Bridge loans are a key way to finance large acquisitions, but their terms are very specialized. In "The Basics of Bridge Loans", the White & Case team explains the key terms of bridge loans and discusses some challenges faced in the current market.
Bridge loans serve as an essential way that a potential acquirer demonstrates its ability to fund an acquisition. Certainty of funds is required both for regulatory reasons for financing the acquisition of listed companies in Europe (i.e., under the UK takeover code cash consideration should be available to proceed with a bid), as well as practical considerations, such as providing assurance that both private equity buyers and corporate buyers can raise the necessary funds to support their bids during an auction process.
Traditional bridge loans are temporary loans with an initial maturity of one year or less, put in place to bridge a potential gap between the announcement of an acquisition until a company can secure permanent financing. However, bridge loans carry significant risk. The borrower would prefer to avoid certain expensive fees and pricing the permanent financing at the interest rate cap (discussed below) and lenders would prefer to be engaged as the initial purchasers on the permanent financing (usually high yield bond) rather than assume such a large balance sheet liability. The intent among all parties at the commitment stage is therefore not to fund a bridge loan, but to draw down the bridge loan only to remove funding risk from the M&A transaction. To this end, the fee and interest rate structure of the bridge commitment is set up to incentivize the borrower to launch a high yield bond offering or other permanent financing transaction ahead of the acquisition closing rather than funding the bridge, or if funding is necessary, to refinance the bridge as quickly as possible following the closing of the acquisition.
In recent years and during times of strong market conditions, it has been relatively straightforward for borrowers to then finalize the permanent financing transaction either before drawing the bridge or immediately after and quickly refinance bridge loans. However, recent changes and ongoing volatility in credit markets have delayed the permanent financing and put a damper on the ability to refinance the bridge facilities during the initial one year term. In such market conditions, banks need to consider whether to wait and stay in the bridge loan, or potentially price the high yield bond above the Cap (discussed below) and/or price with significant original issue discount, which would mean the banks might ultimately lose expected fees or more from the transaction.
Main Features of a Bridge Loan
The key parties to a typical bridge loan are the acquirer (typically a newly established company) in an M&A transaction (the borrower), the banks acting as arrangers and the administrative agent.
Duration / Maturity
In a typical transaction, the bridge loan's maturity of one year will automatically be extended into long-term financing should the borrower fail to refinance the bridge loan at the end of its initial term. The bridge loan will convert into a tradeable loan instrument, typically with a fixed interest rate set at the "Cap" rate (see below).
As further discussed below, once a bridge loan "terms out" into an extended term loan, lenders have the right to exchange such loans for "exchange notes". Bridge loan documentation is drafted on the basis that at the time of conversion, lenders will want to exchange their extended term loans into "exchange notes". Such exchange notes are cleared through clearing systems and are freely tradeable, as opposed to extended term loans, which are less liquid and subject to certain transfer restrictions.
Typically, bridge loan commitments are documented by a commitment letter, bridge term sheet, bridge fee letter and high yield bond engagement letter.
- Commitment letter – The commitment letter is the key operative document where the banks commit to make the bridge loan available to the acquirer to fund an acquisition. This contains the overall quantum of the financing, roles/titles of banks, as well as certain other key commitment terms, including any conditionality (typically limited to items within the control of the borrower) to the availability of the funds. The commitment may also include additional elements of the senior part of the capital structure (for instance, term loans of one or more types) and possibly a revolving credit facility commitment. Attached to the commitment letter are term sheets detailing the terms of the loan facilities that will be made available, including the bridge term sheet.
- Bridge term sheet – The bridge term sheet is typically attached as a schedule to the commitment letter and provides a summary of material terms of the bridge facility agreement. This term sheet also includes exhibits detailing the exchange notes and covenant baskets that would govern the exchange notes and are also used as the basis of the anticipated high yield bond to refinance the bridge loan (or exchange notes).
