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THE ECONOMICS OF THE PRIVATE MARKET

Appendix F.  An Example of a Private Placement Assisted by an Agent

This appendix describes a private placement transaction involving an agent from start to finish.  So much variety exists in the private market that no single transaction can be called typical. This example introduces terminology, concepts, and a sense of the stages that deals must pass through.  It is based partly on publicly available data about an actual transaction, but names and amounts have been changed, and many of the details are fictional.

In late spring 1991, Acme Stores, Inc., opened negotiations with its primary bank, BigBank, to renew a revolving credit agreement that had been in force for three years. Acme Stores is a publicly held company with $1 billion in annual sales, operating in a highly competitive area of the retail sales sector. BigBank is a bank affiliate of a large U.S. bank holding company.

The occasion inspired wide-ranging discussions between officers of Acme and those of BigBank about Acme's current and prospective capital needs. BigBank's officers adopted the ''corporate finance'' perspective now coming into fashion among loan officers at many of the large banks, in which the loan officer advises on financial strategies involving a wide range of instruments instead of focusing on the sale of bank loans. BigBank noted that the history of takedowns and repayments for the existing revolver indicated that about $30 million of the $45 million now outstanding was essentially a term loan that probably would not be repaid in the near future. Traditionally, BigBank noted, an expiring revolver would have been rolled over into a combination of a term loan for the longer-term component of the balance and a line of credit for the remaining, seasonal component. BigBank was not devoted to tradition and said that it would be happy to arrange a new revolver if that was desired, as Acme was a relatively high-quality borrower. BigBank stated, however, that investors often look more favorably on middle-market companies that have obtained long-term debt financing and that this point in the interest cycle appeared to be a good time to borrow at a fixed rate.

Acme was interested in obtaining long-term, fixed-rate financing. BigBank noted that a floatingrate term loan could be swapped into fixed rate, but the maximum maturity that BigBank could offer would be about five years. Acme was in principle interested in a longer term. BigBank advised that the combination of Acme's size, business profile, financial condition, and the amount of the term loan (around $30 million) was such that a public offering of debt was infeasible but that a private placement including some financial covenants might be an attractive option.  At this point, BigBank's private placement agent was called in for consultation. As a major corporate lender, BigBank had found setting up its own private placement agent organization profitable.

Based on a quick review of Acme and its financial position, the agent estimated that a private placement of fixed-rate, senior, unsecured notes with a maturity of about ten years would be feasible. Current private market conditions for borrowers like Acme were such that the loan would have to amortize; a bullet loan probably could not be placed with investors. Further discussion yielded a plan for an issue of $32 million of eight-year notes, with annual principal repayments of $4 million.

The agent explained the best-efforts nature of the process. In cooperation with Acme, BigBank would design an initial set of terms for the securities and then seek investors, which would likely be life insurance companies. BigBank would not guarantee the pricing of the issue. Terms might change during negotiations with the investors, and the possibility of no deal being struck was real. BigBank's fee would be 3/4 of 1 percent of the face amount of the placement, but the fee would be collected only if the placement were successful. After signing an agent agreement with BigBank, obtaining commitments from investors would take about two months, and funds could be disbursed another month or so after that. 200

Acme sought bids and advice from other private placement agents and found BigBank's fees to be competitive. It also found that some agents were not interested in the transaction. They explained to Acme that $32 million was a relatively small placement, and that the staff time and other fixed costs to do a placement were about the same regardless of a deal's size. Thus, some agents preferred to concentrate only on larger transactions for which the fees were larger.

Acme also knew that it had to renew its revolver before funds from the private placement would be available. If the private placement did not succeed, Acme would need either a term loan or a larger revolver, which would be easiest to negotiate if BigBank were the agent that failed to complete the private placement. Thus Acme gave a mandate to BigBank's agent organization to arrange the transaction.

The agent's first action was to conduct due diligence, meaning it made a close examination of Acme's business, financial position, and plans.  This examination was similar to the one that lenders would later conduct, and it included a visit to Acme's facility. Performance of due diligence was relatively easy for BigBank because its relationship officers already had substantial information about Acme.

Having gathered much information about Acme, the agent began writing the offering memorandum (offer memo) and term sheet. An offer memo describes the borrower and is functionally similar to a prospectus for a public offering. However, it usually includes more information, such as forecasts, than does a prospectus. The term sheet is a description of the major terms of the securities to be offered, including covenants. An interest rate (expressed as a spread over Treasuries of comparable maturity) is generally not included initially.  Lenders use the offer memo and term sheet in deciding whether or not to buy the securities.  Initial term sheets vary in their content and detail, depending on the nature and quality of the borrower, the complexity of the transaction, and the distribution style of the agent. In this case, the BigBank agent wrote a relatively detailed term sheet, which included covenants restricting Acme's financial ratios. These covenants were similar to those in the new revolving credit agreement concurrently being negotiated with BigBank. A substantial penalty for prepayment of the note was also included. Although Acme was quite unhappy about this penalty, the agent noted that the securities could not be placed without it. 201  The ''final'' versions of both the offer memo and term sheet were produced after extensive consultations with Acme, about two weeks after BigBank received the mandate to go ahead.

With the offer memo and term sheet in hand, the agent initiated the process of getting a ''prerating'' of the securities. 202  The NAIC does such ratings only at the request of an insurance company. The agent used a contact to make a request, reimbursing the insurer for the NAIC's fee. This insurance company made no commitment to buy the securities. With securities issued by very-high-quality borrowers, beginning and sometimes even completing distribution with no rating in hand is possible; but with a borderline borrower like Acme and under the market conditions of the time, no lender would seriously consider a purchase without knowing the rating.  The NAIC rating process takes at least three weeks.

