09 May 2013

Loan to own transactions Part 2: Due diligence, price and other considerations

by Matthew Wilson, Graeme Gurney

Understanding how to evaluate and implement a loan to own structure will prove to be a valuable tool for buyers to unlock, and/or preserve, existing value in a target business.

In our last article we looked at the basic elements and how to structure a relatively straightforward loan to own transaction. In this article, we outline a few practical tips to assist a buyer in evaluating, structuring and implementing a similarly straight forward loan to own transaction.

Due diligence and evaluation

After entering into confidentiality arrangements, the second and probably the most important step in the loan to own transaction is the due diligence phase. As is always the case in an investment decision, proper financial, tax, legal, accounting and other due diligence are critical. From a financial and legal point of view, understanding the nature and substance of the loan agreement and securities to be acquired will provide a proper basis for calculating the value (ie. price) of the transaction.

The following are a few key issues that a buyer should bear in mind as part of the due diligence phase and decision-making process when determining the price of the loan and ultimately the target business. The list is not exhaustive but provides a good starting point for consideration.

  • What is the nature of the loan – bilateral or syndicated? It is important to understand the number of banks/creditors that the buyer will need to negotiate with. The loan to own proposition becomes more complex with more banks/participants.
  • What securities and guarantees are available? Understanding the security and guarantee position will assist a buyer in determining the value of the debt.
  • What is the debt size? Where does the 'value break'? That is, where is the point at which the loan amount exceeds the value of the secured property.
  • Are there any other creditors of the borrower? Are they secured or unsecured? How will these creditors be treated?
  • What is the current equity profile of the target? It is relevant to consider whether it will be necessary to convert all or only part of the debt to obtain a controlling interest in the target. There may be value, including tax benefits, in maintaining a mix of secured debt and equity.
  • Is the assignment or transfer of the debt and securities permitted under the loan agreement and securities? Is it with or without consent or other, eg. a consultation process?
  • Are there any other third party consents required to the transfer? Would the transaction give rise to any rights to a third party to terminate material agreements?
  • Which securities will require release, if any?
  • What are the steps to enforce the securities if necessary?
  • Is interest currently being paid? Are there any amounts of interest or expenses which have been capitalised? Is default interest available/being paid if so at what rate and on which amounts?
  • If receivers have been appointed, what are the receivers'/enforcement costs to date? What stage is the receivership at? If the receivers will be required post-acquisition, then additional steps may be required.

Deciding on how much due diligence is required and the extent of the due diligence will be, as mentioned above, a key consideration for determining the price of the debt. The results of that due diligence, particularly the substantive risks and any mitigating factors, are likely to be determinative for a buyer in deciding whether to pursue the loan to own transaction or to structure some other form of acquisition, if desirable.

Debt for equity swap

If a decision is made to acquire the debt and to structure the acquisition as a loan to own transaction, then the next step will be to consider how to deal with the existing shareholders and swapping the debt for equity. As mentioned in the first article, cutting a deal with existing shareholders may be the most complex stage of the transaction and must be front of mind from the outset of the transaction. Finding the point of leverage which convinces the existing shareholders to give up control of the company will be imperative and may take many forms.

Assuming a deal is cut with existing shareholders for their consent to the transaction and that those shareholders will form part of the business going forward, then the buyer should consider drafting an appropriate form of shareholders' agreement to record each parties rights and obligations in relation to the business. In drafting such shareholders' agreement for the target company, the buyer should consider and appropriately deal with the following headline issues (at a minimum):

  • voting/control: The buyer might like to appoint a director, and if any debt is maintained, it may consider including swamping rights ie. enhancement to voting rights for it where the remaining loan is in default);
  • veto rights: The buyer may require veto rights on the appointment or removal of directors, establishing management incentives, making changes to accounting policies, settling litigation matters, approving budgets and business plans etc.;
  • exits: The buyer may wish to include drag along/tag rights;
  • dividends and dividend policy: Payment or suspension in certain circumstances; and
  • information: The buyer might require rights to appoint an investigating accountant.

Important tax considerations

Finally, it is particularly important to remember that there will be tax implications in structuring a loan to own transaction. Tax issues may arise in the acquisition of the debt and also when "swapping" the debt for equity or acquiring the interests of other shareholders.

Some common issues a buyer should consider include:

  • classification issues (debt/equity);
  • realisation of gain/loss;
  • debt forgiveness;
  • tax consolidation – exit taxes and tax structure going forward; and
  • loss carry forwards.

The impact of these tax considerations may either motivate a buyer to enter into a loan to own transaction or cause it to take another tack to acquire the target.

As part of the due diligence process potential buyers should therefore obtain specific tax and stamp duty advice in relation to any proposed loan to own transaction.

Concluding remark

If Australian banks continue to offload difficult or distressed credit in 2013 – as we expect they will – understanding how to evaluate and implement a loan to own structure will prove to be a valuable tool for buyers to unlock, and/or preserve, existing value in a target business.

The path to implementing a successful loan to own transaction is not always clear and straightforward. If you require any assistance in navigating any of the issues that arise in that course, please do not hesitate to contact Graeme Gurney, Partner or Matthew Wilson, Senior Associate, both specialists in Restructuring and Corporate Finance from the Banking Team.

 

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Disclaimer

Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.