Part IV

Negative covenants

promises by the debtor not to engage in particular activities like paying dividends or issuing new debt

fulcrum securities

the more junior debt securities that are most likely to be converted into the equity of the reorganized company. One of the distressed investment strategies in order to gain control through a blocking position of the reorganized company

Story credit

A debt issue with credit risk based on unusual circumstances, and may involve special aspects, such as corporate reorganizations, that distinguish their analysis from more traditional circumstances and as such involve a story *Usually exist as senior secured financings of firms with good credit

Middle market

Companies that are not as large as companies that have ready access to financial markets but are larger companies seeking venture capital

Mezzanine Debt general

Contains equity and debt-like features and exists in the capital structure between the floor of equity and the ceiling of debt *appears on debt on issuer's balance sheet but can have equity participation *typically constructed as an intermediate-term bond with an equity kicker *Includes senior subordinated debt, convertible subordinated debt, and convertible preferred stock *often used to finance buyouts when senior creditors are not willing to provide capital *operates between story credits and the junk bond market *a middle market vehicles

Entrepreneurship stimulators

LBOs that create value by helping to free management to concentrate on innovations.

Efficiency Buyouts

LBOs that improve operating efficiency. Management is compensated on revenue growth and so this type seeks to reduce firm assets and revenue with goal of increasing firm profits, operating margins and equity value

Management Buyout

Led by the target firm's current management with no public shares left outstanding *goal is to increase the value of the corporation by unlocking hidden value, maximizing borrowing capacity of a company's balance sheet

VC firm payout

Like a call option, with limited gains and unlimited losses where the price of the option is the amount the VC firm invests and the option premium is the capital invested.

Structure of Private Equity

Payouts resemble long positions in out-of-the-money (risks are great but potential rewards are greater) *Underlying private equity investment (or underlying business enterprise) is the private enterprise that underlies the investment *Claims to these enterprise are private equity investments *Investment pools created to hold portfolios of PE securities are private equity funds *Investing in and managing are private equity firms (GP)

Venture Capital Securities

Privately held stock, or equity-linked securities, that venture capitalists obtain when investing in business ventures that are striving to become larger and to go to public.

Private Investments in Public Equity

Privately issues equity or equity linked securities that are placed outside of a public offering and are exempt from registration *purchased directly from a publicly traded company in a private transaction *a quick way for the company to raise capital without an IPO *only requires an offering memorandum (terms, business, uses of process)

Advantages of PIPE

Privately place common stock: the greater the illiquidity, the greater the discount on PIPE's issue price Registered common stock: acquiring a block of stock at a discount to the public price Convertible preferred shares or convertible debt: Conversion prices embedded in preferred stock and convertible debt tend to be lower than the conversion prices on publicly traded instruments Equity line of credit: enables the issuer to sell a formula-based quantity of stock at set intervals of time

Positive Covenants

Promises to do particular things, such as maintain a specified cash level.

Business Development Companies

Publicly traded funds with underlying assets consisting of equity or equity-like positions in small, private companies that use a close end structure and trade on major stock exchanges *They enable liquid ownership of a pool financial assets and issue pro rata claims against these assets *Legislation allowing BDCs to qualify as investment companies enjoy pass-through income tax status, and so avoid corporate tax, but shareholders are subject to income tax on distributed profits and to avoid corporate income tax BDCs distribute almost all profits to shareholders *BDCs impose fees at the ETF level and have expense ratios

Angel Investing

Refers to the earliest stage of VC, where investors fund the first cash needs of an entrepreneurial idea; done without PPM or subscription agreement and is between $50k and $500k

Maintenance Covenant

Requires a standard to be regularly met to avoid defaults, such as limiting borrowing amounts and the borrower must pass this test each quarter without adding more debt or earnings and cash flow deteriorates *without these, lenders do not have the ability to step in to reprice the risk, restructure the loans, or shore up collateral provisions

First or Early Stage VC

The company has a viable product that has been beta tested, and must begin testing with end-users. Comes after seed capital but before commercial viability and revenues are being generated. Usually $2m or more *has a complete or close to management team with real production facilities. *the goal is to reach a break-even point

Mezz debt as bridge financing

a good portion of initial debt in an LBO is a form of gap financing - a method of debt financing that is used to maintain liquidity while waiting for an anticipated and reasonably expected inflow of cash

Buy and Build strategy

an LBO value-creation strategy involving the synergistic combination of several operating companies or divisions through additional buyouts. Also known as a leveraged buildup or roll up

