Let’s quickly look at an interesting example of how a CFO may think about altering its company’s capital structure.
Here is our very simply capital structure.
To set this up, let’s run through what exists today. The Company has $250mm of cash on balance sheet. The Revolver is $250mm, which is undrawn today… so full $250mm is available. $1,000mm Term Loan B. $250mm Delayed Draw Term Loan (DDTL).
The DDTL serves a similar purpose to the revolver. It’s undrawn today, but if the Company needs liquidity, they can take down the DDTL for $250mm.
Interestingly, there’s usually a cap on how many times a company can draw on the DDTL. In this case it’s twice, but that’s not relevant anywhere else in our discussion. There’s also a notice period detailed in the credit agreement which states how many business days it would take for the company to receive the money. This can be as quick as 2 business days.
Total First Lien debt of $1,000mm. You don’t count the unfunded revolver and DDTL in the total since those two facilities are undrawn / unfunded.
Behind this, there is a $500mm Second Lien Term Loan (“2L TL” or “2L”).
Let’s focus on the 2L. To start, we need to factor in cost of capital. See below the updated capital structure including illustrative cost of capital for each tranche.
Couple notes:
“S +” indicates SOFR plus a spread. SOFR is the benchmark that most US-denominated floating rate debt floats against. This was LIBOR before the transition effective on 6/30
Revolver and Term Loan’s often have the same rate assuming it’s a cash flow revolver and not an ABL revolver
The DDTL is marginally more expensive than the TL. But, as it’s not funded, the company does not pay S + 400 on the unfunded quantum of $250. Instead, there’s a small ticking fee that they pay… this is the price of having the facility be an option for you. Options are never free
Now, a few more details on the 2L. Let’s say the facility doesn’t mature until 12/1/26. A hard call of 101 exists until 12/1/23. Meaning, if the Company were to pay off the 2L before 12/1/23, they would pay 101, rather than par of 100. This reflects the 1% call premium… which translates to $5mm.
The CFO has an idea - let’s do a $500mm incremental to the existing $1,000mm Term Loan (priced favorably at S + 300 bps) and use those proceeds to pay off the 2L (more expensive debt at S + 600 bps).
Great idea - one consideration, however, is the 1% call premium.
So how do we figure out if this trade makes sense?
Keeping it very simple, you would want to compare the interest expense savings to the $5mm call premium.
For example, let’s say that doing an incremental to the TL and paying off the 2L saves you $10mm / year (so getting rid of the S + 600 bps debt and replacing it with cheaper S + 300 bps debt).
But, we shouldn’t compare the $10mm of annual interest expense savings to the $5mm call premium. That would mislead us to thinking the trade makes sense.
The right time period is today, which is when we would do the trade, until 12/1/23 when the call premium goes away. That’s 5 months and ~$4mm of interest expense savings.
From this angle, it appears the trade doesn’t make sense because the call premium of $5mm outweighs the interest savings of $4mm. This doesn’t include fees paid to banks to facilitate the trade, which would make the deal look worse.
If there were no call premium, the trade would make plenty of sense and be a great idea to save the company money. Instead, it’s likely best to wait until the call premium goes away.
That raises our next question.
What are the options when the call premium disappears?
Option 1: initiate the deal mentioned above. $500mm incremental to the first lien with a use of proceeds to fully repay the 2L
Option 2: draw $250mm under the DDTL. Combine that with the $250mm of cash on balance sheet and repay the 2L
Option 3: draw the full $250mm of revolver availability. Combine this with cash on the balance sheet and repay the 2L
Using the revolver and DDTL without touching cash probably doesn’t make much sense. The reason is because you would be paying interest on both the revolver and DDTL if used, when you can just use the cash to finance half of the repayment and not pay interest on this piece. So, the options above use a mix of cash + one of the unfunded facilities (revolver or DDTL).
Now, one important thing to note is that if using the revolver, you’re significantly hurting the Company’s liquidity. Not only are you fully tapping the revolver, but you’re also using all available cash.
Option 2 feels better than option 3. Sure, the DDTL is marginally more expensive than the revolver. But, tapping out the revolver and cash significantly limits liquidity. Even worse, remember above what we said about drawing on the DDTL? There’s a cap of two draws. So, you can’t use the DDTL as a revolver by drawing whenever needed. Instead, if you did option 3, you would likely need to draw the DDTL in full anyways for liquidity purposes. Which brings us to doing option 2 over option 3.
But, back to option 1.
The best option seems to be the incremental TL to repay the 2L. To do this, the Company can go to market in November and close the transaction on 12/1 or 12/2 when the call premium goes away. In this scenario, they raise the new $500mm the same day the 1% call premium disappears, so they can instantly repay the 2L and begin realizing the $10mm of annual interest expense savings.
Hopefully this was a quick and interesting example how companies think about their capital structure.
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Until next time.
John Galt