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Some pitfalls in financial carve-outs

by contributors Jeffrey E. Ross and Scott B. Selinger, Debevoise | Published July 23, 2012 at 1:33 PM

The job of buying subsidiaries and divisions of larger corporations and unraveling the assets and liabilities of a business from its corporate parent is not for the faint of heart. Most of these carve-out divestitures are complex and bespoke transactions. Among the most challenging issues are those involved in financing the acquisition of a business that is not being run on a standalone basis and, therefore, does not have financial statements sufficient for optimal financing execution.

Historically, companies often did not prepare comprehensive financials for their component businesses. As a result, when a company decided to divest an operating unit, it was unlikely to have standalone financials for the unit. Since the release of FAS 131 by the Financial Accounting Standards Board, segment reporting by public reporting companies with respect to divisions has become more stringent and, as a result, public sellers are more likely to have comprehensive financials for a division being divested. In addition, even where FAS 131 is not applicable, in well run auctions, financials will have been completed in advance of approaching potential buyers.

Notwithstanding these reporting requirements and market practices, in more cases than one might expect, buyers seeking to finance a carve-out acquisition find themselves with insufficient financials to pursue their desired financing. This may occur because, following negotiations as to the precise scope of the business to be sold, the financials produced for the auction no longer match the actual assets and liabilities that will be acquired. New financials can usually be produced, given sufficient time and management attention, but these resources may be in short supply in a fast-moving sale process. More infrequently, financials either cannot be produced or cannot be audited, as a practical matter.

The simple fact of life for many buyers is that some combination of audited and unaudited financials of a target business will be needed in order to obtain debt financing. It is also generally true that the more financials that are available, the more financing alternatives there will be and, in the end, the more likely that the buyer can pursue the financing structure of its choice.

A marketing of high-yield bonds is likely to require as much, if not more, disclosure of financials as other forms of financing. These bonds are usually sold to investors in a transaction exempt from the registration requirements of the Securities Act of 1933, pursuant to the "Rule 144A safe harbor." For an offering to be eligible for this safe harbor, an issuer must satisfy certain informational requirements, including providing the "issuer's most recent balance sheet and profit and loss and retained earnings statements, and similar financials for such part of the two preceding fiscal years as the issuer has been in operation (the financials should be audited to the extent reasonably available)."

Notwithstanding the apparent flexibility of the rule, under customary market practice, a high-yield offering under Rule 144A is modeled on a public offering, which would typically include two years of audited balance sheets, three years of audited statements of income, changes in stockholders' equity and cash flows, and two additional years of selected financial data, all as required under Regulations S-X and S-K of the Securities Act of 1933. Market practice allows for variation from this standard in cases where the full package of financials is not available, but it would be uncommon for disclosure to include fewer than two years of audited financials.

In addition, most high-yield bonds offered under Rule 144A are accompanied by registration rights. In a case where registration rights are offered, an issuer will need financials that comply with the requirements of Regulations S-X and S-K by the negotiated deadline for the filing of a registration statement. This deadline customarily ranges from 45 to 420 days after the acquisition, with 180 days being the most common.

As a result of market practice, if at least two years of audited financials and unaudited interim financials for the target business cannot be provided within the contemplated time frame for the closing of the transaction, a buyer risks losing the option of tapping the high-yield bond market and may instead need to obtain a more expensive and less flexible financing. Moreover, even if this limited set of financials is available, it is also possible that the financials necessary to register the bonds will not be available by the deadline for filing a registration statement.

In carve-out transactions, it is not uncommon for a buyer to find itself without the financials necessary to meet market demands with respect to Rule 144A offerings. Here are a few practical solutions that may be available depending on the situation.

Push the seller. Given the potential impact on a buyer's cost of capital and on the portfolio company's post-closing operating flexibility, before pursuing one of the alternatives below, a buyer should probe assertions that the necessary financials are not available or cannot be produced on an acceptable timeline. The absence of these financials reduces the buyer's flexibility with respect to its financing, and there is often a real cost to this loss of optionality. Depending on the dynamics of the sale process, it may be useful to share with the seller the impact of these costs on the value of the target business to the buyer. In the end, a more costly financing is a shared problem and there can sometimes be a shared solution.

Push the arrangers. If financials necessary for a customary marketing of high-yield bonds will not be available on the desired timeline, a buyer should still consider pressing its prospective arrangers to provide bridge commitments supporting the bond offering. As noted above, the Rule 144A safe harbor information requirements are more lenient than customary market practice requires. Therefore, an offering supported by less financial disclosure (for example, only one year of audited financials), may still comply with Rule 144A. Given the unusual nature of this type of bond offering though, it may be difficult to predict market appetite, and as a result, potential arrangers are likely to be resistant to underwriting a bridge on this basis or, at least, at pricing that would be attractive to the buyer. However, given the right circumstances, including an attractive credit and a competitive "bake-off," it may be feasible.

144A-for-life and variations thereof. In the more common situation where at least two years of audited financials for the target business are available but a third year of audited statements of income, changes in stockholders' equity and cash flows and/or two additional years of selected financial data will not be available by the deadline for filing a registration statement, it is not uncommon for a buyer to obtain bridge commitments supporting a 144A-for-life offering (that is, an offering without registration rights) or a "modified" 144A offering with long-dated filing periods that will allow the issuer to ultimately satisfy the Regulation S-X and S-K requirements. However, for several reasons, the market for and liquidity of these types of bond offerings may be limited. Most importantly, some high-yield investors have limits on the percentage of unregistered securities they may hold in their portfolios, which may preclude these investors from participating in 144A-for-life and "modified" 144A offerings. As a result, financing sources may be less willing to commit to bridges for these types of offerings and, when they do, there may be an incremental cost.

Mezzanine financing. Depending on the size of the financing shortfall, a sponsor could consider a mezzanine or private high-yield financing. These types of financings are likely to be more expensive, and the related covenants are likely to be more restrictive than could be obtained in a traditional high-yield offering. A buyer will need to take into consideration both the direct incremental costs and the potential impact of lost operating flexibility of these financings. Moreover, while the number of financing sources and the magnitude of debt available in this space have both increased significantly over the last several years, supply in this market is still relatively limited, when compared to the high-yield market. As a result, this may not be a solution for large-cap deals.

Seller paper. Whether in the form of debt or equity, seller paper might be considered as a bridge to a time when the necessary financials can be produced and a customary 144A offering can be made. Obviously, this option is unlikely to be viewed favorably by the seller, but a buyer might reasonably conclude that the seller should bear some responsibility for the lack of requisite financials and play a role in resolving the issue. The availability of this alternative will depend on the dynamics of a given sale process. The cost of and flexibility of covenants, if any, in seller paper will depend on the negotiating leverage of the parties and, therefore, will differ on a case-by-case basis.

None of these alternatives is perfect. Each carries its own peculiar cost-benefit analysis. However, when confronted with a carve-out acquisition in which customary financials will be unavailable to execute an optimal financing, one of these alternatives might prove to be a workable solution for what otherwise appears to be an intractable problem.

Jeffrey E. Ross is a partner and Scott B. Selinger is an associate in the New York office of Debevoise & Plimpton LLP. A version of this article originally appeared in the winter issue of the Debevoise & Plimpton Private Equity Report.

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