In the past year, sponsor-backed borrowers have turned increasingly to ‘holdco financing’ as a funding solution for both new platform acquisition financings and ‘add-on’ acquisition activity. Here, we explore terms and documentation considerations of this product.
What is holdco financing?
Holdco financing refers to debt incurred by a holding company one or two levels removed from an operating group. This is permitted under the opco’s senior debt documentation because activity at the holdco level is outside the credit group and therefore not subject to the financial metrics and negative covenants imposed by the opco’s senior debt documentation.
Often there is a wholly owned intermediate holding company between the opco and holdco that issues no debt (or debt-like equity) of its own. This intermediate holding company will act as a guarantor of opco’s senior secured debt and will pledge the equity of opco as collateral for the senior debt.
Why has it gained popularity?
Holdco financings allow portfolio companies of private equity sponsors to raise more capital without increasing leverage at the opco level. Holdco debt also reduces the amount of the sponsor’s equity contribution as a source of capital for the acquisition consideration at a time when senior lenders to the opco are requiring more favourable loan-to-value ratios.
Since the debt proceeds of the holdco financing are typically injected into the operating business as a capital contribution, this also keeps more cash in the business for growth purposes, which is particularly helpful for acquisitive businesses in expanding sectors.
From a lender perspective, holdco financing is priced higher than opco debt to account for structural subordination, lack of collateral and non-cash pay interest (also known as “paid in kind” or “PIK” interest) and is commonly subject to more robust prepayment protection (or “call protection”) including, in many cases, a make-whole in the initial year or two of the instrument.
Holdco financing typically has a final maturity date outside that of the senior debt issued by opco. PIK interest is capitalised to the principal balance of the loan instead of being periodically paid to the lender in cash, and if there is a cash component it will usually be voluntary or de minimis. The combination of PIK interest and the absence of scheduled principal payments until maturity allows the company to tap financing sources without the burden of added debt service at the opco group.
Holdco financing may be issued concurrently with debt at opco in connection with a leveraged buyout, upsizing add-on transaction or other refinancing transaction. Since a holdco financing is incurred above the opco group, incurrence is not restricted by the senior credit documentation at the opco level.
Representations, undertakings and reporting covenants under the holdco financing will often align with those already agreed in the opco group’s senior debt documents but will include an agreed 15-25 percent cushion to the opco group’s senior debt for dollar-based baskets. Reporting requirements in holdco financing documents are usually limited to the extent that the relevant financial information is delivered to opco lenders, except that holdco lenders may in limited cases receive access to board materials not made available to opco lenders.
Holdco debt is generally not subject to a leverage-based financial covenant typically seen in a debt facility at the opco level.
However, holdco lenders often negotiate an overall leverage test that must be satisfied on a pro forma basis for any dividends, junior debt prepayments or debt incurrences to prevent ‘leakage’ and to prevent the company from becoming overleveraged. This leverage test is calculated including the debt and earnings from the holdco down the corporate structure (unlike the leverage test in the opco credit agreement, which often excludes holdco).
Typically, there are no mandatory prepayment provisions with respect to proceeds received from asset sales or from excess cashflow. Instead, mandatory prepayments are limited to the occurrence of a refinancing; a change of control; a sale of all or substantially all of the assets of the holdco and its subsidiaries; an initial public offering; or a bankruptcy, liquidation, dissolution or winding up of holdco or opco.
Events of default under holdco financing documentation generally mirror those in the opco credit agreement, but since holdco financing is usually non-cash interest with no scheduled principal payments and there is no financial covenant, events of default are generally rare, only being triggered upon a cross-payment default to, or acceleration of, the opco facility or a bankruptcy filing.
Holdco financing is usually unsecured, and the only obligor is holdco. In rare instances, holdco financing may be secured by a share pledge over the shares in holdco or an all-asset security interest granted by the holdco (but the holdco typically will not own many, if any, other assets).
Further, even where the lenders have the benefit of a holdco equity pledge, any enforcement of the pledge will likely trigger a ‘change of control’ under the opco credit documents. Thus, the utility of such a pledge may be limited to providing holdco lenders a seat at the table in any downside scenario rather than an actual enforcement of remedies.
In addition to the overall leverage test referenced above, ‘anti-layering’ protection is an important feature of holdco financing. Such provisions limit the amount of additional debt for borrowed money that can be incurred by any intermediate holding company between holdco and the opco including the issuance of preferred equity (equity with debt-like repayment requirements). They also require that 100 percent of the equity of opco (and any intermediate holdco) be held, directly or indirectly, by the holdco in the form of common equity.
Holdco lenders may also negotiate provisions restricting amendments and refinancings to the opco debt (eg, increases in principal amounts, extensions to maturity dates and revisions to the distribution conditions or financial covenants) that could adversely affect the recovery of the holdco lenders.
What should lenders be concerned about with holdco financing?
Given its structurally subordinated position, holdco lenders should consider the prospective yield relative to the relative risk of their investment
Holdco lenders typically lack effective control over the activities of the corporate group or its financing providers, including a limited ability to influence the outcome of restructuring negotiations in a downside scenario.
For these reasons, it’s important to closely monitor the performance of the borrower and, if feasible, to be a source of capital to the borrower to help deleverage the opco lenders if trouble arises.
Evan Palenschat is a partner and Eitan Goldberg is a special finance counsel in the private credit group at law firm Proskauer