BSL Backstopping to Increase Certainty and Optimize Execution
BSL Backstopping to Increase Certainty and Optimize Execution
One of the more significant changes for private equity sponsors in the upper middle market has been the rapid increase of lending funds capable of providing credit at a scale that rivals the lower end of the broadly syndicated loan (“BSL”), or Term Loan B, market. Traditionally, sponsors and borrowers look to the BSL markets when a facility reaches the $200-300mm level. These markets are more liquid, and the sheer volume of investors in liquid credit allow the broadly syndicated to accommodate larger facilities. For decades, sponsors and borrowers had only one option for a facility of that size – hire an investment bank with a large sales and distribution platform to run a broadly syndicated loan process. This exercise requires weeks of preparation for launch, including potentially receiving a rating from at least one agency, and ultimately exposes sponsors to “flex” in key terms and uncertain execution in the market.
Over the last decade or so, however, the credit markets have evolved rapidly. Private credit, once a relatively new asset class for investors, has become the focus of institutional investors and fund size has scaled significantly. As a result, the number of private lenders capable of holding $100mm+ has increased dramatically – Configure’s database reflects 90+ lenders able to hold more than $100mm in a single position. In fact, many private lenders are now capable of holding $500mm+, allowing sponsors to rely on the private credit markets for larger and larger transactions. Meanwhile, the BSL market continues to be an attractive option, leaving sponsors to consider the merits and considerations of each approach for each new transaction.
Savvy private equity sponsors have used the new(er) optionality to their benefit – increasing certainty and optimizing execution so that they can close more deals with optimal capital structures.
Prior to the evolution of private credit, the BSL market was one of two pillars of credit execution in the upper middle market. Although not typically as liquid as bonds, BSLs offered investors a relatively liquid opportunity to deploy capital. CLOs and other similar vehicles were established for the purpose of investing in and holding BSL facilities. BSLs are often rated by one of the credit agencies, which allows investors to conduct diligence more quickly in order to make smaller investments in a BSL facility. After all, if something doesn’t go according to plan, investors can almost always trade out of the credit. As a result, the primary borrower-side benefit to BSL execution is lower cost of capital.
Many deals in the BSL market are cov-lite (cov-less), which some sponsors and other borrowers value from a flexibility perspective. Cov-lite structures allow for borrowers experiencing mild to moderate financial issues to “weather the storm” without the added concern of a financial covenant breach. More acute financial stress, however, can be more challenging in the context of a BSL (discussed below).
Underwriting / Commitment Process
Especially in today’s competitive market, where private equity sponsors are forced to move at lightning speed in order to be competitive, the BSL underwriting process is most frequently identified as the impediment to execution. Although the market is fairly defined – only about a dozen banks underwrite most of the BSL issuances – selecting an underwriter and limiting migration in terms and execution during the process is more difficult, particularly in the context of a time-constrained transaction. The typical BSL underwriting process is significantly longer than that in private credit. The committee process in almost every bank is significantly more complex. As a result, sponsors are exposed to migration of terms in each committee meeting, typically a migration from good to worse. At the same time, the sell-side process is competitive with multiple sponsors devoting time and energy into winning and ultimately closing the transaction. As a result, sponsors are often “price takers” in a BSL process – forced to accept the committed terms they are offered at the last minute in order to secure the transaction.
The uncertainty, unfortunately, continues after the commitment process. Almost all BSL commitments contain “flex,” which allows the underwriting bank to modify terms within a pre-agreed range while in market in order to fully syndicate the facility. Broadly syndicated deals are often rated by a credit agency, which introduces additional risk in the syndication process and may also expose the borrower to a go-forward requirement to maintain a certain rating (and the related risk of company performance becoming public knowledge).
The Hidden Costs of Liquidity
The liquidity of a BSL has its advantages, most notably in the form of interest rate. The increased liquidity drives down the cost of borrowing. Conversely, there are hidden costs of a highly liquid BSL, particularly when a company encounters unexpected financial challenges. In those instances, the breadth of the holders of a BSL along with the ability for those holders to trade in / out of the credit can result in a very challenging situation for borrowers. “Herding the cats” for even a relatively simple amendment can become challenging and deeper distress often results in trading – often to not-so-friendly holders.
Private Credit Considerations
The most tangible trade as between BSL execution and privately placed credit is the economic cost. While spreads between BSL and private credit have compressed significantly alongside increased competition in private credit, the average like for like transaction will be 50-100bps more expensive in the private credit markets.
Private lenders are not subject to the same leveraged lending guidelines as banks. As a result, sponsors and borrowers can often find increased appetite for higher leverage levels on the same company in the private credit markets. While this isn’t always necessary (or even appealing) to sponsors / borrowers, there are instances where the enhanced leverage is important to the transaction, particularly in higher EV transactions.
Direct lenders have become more agreeable to covenant structures that rival the BSL market, and it is not unusual for larger companies to have a single covenant in the private credit markets. That said, a true no financial covenant deal is more difficult to achieve in private credit than in the BSL markets.
Increased Speed & Certainty in Execution / Documentation
The private credit benefit that Configure clients value most is the increased speed and certainty associated with a direct lender or even a small club of direct lenders. As opposed to the committee-laden process of a BSL, the average private lender has 1-2 committees and can provide a high degree of confidence around terms in just a few weeks. Without the additional levels of committees, the risk of deterioration in the initial terms is significantly lower with private lenders. In addition, private credit solutions almost never contain flex. The terms are the terms. Finally, documentation can be more easily negotiated and is more flexible amongst private lenders.
The Hidden Benefits of Illiquidity
As the inverse of a liquid BSL facility, a private credit facility often involves a single lender. Even the clubbed private credit deals involve just a small handful – 3-5 lenders. Amendment processes are easier to manage and even deeper levels of distress can be addressed in a more “partnership” approach given the relationship focus of private lenders (as compared to the liquidity focus of BSL investors). This is not to say that private lenders are not advocates and fiduciaries for their LPs. They most certainly are. That said, it is a nearly absolute truth that private lenders are more flexible and willing to accommodate in a distressed situation.
The “Best of Both Worlds” Backstopped BSL
Leveraging a process to maximize options – including BSL and private credit solutions – yields a “best of both worlds” approach that allows sponsors and borrowers to preserve the tighter pricing and cov-lite option of BSL execution while also reducing risk to the acquisition itself. Admittedly, the incremental effort associated with this approach can overwhelm a deal team from a simple allocation of time perspective. This is where Configure has been able to assist in expanding the effective capacity of the deal team, allowing internal private equity resources to focus on higher value-add activities.
In short, Configure works with sponsors and borrowers to “dual track” the financing process. We identify a hybrid group of bank BSL underwriters, as well as the most logical group of private lenders, and organize a financing process that fits within the demands of the sell-side deadlines. Configure alleviates the sponsor’s internal team of the burden of facilitating lender diligence, allowing sponsors to focus on their own operational due diligence and equity thesis. Running a competitive process for the lead arranger role for the BSL drives tension that forces BSL underwriters to tighten the flex range and reduces the risk that economic terms will deteriorate through the committee process. The “runner up” BSL agents can also serve as joint lead arrangers, which further reduces the underwriting risk for the lead bank and lessens the likelihood of terms flexing in the syndication process. The inclusion of the logical private credit lenders further increases competitive tension and also creates a warm “backstop” in the event that the BSL track becomes unattractive or if the transaction timing dictates an accelerated financing process.
Particularly in hyper competitive markets – where sponsors are forced to move very quickly in order to secure deals and deploy capital – reducing the execution risk associated with debt financing is an insurance policy worth the investment.
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