Financial Affairs

Corporate debt buybacks | King and Spalding

As market uncertainty persists, companies are taking proactive steps to ensure liquidity in the short to medium term, including making full use of revolving credit facilities. In turn, financial institutions would be wise to focus on another tool that companies (especially those whose financial sponsors are willing to inject additional liquidity into the balance sheet) could use once the immediate liquidity crunch has passed – financial institutions. debt redemptions authorized.

Generally speaking, syndicated loans follow the same axiom in terms of early repayment: senior debt is repaid first, dollar for dollar (plus interest) for the amounts loaned and in proportion to all lenders. Debt buybacks turn this scenario upside down. When a Borrower redeems its debt, it is incentivized to (a) buy back the more expensive junior debt first (to the extent otherwise permitted by the credit documentation), (b) buy that debt from lenders willing to sell, and (c) redeem that debt at the greatest available par discount. This Client Alert briefly analyzes why and how borrowers are paying off their own debt, and then examines the standard limitations that most credit agreements have on such activities. He concludes by noting the practical steps lenders can take to prepare before borrowers start to redeem their debts.

Why borrowers buy back debt

Debt buybacks allow Borrowers to reduce their overall net leverage in an economically advantageous manner over traditional voluntary prepayments. For example, consider the case where a borrower has an outstanding term loan of $ 100,000,000 and a healthy balance sheet that would allow the borrower to prepay $ 10,000,000. If the debt is trading at 75% of par, rather than voluntarily prepaying $ 10,000,000 of the outstanding term loan on a dollar-for-dollar basis, the borrower could use the $ 10,000,000 to redeem and repay 12 $ 500,000 of his own debt. In addition to reducing the overall net leverage, this has the corresponding effect of reducing interest and amortization costs.

How borrowers redeem debt

Borrowers redeem debt in two ways: a Dutch auction or a purchase on the open market. Most credit agreements contain provisions for Dutch auctions, while purchases on the open market are a less common option for borrowers.

Dutch auction

In a Dutch auction, the Borrower notifies an auction manager of its willingness to purchase a full amount of term loans from existing lenders at a specified price. The Borrower also informs the auction manager of the range of discounts to par at which it would be willing to purchase the term loans. Each lender then informs the auction manager of their willingness to sell term loans to the Borrower, including the amount of term loans that lender is willing to sell as well as the discount to par at which that lender is willing to sell. . The auction manager then calculates the lowest purchase price that will allow the borrower to complete the auction by purchasing the full amount offered (or a lower amount for which eligible bids have been made by the lenders) . Dutch auctions are considered more favorable to lenders because all lenders have the option to sell their loans, the borrower buys at the lowest cost and does not favor any party otherwise and the borrower has to incur significant economic and time costs. to hire the auction manager and manage the auction.

Free market purchases

In an open market purchase, the Borrower goes to all or a subset of the lenders (or even a single lender) and inquires about his willingness to sell his term loans to the Borrower at a price lower than par. To the extent permitted by the credit agreement, this approach circumvents the basics of a syndicated facility described above: it allows the borrower to shop around to buy back the most expensive debt a lender is first. ready to sell, including at a non-prorated price, and gives the Borrower significant leverage to encourage lenders to demean against each other, especially in the event that one or more lenders wish to opt out of ease. It also allows the borrower to select lenders authorized to leave the establishment. Thus, redemptions on the open market are considered more favorable to the borrower.

Common limitations to debt redemptions

Most credit agreements authorizing debt repurchases also include certain customary limitations on the borrower’s right to repurchase debt:

  • Any debt redeemed is automatically and permanently canceled upon acquisition by a creditor (this may also result in the cancellation of debt income, potentially increasing the tax distributions to be paid to the Borrower and its parent companies);
  • The Borrower is often not allowed to buy back debt if an event of default has occurred and is continuing; and
  • No revolving loan proceeds will be used to finance such a purchase.

In the context of current market considerations, the third bullet is particularly interesting. As the Borrowers continue to draw large amounts from their revolving credit facilities, it is the administrative agent and the lenders’ responsibility to ensure that these charges are not subsequently used to redeem term loans. Given the fungible nature of liquidity, it is important that the Borrower can track the inflows of cash used to repurchase loans from a source other than the revolving drawdown.

Practical considerations for lenders

  • Be active managers of your portfolio! Staying on top of where debt trades on a regular basis and understanding your risk tolerance (i.e. how far you would be willing to sell below par) will allow you to make decisions quickly when you receive a notice of Dutch action or unsolicited solicitation by the Borrower.
  • Understand how redemptions might otherwise go through the credit agreement and pave the way for further leaks. For example, many credit agreements increase the amount available by the amount spent to redeem debt. For trades under negotiation or modification, make sure that this amount matches the amount redeemed, not the face amount withdrawn.