Covenants

*covenants are promises made by a debtor to the creditor that strengthen the perceived credit quality of the obligation *May be required by creditors to protect their interests or offered by debtors to negotiate better terms

Keys to VC investing

1) Access to top tier Vc managers that will boost returns 2) achieving vintage year and industry diversification

8 characteristics of Mezz debt

1) Board Representation 2) Restrictions on the borrower 3) Flexibility 4) Negotiations with senior creditors: includes an intercreditor agreement between the company's existing creditors and others. 5) Subordination: either blanket or springing, where a blanket sub prevents any payment of principal or interest to the mezzanine investor until after senior debt has been fully repaid. A springing sub allows the mezz investor to receive interest payments while senior debt is outstanding 6) Acceleration: Violation of any covenant causes this, which is a requirement the debt be repaid sooner 7) Assignment: restrictions on mezz investor to assign, or sell, its interests to a 3rd party 8) Takeout provisions: allows the mezz investor to purchase senior debt once it has been repaid and by taking out the senior debt the mezz level becomes the most senior and can take control of the company

Hedge Funds vs. Private Equity

1) Hedge fund incentive fees are front loaded; PE collects at termination of deals 2) HF incentive fees are based on changes in NAV; PE is based on realized NAV 3) HF fees are collected on a regular basis; PE collects at the time of an event, such as an exit 4) HF does not need to return all investor capital to collect fees; PE can't distribute fees until the original investor capital has been repaid 5)HF have no provisions for clawback, usually; PE funds typically have clawbacks 6) HF have no preferred rate or hurdle rate that must exceed before incentive fees kick in; PE does

Leveraged Buyouts

1) buys control of the assets 2) uses leverage 3) itself is not publicly traded The target is usually public but this process brings it private distinguish themselves by small cap ($100m to $1b in revenues), mid cap ($1b to $5b) and large cap ($5b and above) Deals with a high leverage ratio will give the equity holders a high return rate because the debt is locked up a coupon rate *Three trenches of debt in LBO financing: senior debt, mezzanine debt and equity

Life cycle of a VC fund

1) fundraising stage: Capital is committed not collected, where the LPs sign a subscription that legally binds them to make cash investments. 2) sourcing investments: Generating deal flow and in this stage the VC funds generate losses because the manager continues to draw annual management fees and this is where the J curve dips 3) Investment of capital: determines how much capital to commit to each company, at what level of financing, and in what form of investment 4) Operation and management of the portfolio of companies and lasts until the end of the fund 5) windup and liquidation: being sold to a strategic buyer, brought to IPO, or being liquidated through bankruptcy proceedings

LBO Exit Strategies

1) sale to a strategic buyer (most common) 2)IPO 3) Another LBO (debt will be reintroduced to the company) 4) straight refinancing (takes on large debt o payout cash distribution to equity owners) 5) Buyout to Buyout deaL: when a private equity firm sells its companies to another, also known as secondary buyouts

Management Buy-in and Buy in Management Buyout

1) where the buyout is led by an outside management team and control is taken over by the new management team 2) a hybrid where the new management team is a combination of new and incumbent.

Mezz debt for growth and expansion

A company pursuing growth that cannot raise traditional bank financing or public financing may seek mezz financing

Mezz debt for an acquisition

A middle market company seeking to purchase an even smaller company may seek mezz debt financing as part of the capital

Prudent person standard

A requirement that specifies levels of care that should be exercised in particular decision-making roles, such as investment decisions made by a fiduciary. *This rule was established to ensure competent investment decision-making with regard to the large and growing pension assets and liabilities of US corporations *A 1979 clarification indicated that VC and other high-risk investments should not be considered on a stand-alone basis but on a portfolio basis, so managers can reduce the risk through diversification

Mezzanine venture Capital

Also known as pre-IPO financing is the last funding stage before an IPO It keeps the company from running out of cash until IPO or strategic sale and may be in the form of convertible debt *also ranges from $5m to $25m

Turnaround strategy

An approach that looks for underperforming companies with excessive leverage or poor management. Comes from two primary sources: 1) ailing companies on the brink of bankruptcy 2) underperforming companies in another LBO's fund portfolio

equity kicker

An option for some type of equity participation in the firm that is packaged with a debt financing transaction *Provides the investor with an interest in the upside of the company, while the debt component provides a steady payment stream

compound option wrt VC

An option on an option, where money invested in each stage of a CV company is the purchase of a call option and investing in the next stage is another call option. *Price of the first option is the investment *most commitment of next stage investment capital is delayed until new information has arrived or the company reaches a milestone. *Option expiration date is the time at which either additional capital is to be invested or the project is sold *the value of the next option must exceed the strike price of the current option *Each call option is purchased far out of the money

