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At a glance: Deal type: 9%/9.75% $700 million notes due 2015, part of the financing of the $5.1 billion buyout of Neiman Marcus Bookrunners: Credit Suisse, Bank of America, Deutsche Bank, Goldman Sachs Date: October 2005 |
When Texas Pacific Group and Warburg Pincus started bidding for luxury US retailer Neiman Marcus in 2005, they were up against several other private equity consortia. In order to nail the deal last May, the two agreed to pay $5.1 billion for the company, a 25% premium to Neiman Marcus’s share price before it was announced that the company was for sale.
With that sort of a price tag, the sponsors wanted to find a way to decrease the debt service burden in case of a downturn in the cyclical retail business. Leverage on the deal, at 6.2 times 2005 pro-forma adjusted ebitda, had already easily been topped in leveraged buyouts, but it was still pretty hefty by 2005 standards. In a downturn, however, it would be a lot more painful.
Credit Suisse, which was financial adviser to the sponsors, was commissioned to make the capital structure of the new company as flexible as possible. “As the sponsors were paying a full valuation for the deal, we wanted to create flexibility in the capital structure,” says Craig Packer, managing director and global head of high-yield capital markets at Credit Suisse.
One innovation Credit Suisse came up with was a $700 million senior payment in kind (PIK) note, which represents 21% of the company’s pro forma debt. There have been sizeable PIK loan portions in the financing of some of the biggest LBOs this year, such as Wind and TDC in Europe, but PIK bonds are rare in the high-yield market and this one was a first. The company can decide whether it wants to pay interest in cash or in more bonds each quarter. If they choose the PIK option, the coupon on the senior notes steps up 75 basis points for that interest period.
“Before, there have been zero-coupon bonds, where the issuer cannot pay in cash, or straight pay in kind bonds, where the issuer has the option not to pay cash,” says Packer. “This was the first of its kind where the issuer decides every quarter which way it wants to pay, but is rewarded for paying cash.” As the sponsors want to pay interest with cash, and use the PIK option as a back-up plan, this suited them well.
Normally a PIK note would be the subordinated piece of a high-yield bond yet, at 6.2 times leverage, this could have bumped up the cost of capital. So the PIK portion was done on the senior note, which also made the market more comfortable about the new structure. “Initially, investors were sceptical as it was unusual, but they came to understand that this was done for sound corporate finance reasons for a best-in-class company,” says Packer.
It wasn’t exactly plain sailing to win round investors. The bond was issued during a particularly rough patch for the high-yield market and investors had to be given concessions to buy into the story. The notice the company had to give investors to exercise the option to pay in kind was extended to 90 days and price talk was widened. But in the end the 9% 10-year bond was issued and, along with another $500 million subordinated piece, was actually oversubscribed. Considering this was at a time when three of the 10 high-yield bonds that had preceded Neiman Marcus to the market had been downsized and three had been pulled altogether, the leads did well to get it done at all.
Could this structure be replicated as a safety net for other buyout targets, particularly as leverage multiples creep higher, deal sizes get larger and premiums paid increase? After all, this feature allowed Warburg and Texas Pacific to bid more than their competitors and win the deal. Richard Zogheb, co-head of global loans and leveraged finance at Citigroup, says the development of this market will be limited because the investor base is relatively small. “Some investors can’t buy non-cash pay securities, so there’s a limited capacity to this market. It’s rare that you’ll see one over $500 million in the US, and $300 million to $400 million is more common. In Europe, because of the strong mezzanine market, it’s possible to do more,” he says.
Still, Ed Yorke, head of financial sponsors for Credit Suisse in New York, thinks that other companies might benefit from it. “This sort of structure could work for any company in a cyclical business, such as commodities or chemicals.” However, Packer says this would have to be done for good credits and for sound corporate finance reasons. “I think if this was just being done to load more debt on a company, investors would be more worried.”