- Bridge fee letter – The bridge fee letter describes the fees and commissions that will be paid to each of the banks in exchange for their bridge commitment, funding the bridge and rolling the bridge into a long-term debt obligation. The fees are typically set as a percentage of the gross proceeds or principal amount. The fee letter also lays out the Cap and the securities demand (all as discussed in detail below). The fee letter will also include fees of any additional elements of the senior capital structure, such as revolving credit facility fees.
- High yield engagement letter – The high yield engagement letter is a letter from the acquirer to the lending banks where it engages the banks to act as initial purchasers in any future bond offering to take out the bridge loan. This letter provides the key engagement terms for the high yield bond offering to refinance to bridge loan, including the fees to be paid to the initial purchasers. In exchange for providing the bridge and signing the bridge commitment letter, the banks expect to be engaged on the bridge takeout financing by way of signing the engagement letter.
Fees, interest rates and rebates
Fees, interest rates and various rebates are typically structured to incentivize the borrower to refinance the bridge at the earliest possible opportunity. The fees in a typical bridge loan may include the following, all of which are payable only if the acquisition closes – known as "no deal, no fee":
- Commitment fee – A fee for the bridge lenders' commitment, payable regardless of whether the bridge loan is funded (provided the acquisition closes);
- Funding fee – Payable only if the bridge loan is funded. Typically, the bridge fee letter provides for a "rebate" of the funding fee, ranging from 25% to 100% of the initial fee paid, depending on how long the bridge loan is refinanced before its initial maturity. The less time between the funding and the refinancing of the bridge loan, the greater the discount;
- Deal-away fee – In the event another source of funding is utilized on the acquisition closing date, the lenders are either fully or partially (depending if the bridge was funded) compensated as if they had led the permanent financing. This fee is typically set out in the high yield engagement letter and ensures that the banks providing the commitment will act as the mandated lead arrangers and/or initial purchasers in the permanent financing transaction, or otherwise are compensated accordingly;
- Alternative transaction fee – This is payable if the borrower terminates the high yield engagement letter and completes the M&A transaction within an agreed period thereafter (usually within 6-12 months), with similar financing provided by other banks. The original banks would be compensated a percentage of the fees they would have received, had they committed to the bridge loan;
- Conversion or Rollover fee – If the bridge loan is not refinanced at its initial maturity date and is converted into long-term financing, a conversion fee is imposed on the borrower. The banks will receive a fee, which should cover the fees the banks would have received had the bridge loan been refinanced by a high yield bond led by the banks committing to the bridge loan financing. This may, in some transactions, be subject to a rebate mechanism similar to the rebate of the funding fee, decreasing with how long after the conversion date the extended term loans are refinanced;
- Bond underwriting or loan arrangement fee – The banks receive a fee for underwriting the bond offering or arranging a syndicated loan to refinance the bridge loan;
- Administrative agent fee – If syndicated banks are committed to the bridge loan, the agent will receive a fee once the bridge loan is funded and annually thereafter if the bridge loan remains outstanding; and
- Interest rate – the key interest rate will be set out in the commitment documents, with an interest rate that typically "steps up" on a quarterly basis over the course of the bridge loan.
The securities demand provisions in the bridge fee letter give the banks the right to demand that the borrower issue a high yield bond to refinance the unpaid bridge loan. Once the borrower and the banks satisfy the conditions of such demand, the banks in theory gain full control of the timing and structure of the long-term financing.
The securities demand provision is typically exercisable by the banks upon the expiry of a holiday period following the closing of the acquisition (or potentially prior to the closing date). Once available to exercise this provision, the banks can "force" the borrower to go to market with permanent high yield bonds at the Cap interest rate and on the terms set out in the bridge fee letter. If the borrower does not comply with the securities demand, then a "securities demand failure" will have occurred under the bridge loan, which results in the loan immediately "terming out" into an extended term loan (which will carry an interest rate at the Cap rate) which can be exchanged into exchange notes and the conversion fee will be due. A securities demand failure will however not constitute an event of default under the bridge facility agreement.