Agency issues

Arise when actions of managers are not in shareholders' best interests In a buyout situation the management team can lead a buyout that unlocks tremendous value to themselves rather than the shareholders, and this is an agency issue because 1) incumbent managers have a strong incentive to resist any buyout attempt that displaces them as managers if the buyout doesn't provide them with a generous golden parachute 2) Incumbent managers have a strong incentive to encourage buyouts that offer generous compensation Also comes in two forms 1) Cost to align management goal with value creation goal of shareholders usually achieved via compensation arrangement 2)Can include the erosion of shareholder value from managerial actions

Chapter 11 Bankruptcy

Attempts to maintain operations of a distressed corporation that may be viable, and protects a company from creditors while the company works through operational and financial problems. Imposes a plan or reorganization, and the claimants in each class of credits are entitled to vote on the plan and within the 180 days after declaration no other party can file a reorganization plan.

Mezzanine Debt

Becomes equity-like with an equity kicker usually in the forms of warrants, which is a call option used by a corporation on its own stock; the number of warrants in the kicker is inversely proportional to the coupon rate Can be seen as a combination of a long position in the firm's assets and a short position in a call option with a strike price equal to the FV of the firm's debt The remaining exposure is the debt holder's long position and the mezz debt behaves like an unlevered long position The coupon rate contributes the largest piece of total return J curve is eliminated because of coupon rate

Contingencies on Chapter 11

Classification of claims Prepackaged bankruptcy filing Blocking position: a single creditor can block a plan if it holds one-third of the dollar amount of any class of claimants The cramdown: as long as the plan does not unfairly discriminate against the members of that class and is far and equitable then the court may implement the plan over the objections of an impaired class of security holders. Usually a last resort Absolute Priority: a specification of which claims in a liquidation process are satisfied first, second,. third etc. in receiving distributions Debtor in possession: when secured lenders extend additional credit to the debtor it becomes debtor-in-possession (DIP) and DIP loans get priority over any forms of debt or financing before filing for chapter 11

Second or Late Stage/Expansion VC

Commercial viability is established and cash-flow management is critical because operating cf can not alone sustain its growth. This stage fills the cash flow deficiency once commercial viability is established *$5m to $25m Working capital is short and receivables are snowballing

Junk bonds

Debt instruments with high credit risk *high-yield, non-investment graded or speculative grade debt

Distressed Debt general

Debt that has deteriorated in quality since issued and that has a market price less than half its principal value, yields 1,000 or more basis points over the riskless rate, or has a credit rating of CCC (Caa) or lower *Investors in these are relatively unconcerned with coupon payments, debt service and repayment schedules *exposed to event risk that the company will not be able to emerge from bankruptcy, and through potential default risk it becomes more equity like *if the value of the assets falls near or below FV of the debt, the debt holders' short position in the call option moves out-of-the-money and becomes smaller value relative to the long position in the assets. and the position behaves increasingly like an unlevered long position

J-Curve wrt VC

Due to accounting based losses and little or no revenue generated during the initial development there is a dip in the IRR performance *IRRs are based on the nonmarket value (NAV) estimated at that point in time

Venture Capital

Early stage financing for young firms with high potential growth that do not have a sufficient track record to attract investment capital from traditional sources. *Typically represents senior equity stakes in firms that are still privately held and are therefore illiquid *Strategy is to strive for very high rates of return commensurate with risks *Exits typically focus on going public, sales acquisition to another firm, or leveraged recapitalization (where proceeds from the debt are paid to the VC firm) *

WACC wrt Mezz debt

It is the sum of the products of the percentages of each type of capital used to finance a firm times the annual cost to the firm Since equity has a high cost of capital, mezz debt (which is equity-like) can lower this metric

20-bagger

Indicates a company that appreciates in value 20-fold compared to the cost of the VC investment.

Mezzanine Funds

Investors in Mezz debt that are organized like HF, VC or buyout funds and have institutional investors Fee structure is a management fee of 1% to 2% and a profit sharing fee of 20% Seeks total returns in 20% to 30% Mezz financing is the most expensive because it is the last to be repaid on the debt spectrum and right above equity Distinctly a middle market phenomenon

Auction Market

Involves bidding among several PE firms with the deal going to the highest bidder, usually done by an investment banker.