Upon obtaining the rating, and finding it to be a NAIC-2 (or BBB) as expected, the agent began looking for investors who would buy the securities.  The style in which private placement distributions are conducted varies widely across both agents and transactions. In this case, BigBank's agent noted that the transaction was for a relatively small amount of senior unsecured debt and that the borrower was moderately risky by the standards of the private placement market.

These facts had several implications. First, one or more lead lenders were required. A lead lender is one that commits to buy a significant fraction of the placement and that has the necessary credit evaluation and monitoring capacity to assess the loan's risk, negotiate terms, and monitor performance during the life of the loan. Relatively small lenders with limited evaluation and monitoring capacity will rely to some extent on the quality signal implicit in a lead's commitment when making their own decision to purchase a placement. Second, lead buyers of senior unsecured private debt are usually life insurance companies. Third, the largest life insurance companies were less likely to be interested in a transaction of relatively small size.

Thus BigBank's agent began distributing the placement by sending the term sheet and offer memo to several insurance companies, moderate to large in size, verbally suggesting an interest rate of about 190 basis points over Treasuries. These insurers were known to the agent to be receptive to deals with borrowers in Acme's industry and risk category. 203 The securities were offered to these lenders on a first-come, first-served basis.

Although private market lenders often call the agent to obtain information not in the offer memo, and in rarer cases may perform substantial amounts of independent due diligence before making a commitment, the norm in the private market is for lenders to make semiformal purchase commitments based on analysis of the information in the offer memo and term sheet and to do so fairly rapidly, within a week or two. 204  Potential lead lenders generally indicate interest by making a counteroffer in which they state that they will purchase a given amount at a given rate and with given changes in the other terms. 205

A life insurance company of moderate size circled (agreed to buy) about half of the placement at a spread of 200 basis points over Treasuries of comparable maturity, and two others followed this lead in committing to another 40 percent or so, one at 190 basis points over and one at 195 over Treasuries. Left with only $3 million of notes to place, the agent turned to several smaller insurance companies, offering them all or part of the remaining notes on the terms negotiated with the lead lender. These companies rely most on the signal implicit in the lead lender's decision, as they are offered a take-it-or-leave-it proposition and given only two or three days to decide.

Time required for distribution varies. In this case distribution took about two weeks.

Having fully subscribed the placement, BigBank's agent informed the lenders that they were in the syndicate and set the coupon rate (at 200 basis points over Treasuries on that day) and then turned to the next stage, lenders' due diligence. Each of the major lenders conducted an investigation of the borrowing company, including visits to the Acme's facility, that was similar to that done by Bigbank at the beginning of the process. Due diligence is done promptly, and on its completion the lenders' committees pass formal judgment on the loan and dispatch formal commitment letters.

In the final stage of the private issuance, lawyers hammered out the language of the debt contract, which involved several documents besides the notes themselves. The lenders were represented by a bond counsel that was chosen by the lead lender but paid by Acme. Acme was represented by its own counsel with assistance from BigBank. The process of working the contract took three weeks.

Closing ends the process of issuance and the agent's role. In this case, BigBank collected a fee of $240,000. Acme paid down a $30 million bridge portion of its new revolver, which went into effect while the private placement transaction was in progress, and put $2 million into its treasury.

  1. The two-month lead time was required partly because Acme had to be rated by the NAIC. A rating was especially important because Acme was on the borderline between a BB and BBB rating (NAIC-3 and NAIC-2). Under current conditions, investors would be hard to find for a BB issue, and the coupon rate would be so high that Acme would be better off with a five-year bank loan. With a BBB rating, a coupon rate in the vicinity of 200 basis points over comparable Treasuries was likely. See part 3, section 1, for a discussion of the special circumstances currently surrounding BB private placements.

  2. Acme objected to the prepayment penalty for two reasons. First, it effectively removed Acme's option to reduce financing costs in the future should interest rates fall. Second, should Acme wish to pursue a strategy in the future that would cause one of the covenants to be violated, Acme would have either to persuade the lenders to grant a waiver or to prepay the bonds (incurring the penalty) to escape the covenant restrictions. Acme reluctantly agreed to the prepayment penalty provision only after BigBank assured it that lenders with a history of flexibility in waiving covenants could be found.

  3. Virtually all securities bought by life insurance companies are rated by the end of the year of purchase by the NAIC.  As these ratings influence capital requirements and determine reserves that must be held against placements, many insurers prefer to obtain ratings before purchase, known as a ''preratings.''

  4. Some insurers avoid some industries or risk categories, and the nature of insurance company preferences is constantly changing. Preferences for particular kinds of restrictive covenants also vary across private market lenders.

  5. When demand for new issues is very heavy, the decision period may be compressed to a few days.

  6. In this sort of lead-lender distribution, the coupon rate is fixed at the time the deal is fully subscribed. If a lender that circled (agreed to buy) withdraws after the coupon rate is set, the coupon rate may be revised upward if the agent finds doing so necessary for completing the distribution, but it may not be revised downward. Circling is a semiformal commitment that can be (but rarely is) overturned by an insurance company loan committee. Withdrawals of commitments occur mainly because a lender finds on further investigation that the offer memo and term sheet did not accurately represent the borrower or securities.  Withdrawals for such reasons are fairly infrequent.

Appendix G.  Estimates of Issue-Size and Maturity Distributions

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