Key securities demand negotiating considerations from the lenders' perspective include:
- Most importantly, the "Cap" interest rate. This is a key term included in the bridge fee letter that determines the highest interest rate the borrower will pay in the permanent financing and provides a practical limitation to the banks' exercise of the securities demand. If the Cap is too low for the existing market conditions, then exercising the securities demand could result in the banks needing to effectively cover the gap between the Cap and the market rate resulting from poor market conditions if they want to place securities above the Cap;
- Negotiate a floor to any potential original issue discount (OID). Such discount is usually set at a 98% floor such that the issue price will not be lower than 98% from the par amount of the bonds;
- Establish a reasonable marketing period for the high yield bond to encourage the borrower and banks to launch a high yield bond on an efficient timeline; and
- Provide the banks with the right to reject the borrowers' request for a holiday period before the securities demand is initiated, or negotiate to shorten the holiday period as much as possible.
One option that the banks can negotiate at the outset in the context of a securities demand is for certain "flex" in the bridge fee letter, which allows banks to "flex", or amend, certain terms of the securities offered under a securities demand to facilitate the issuance of permanent financing. Flex provisions could include, but are not limited to, forcing interest rate increases, restructuring low-cost senior secured loans to higher priced mezzanine loans or bonds, shortening or extending maturities of the loan tranches or tightening covenants. However, this type of flexibility is less commonly seen recently in the European leveraged finance market.
Extended Term Loans and Exchange Notes
As noted above, if the initial bridge loan terms out either by reaching its one year maturity or upon a failed securities demand, the bridge loan automatically (subject to very limited exceptions such as non payment of fees) is refinanced into extended term loans, which have a maturity date equivalent to that proposed for the permanent financing (i.e., the tenor of the high yield bond take out financing). At certain regular intervals and subject to minimum issuance amounts, the lenders under the extended term loans can exchange their extended term loans for an equivalent amount of exchange notes, which are privately held securities that have typical features of long term financing, such as call protection and free transferability, and accrue interest at the Cap. The lenders also receive the conversion or rollover fee to compensate for the longer exposure to the credit.
In the European leveraged finance market, bridge loans are typically not syndicated to other institutions and there is a strict limitation on transferability of such bridge loans, which are relaxed for extended term loans and fall away for exchange notes. Therefore, the investment banks funding the loans will hold the commitments until the high yield bond offering is accomplished (either prior to the closing of the M&A transaction, in which case the bond is issued into escrow, or after the closing of the M&A transaction, in which case the underwriting banks will have funded the bridge loan and will be repaid with the proceeds of the bond).
Preparation for the high yield offering will therefore kick off as soon as possible following the signing of the sale and purchase agreement for the M&A transaction, to permit the bond offering to launch as soon as possible. high yield bonds are issued pursuant to Rule 144A / Regulation S under the US Securities Act, so three years of audited financials, applicable interim financials, pro forma financial information (if applicable), a fulsome offering memorandum and diligence of the target company will be necessary to launch the high yield bond offering. Pre-commitment, the underwriting banks will have considered the timing to market and availability of financials and should have factored additional timing constraints into their decision to underwrite by considering the issuer's readiness to market.
What Happens if the Bridge is Still in Place?
Bridge loans can, and are, funded. However, the intention is that they are outstanding for as short a time as possible.
If, due to market conditions, it is not possible to avoid drawing down on the bridge loan or, if the bridge loan is funded, a quick refinancing, underwriters will need to weigh whether to wait and stay in the loan, or potentially price the bond above the Cap, which would mean the banks may ultimately lose expected fees (or more) from the transaction. If the banks are unable to place the high yield bonds at an acceptable price, a hung bridge loan occurs. At this stage, the bridge loan has rolled over into an extended term loan and/or exchange notes with an interest rate set at the Cap. In the current market conditions, either of these options are possibilities.