Covenant-lite loans

Loans that place minimal restrictions on the debtor in terms of loan covenants. *These are more likely to become distressed *Have bond-like incurrence covenants like high-yield bonds

Insurance companies

Major source of mezzanine financing and are natural providers because the duration of their liabilities are best matched with longer term debt instruments. Place a high value on the scheduled repayment of principal and are more concerned with a higher coupon rate than total returns

VC fund fees

Management fees range from 1% to 3.5%; and the management fee is assessed on the amount of committed capital, not invested capital. *The managers can also earn incentive fees on capital calls *Usually contains a clawback provision that allows the LP to receive back previously paid incentive fees if at the end or liquidation of the venture fund the LPs have a net loss. *Usually an escrow agreement freezes a portion of the manager's incentive fees until the entire fund is liquidated

LBO fees

Management fees: 1.25% to 3% Incentive fees, or carried interest: 20% to 30% Arranging and negotiating of LBO: up to 1% of total selling price Breakup fees if deal fails Divestiture fee for sale of a division of a private company after the buyout

Mezz debt in commercial real estate

Mezz debt fills the gap between first-mortgage financing, with a loan-to-value ratio of 40%-70% and the equity contributed to the project.

Mezz debt to recapitalize a company

Mezz debt may be used as part of a new capital structure for a firm to create a new balance sheet, such as having a senior term loan, senior subordinated mezz debt, junior subordinated mezz debt, convertible preferred stock and common equity

Mezz debt in an LBO

Not all debt for buyouts can be senior and a significant amount of financing may come from mezzanine investors

Leveraged Loans/High Yield Bonds/Mezzanine Debt

Seniority: Type of security: first lien, unsecured, unsecured Loan covenants: extensive, less so, minimal Term: 5 years, 7-10, 4-6 Amortization: installments, bullet payment, bullet Coupon type: cash/floating, cash/fixed, cash/PIK/fixed (no collateral means higher coupon rate) Liquidity: High, low, minimal (because of the level of tailoring)

Secondary Markets

Several needs cause this market: 1) to raise cash for funding requirements, on the investor side 2) to trim the risk of the investment portfolio 3) to rebalance the portfolio from time to time 4) gaining access to a particular vintage year 5) an investment further along closer to harvesting cash flows 6) gaining access to future funds *The motivation to sell is typically not to do with the underlying investment *Discounts to NAV are large and are opportunistic buying

VC firm financing

Structured as a limited liability corporation so that LP losses will not exceed their investment. *LPs will set down covenants that control the size of each investment in any one start-up venture. *LPs can also set down covenants on how much debt or leverage is used by the fund and the VC firm won't gear up through leverage *GPs may limit secondary sales of LPs

Distressed Debt Supply and Demand

Supply: Companies that have been leveraged for an LBO and a leverage fallout occurs Demand: Lack of liquidity leads bonds trading at steep discounts to their true value and institutional investors with risk aversion may sell their claims at depressed prices. *Sometimes used to gain an equity stake in a company. *Distressed investor must receive enough coupon income to cover credit losses, which are the product of the default rate and the loss rate given default on the portfolio

Leveraged Loans

Syndicated bank loans to non-investment grade borrowers. Syndicated meaning a group of entities that underwrite a security offering *Leveraged refers to the use of leverage by the borrower *The loan has a second lien interest after other senior secured loans (second lien loan is synonymous with the leveraged loan market) *Loan is considered leveraged if the borrower has outstanding debt that is below BBB by S&P or Baa by Moody's; the loan bears a coupon that is in excess of 125 basis points over LIBOR *Growth of this market has been driven by the development and expansion of their secondary market

Traditional Senior Lenders

Takes the form of stretch financing, where a bank lends money beyond the collateral value of a company's business assets

Seed Capital

The first stage where VC firms invest their capital into a venture and it is typically prior to having established the viability of the product. *Beta testing is done here to get input into product's viability. *Very little revenue generated *Between $1m and $5m

Segmentation wrt Buyouts

The grouping of market participants into clienteles that focus their activities within specific areas of the market *When a market is segmented, the valuations in that market can vary based on the preferences of the clienteles that dominate the particular segments *E.g. the fixed income market is segmented based on the maturity ranges in which different investors (clientele) prefer to invest

Charge-Off loans

The loan of financial institutions or other lender that have been sold to investors and written off the books of the lender at a loss *typically auto deficiencies, credit card paper, medical and health-care receivables, personal loans, retail sales agreements and insurance premium deficiencies

