Building on bridges
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As leveraged buyouts (LBOs) in the US get ever larger and more lucrative for banks, financial sponsors continue to push the boundaries on participation terms and develop new concepts, such as 'bridge equity', which test the banks' traditional appetite for risk. The bridge equity structure has gained prominence in the US during the past year, becoming a widely used tool for sponsors in their buyout bids.
Conceptually similar to bridge debt financing, bridge equity involves the bank taking a portion of the sponsors' equity commitment on a short-term basis, until permanent equity investors are found. In the context of a public offer, the sponsor will require a firm commitment to fund the equity from the bank similar to its own commitment in order to fulfil its cash confirmation requirements. If all goes well the bank would aim to sell its equity commitment before the closing of the transaction so as to avoid funding its commitment. If not, the bank will be required to fund the commitment and purchase the previously agreed amount of equity in the acquiror (usually a special purpose vehicle (SPV) set up by the sponsor) and then seek to sell the equity purchased within a given time.
Spreading the risk
While the concept of bridge equity has been around in the US since the late 1980s, its renewed use in leveraged transactions has owed much to changes in the buyout market during the past few years. As the bidding consortiums used by many sponsors in the US from 2004 through to 2006 began to come under increased anti-competition scrutiny from US authorities, sponsors looked for a new way of spreading equity risk for some of the largest transactions.
Blackstone's acquisition of Chicago-based Equity Office Properties (EOP) Trust in November 2006 officially announced the return of bridge equity as a financing tool. This $39bn (£19.31bn) transaction, at the time the largest ever announced LBO, contained a commitment by a consortium of banks to purchase approximately $3.5bn (£1.73bn) of bridge equity.
The EOP deal was followed quickly by the announced $45bn (£22.29bn) purchase of Dallas-based energy company TXU Corp by Kolberg Kravis Roberts & Co and Texas Pacific Group - the deal that surpassed EOP as the largest LBO in history. This deal contained a bridge equity commitment of approximately $1bn (£495.24m).
These two mega-deals solidified the role of bridge equity as an important tool in the US buyout market for the first half of 2007 and were followed by significant bridge equity roles in the buyouts of First Data, Alltel and Dollar General Corporation.
The pros and cons
For the banks, the provision of bridge equity can sometimes be the price of admission to a lucrative debt financing role, but it has the significant downside that it may well have to fund the equity commitment from its own balance sheet and be left with an unwanted equity stake. For the private equity firms, the obvious advantage is to reduce the size of their equity position and free up fund resources for other transactions.
Key to successful bridge equity financing is the way the sell-down process of the bank's equity is managed. Sometimes the bank will decide to keep a portion of the equity for itself as a 'hold' or 'core' position. In most cases, however, the banks will be asked to provide equity commitments in amounts greater than they would be prepared to hold permanently, so there will inevitably be a syndication or sell-down process of the excess, which is the bridge equity. In addition, in the case of certain attractive deals, sponsors have required that any hold equity desired by a bank will reduce the sponsor's commitment rather than the bridge commitment of the bank.
In most cases there will be agreed general sell-down principles applicable throughout the sell-down period, such as requiring that sales are only made to investors so that the sales do not require any registration of the securities under the US securities laws and are structured so as not to create any tax or regulatory issues. To avoid certain US securities law issues, the investors are generally required to be both 'accredited investors', under the US Securities Act of 1933, and 'qualified purchasers', under the US Investment Company Act of 1940. Often the sponsor will want to syndicate bridge equity first to limited partners in its funds and require that they are provided with preferential treatment in the initial stage of the sell-down period.
Control of the sell-down process is another key issue. Both parties would normally like control: the sponsor because it wants control over the identity of its co-investors in the investment; and the bank because it wants to reduce its exposure to the bridge equity quickly and with little interference from the sponsor. Information rights to assist any sell-down are also important.
The banks will usually require sponsors to provide certain information and related rights in connection with their sales prior to the closing of the transaction, as is customary in US private placements, although it is not as detailed as the information generally provided in private sales pursuant to Rule 144A of the Securities Act. The bank will also require further information rights, often including the Securities and Exchange Commission's Rule 10b-5 and other legal opinions and comfort letters post-closing after the sponsor has control of the target in order to assist the sell-down process and marketing effort.
Often the sponsor will take control of the initial sell-down process through a lead manager. The lead manager will coordinate sales of the bridge equity on a pro rata basis and the sponsor will determine to whom the lead manager will sell. After this initial effort the banks are often left to sell whatever portion of their bridge commitment remains. This is often done through a separate Delaware or Cayman Islands SPV, with the bank marketing the interests to sophisticated investors while requiring significant minimum subscription amounts. In the US there might need to be additional structuring considerations given to issues of US withholding tax for foreign co-investors.
If the underlying buyout is being accomplished by tender offer, then consideration also must be given to the US tender offer rules. Because the best price rule requires shareholders to receive the same consideration for their publicly traded shares, providing certain of these shareholders with the opportunity to acquire interests in the acquiror through the sell-down may be considered a violation of the best price rule. In these circumstances, the sell-down is often deferred until such time as the tender offer has been completed in order to avoid the possibility of inadvertently including a shareholder of the target in the sell-down.
The future for bridge financing
With the recent downturn in the US debt markets, there has been some degree of backlash against equity bridge financing. The trouble in the debt markets, coupled with a few recent deals in which bridge equity banks had to fund their commitments as they were unable to fully sell down their commitments prior to the closing, has made the market for equity bridges somewhat less certain going forward. While there has been much discussion during the past few weeks about banks taking bridge loans on their own balance sheets because of problems finding buyers for the debt in certain outstanding US deals, the same issues have arisen for bridge equity. The volatile debt market could potentially alter the balance of power between sponsors and bridge equity providers, enabling the banks to demand more favourable terms or extinguish their appetite for this form of financing for the time being.
Tihir Sarkar and Jeffrey Karpf are partners at Cleary Gottlieb Steen & Hamilton. They were assisted in this article by Cleary associates Evan Schwartz and Paul Tiger