Pre-cap loans a moveable feast for sponsors

Bull markets produce innovation. The latest novelty in U.S. leveraged loans is a pre-capitalization or pre-cap financing, which allows companies to keep existing financing and capital structures in place if they are sold.

Pre-cap loans reappeared in 2012 after debuting in 2005. Six were completed in the U.S. last year and they look set to remain a feature of 2013.

The structure is good for private equity buyers and sellers which save paying a new set of fees. Change of control provisions are not triggered, which usually prompt an expensive refinancing.

The portable pre-cap structure is less popular with investors, which are wary of losing control over who they are lending to.

Pre-caps remove a happy dilemma for private equity firms - whether to refinance and take a dividend from a portfolio company or wait and sell the business later - by allowing them to do both.

"It's very compelling for a private equity sponsor who has been in an asset for a while, who wants to monetize but is not ready to sell yet," said Jeff Cohen, co-head of U.S. loan capital markets at Credit Suisse , which pioneered the structure and completed five deals last year.

Credit Suisse led a $1.06 billion credit, a $660 million term loan B and a $350 million second-lien loan for Atlantic Broadband in March 2012 to refinance existing debt and provide a $345 million dividend to owners ABRY Partners and Oak Hill Capital.

A few months later, Atlantic Broadband was sold to Canadian cable company Cogeco Cable for $1.36 billion, which used the $660 million term loan B to fund part of the purchase.

Easing buyout concerns

Pre-caps are useful in a weak M&A environment and a hot capital markets climate as they ease buyout barons' concerns that they could be missing a refinancing window and give investors a supply of high-yielding paper.

Outside a bull market, investors would not give up their right to choose their borrower. Even yield-hungry investors are disdainful of the structure, which one source called an abrogation of his fiduciary duty. Other lenders with a more sanguine view argue that companies are the same regardless of financial owner.

"We are sensitive. But you can't make a blanket rule that you won't do it," said Jonathan Insull, managing director at Crescent Capital Group. "Each one has its own set of circumstances."

Investor reservations and several failures mean that only top companies qualify for precaps. NEP Broadcasting pulled a dividend effort and Hyland Software dropped the provision.

"It requires a very strong market and a very strong transaction. You need a very attractive credit that is going to draw heavy oversubscription" said Tracy Mehr, managing director at Jefferies.

The investment bank completed P2 Energy Solutions' latest $355 million debt tap as a pre-cap, which waived the change-of-control provision from the close of the deal until the end of 2012.

Some restrictions have been put in place around acceptable buyers, equity contributions and leverage tests. The duration of change-of-control waivers is also usually capped.

The largest precap to date - Kronos's $1.9 billion dividend recapitalization, structured by Credit Suisse for Hellman & Friedman and JMI Equity, came with conditions.

Change of control provisions will only be waived for a maximum 18 months if the new owner is a private equity company with assets above a certain size, makes a minimum equity contribution and meets a maximum debt incurrence test when the M&A deal closes.

The structure has given Kronos more financing options and saved $15 million to $20 million in additional financing costs which will boost profits for the selling sponsor, Cohen said.

Bankers do not see the pre-cap becoming a market norm, as covenant-lite loans are now, as it is only used in specific circumstances. This will not stop buyout firms trying to make the latest innovation a trend.

"Certain sponsors are looking to make this into a permanent feature," said Richard Farley, a partner at Paul Hastings. So far, though, "No one has bitten."

(Editing By Jon Methven)