Buyouts

The purchase of a public company by an entity that has a private ownership structure. *distinguished from mergers by the extent to which the firm is bought out is intended to function as a stand-alone business rather than folded into the company *typically employ debt financing *buyout is termed leveraged when the debt-to-equity ratio is much greater than before the acquisition *the 1980s saw a key element of growth in buyouts with financing using bonds with low credit ratings (junk bonds) *1990s saw a decline due to two events that pushed credit spreads to high levels (recession and Russian default on gov debt) *Buyout growth is driven by economic growth, interest rates and credit spreads

Distressed Debt

The purchase of debt securities of private or public companies that are trading below par due to financial troubles at the firm. Subject the investor to substantial idiosyncratic risk *Driven by negotiation with creditors as opposed to the overall market performance *Distressed refers to the price of the bonds *Any liability that trades at less than half of its principal value, or when the firm is unable to make debt or interest payments *Or its yield to maturity is 1,000 or more basis points over the riskless rate *during the credit market cycle, when perceived quality of debt tumble the new credit becomes scarce and yields widen *This market has grown by expansion of innovative financing, expansion of bank loans, debt loads, covenant lite loans and charge-off loans brought into the secondary market

Burn rate

The speed with which cash I being depleted through time and can be used to project when the organization will again require outside financing

Vintage Year

The year a particular private equity fund commences operations. Secondary offerings include access to different vintage years as a positive attribute

Closed end fund structure of BDC

This structure allows transformation of ownership of underlying assets into shares *The structure does not typically regularly create new shares or redeem old shares in order to meet the desire of investors to invest in the fund or divest from the fund *Runs into problems in the secondary market, where the price per share that they receive or pay may be highly subject to short-term supply and demand factors *The premium or discount of a BDC is found by dividing the market price by the NAV *Returns of closed end are driven both by returns of the underlying asset and the premiums or discounts of the fund shares when positions are established or closed *NAVs are based on subjective valuation methods *Listed BDCs provide an opportunity to observe market prices of private equity to make it more directly comparable for correlations and volatilities

Traditional vs. Structured PIPEs

Traditional: large majority, in which investors can buy common stock at a fixed price. Generally initiated using convertible preferred stock or debt with a fixed price of conversion. Fixed conversion prices limit dilution Structured: include more exotic securities, like floating-rate convertible preferred stock, convertible resets, and common stock resets; can lead to death spiral where a drop in the stock price leads t a drop in the conversion price and dilute shareholder value substantially.

Club deals

Two or more LBO firms work together to share costs, present a business plan and contribute capital *can depress acquisition prices by reducing competition *done because some LP agreements restrict PE funds from investing more than 25% of total capital in any one deal and for very large buyouts this might be necessary

Incurrence Covenants

Typically require a borrower to take or not to take a specific action once a specified event occurs, like maintaining a particular debt load *the borrower can take on debt as long as it is still within constraints but any breaching of this limits incurs additional debt and is in default *If the borrower is above the limit simply because earnings and cash flow have deteriorate without taking on additional debt it would not be in violation of the covenant

Overstuffed Corporation

Used to dismantle conglomerates, shut down or sell inefficient operations and allow profitable divisions to reinvest and meet their growth potential

Venture Capital Securities

VC firms invest in convertible preferred stock of the start-up company because they are senior to common stock in terms of dividends, voting rights and liquidation preferences. Can be converted into common stock upon IPO *Other notes are convertibles notes, debentures which provide for the conversion of the principal amount of the note or bond into either common or preferred shares *VC firms may also be granted warrants to purchase common equity

Risks and Risk Premiums of VC

VC premiums should be 400 to 800 basis points over public market returns due to business risk, liquidity risk (because there is not a good secondary market here any secondary sale requires a pricing discount) and idiosyncratic risk due to the lack of diversification because these portfolios are specialized.

Chapter 7 Bankruptcy

When a company is no longer viewed as a viable business and the assets of the firm are liquidated. *critical issue is the priority of claims: who gets paid first, who gets paid most, and which obligations are never repaid

Merchant Banking

When financial institutions purchase nonfinancial companies as opposed to merging with or acquiring other financial institutions *In some cases, these units establish limited partnerships, and the only difference between this and buyouts is that the GP is a financial institution

Traditional VC firms

When the economy softens, these firms look for ways to maintain returns and mezz debt serves as a bridge here, and often serves as the last step before an IPO

Mezz Financing for an MBO

When the senior management team of a firm leads an MBO, mezzanine debt can fill the gap between senior debt claims and equity