and so cost savings greater at the same time as prepayment penalties cease to apply. And a broader range of companies may use the technique.
Of course, it remains to be seen how these principles will be applied in practice. This development would certainly not reassure those (including the UK’s regulator) who are concerned that it is getting harder to identify the ultimate owners of the economic risk associated with debt. It could be harder to agree a restructuring for a distressed business when the bondholders are widely dispersed, especially if distressed debt investors have taken major positions.
The technique will also require tighter financial covenants to ensure a business can be sold to repay a securitisation before poor performance has undermined its value, and valuations used will inevitably be conservative. But, despite those restraining features, it does appear that this asset class could take on a new lease of life in the New Year.
Brian Carne
Head of Structured Finance and Derivatives Practice.
SJ Berwin is a pan-European law firm with a particular focus on private equity. It has offices in London, Frankfurt, Munich, Berlin, Madrid, Paris and Brussels. If you would like further information on our services to the private equity industry please contact Simon Witney in our London office 020 7533 2222 or visit our website at www.sjberwin.com.
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