By Francesco Lione, Charles Armstrong, Tom Evans, Dominic Newcomb, David Walker, and Catherine Campbell
Undrawn credit lines are essential to private equity but in short supply from banks.
Undrawn revolving credit facilities (RCFs) are essential to private equity. They are a backup in the event of mismatches in the working capital cycle, provide comfort for a rainy day, and preserve swift access to deal-making when other financing sources are unavailable, or less easily accessible. The COVID-19 pandemic could not have proved the importance of undrawn RCFs more clearly. Within a few weeks of the onset of the pandemic, as credit markets gummed up and businesses worldwide grappled with evaporating liquidity, leveraged companies dashed for cash and drew revolving lines.
PE firms may be able to persuade banks to offer RCF commitments more freely by transcending the limitations of current transactional templates and allowing banks to consistently provide undrawn revolving credit in its most secure form — alongside all leveraged loans and secured bonds, rather than just on bond backed deals, as is current practice.
The Current Imbalance in Supply and Demand of RCFs
Banks are the primary (and almost exclusive) source of undrawn RCF commitments. But because the product commands tight pricing in the market and generally is not very profitable, banks tend not to view it as a compelling use of their capital. Instead, they treat RCFs as relationship-driven transactions that grant access to other types of non-credit borrower business, typically capital markets activities and M&A advisory work.
Dealmakers are well aware of the imbalance between high demand for RCFs by private equity and short supply by banks — sponsors requests for a turn of leverage (or more) in RCF commitments can be cut down by underwriting syndicates.
A Novel Idea to Help Solve the Imbalance
Economic theory suggests that the cure for the supply/demand imbalance would be for the pricing of RCFs to rise, but that would be unattractive to PE and futile for banks, which are used to treating the product as a loss leader and are mostly concerned about the constraint that undrawn credit lines put on their ability to lend capital elsewhere.
In our view, enhancing the appeal of RCFs to banks by making RCFs less onerous to bear on bank balance sheets, could be a better approach. This could be achieved by elevating the ranking of RCFs to “super senior” status in all PE financings including those with loans (see box below).
Recent Experience — Ranking of Loans and Bonds
Experience in the recent wave of restructurings shows that super senior RCFs are rarely impaired, even in cases in which term creditors face substantial write-offs. Banks that hold pari passu RCF commitments are not as fortunate, and often end up with the same scaling-down of claims as other secured creditors. The difference in recovery outcomes explains why banks apply a more lenient capital charge to super senior RCFs and why their credit committees tend to have fewer reservations in booking super senior commitments than pari passu ones.
Balancing Risks and Rewards
While this new capital structure, in which super senior RCFs coexist with term loans, is yet to be adopted in mainstream PE transactions, the convergence in both investor base and terms across leveraged loans and secured bonds makes the different ranking of RCFs across the two types of capital structure anachronistic.
Market acceptance may not come without execution challenges, including a few initial loan syndications being more involved than usual, as loan investors digest the proposal, but the new transaction model would be mutually advantageous for PE and banks.
Sponsors may get more of what they want — reliable evergreen sources of liquidity, at a lower price. Banks may be more generous in extending RCF credit when they know they can rely on the comfort of super senior security. And recent examples (including Altice and several deals in the unitranche market) suggest that acceptance of the new capital structure may wind up as more of an anti-climax than a cliff-hanger.
Currently, leveraged borrowers carry one of two capital structures:
- When their long-term debt is entirely in the form of loans, they have a pari passu capital structure, in which all secured claims (including RCFs) rank equally
- Conversely, when their long-term debt is in the form of secured bonds, they tend to have a super senior capital structure, in which banks holding RCFs get first dibs on any enforcement proceeds
Sponsors may persuade banks to offer RCF commitments more freely by adopting “super senior” capital structures in all their leveraged financings, regardless of whether they feature term loans or secured bonds.
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