Why M&A thinking is critical to a “J Crew” style financing

The “J Crew” priming transaction – where assets were moved outside of the banking group and separately financed – highlighted a technique for rescue financing. But it can also be a cheaper alternative to a holdco financing for companies looking to raise liquidity. How should a financier think about it? Here are some pointers:

Existing financing: These dropdown transactions are executed without getting consent from the wider syndicate. Therefore, a financier needs to rely on the existing baskets and permissions. There’s less litigation risk if reliance can be placed on the express basket capacity without having to manipulate the drafting.

Unrestricted subsidiaries: Permissions built into the unrestricted subsidiary basket, the general RP basket, permitted investments baskets and permitted joint venture baskets can all be used to transfer assets out of the purview of the existing syndicate. However, this transfer may create operational difficulties, adverse tax consequences and may result in an increased vulnerability on a bankruptcy.

Non-guarantors: An alternative approach to transferring assets outside of the group is to see if there are options to finance a non-guarantor. Typically in top-tier sponsor-backed financing, non-guarantors will be able to incur a significant amount of debt and use their own assets to secure that financing. This creates an opportunity for a financier to come in on a structurally senior basis. Often it will be possible to transfer assets from guarantors to non-guarantors, but this can end up with the same adverse consequences noted above.

M&A principles: If the financing is being backed by a going concern (as opposed to an asset), the best lending transactions are those founded on good M&A principles. The financier needs to think about how well that going concern is ringfenced from the rest of the group and how much equity value there is within that going concern. The restructuring lawyers need to think about claw-back risk and the vulnerability in a bankruptcy and the tax lawyers can structure the single point of enforcement – but it’s the M&A lawyers which are needed to help determine the equity value. If the financier were to enforce over that single point of enforcement, would they be enforcing over a self-contained business unit or would there be significant reliance on the rest of the group? Some of the key things to diligence are:

• Management and employees
• Intercompany balance and working capital requirements
• Financial reporting
• Pension liabilities
• Shared contracts
• Licences, registrations and permits
• Intellectual property
• Real estate
• Back office functions and procurement systems
• HR and IT systems
• Tax and VAT grouping

It’s not fatal to the financing if some of these aren’t completely separate from the main group – some may be immaterial, some may easily be replicated, some may be priced in and some, in extreme cases, may be dealt with via a form of transitional services arrangement. But the result is that companies which have standalone businesses within non-guarantors could have access to significant amounts of extra liquidity. Overstretched, acquisitive European businesses may be a good place to start looking.