Termgrid Primers 1.2: The debt financing information pack 

We are delighted to announce Termgrid Primers, a new series focusing on basic topics on the debt financing process. 

Written by Leveraged Finance and Capital Markets professionals, Termgrid Primers will focus on practical tips and best practices for executing, coordinating and closing debt deals in the sub-investment grade space.

We are delighted to share the full article below. However, if you would like to fill in the form we will email you with the full report to read at your leisure.

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Series 1: The Debt Financing Process

Episode 1.2: The debt financing information pack

The due diligence process is amongst the most important workstreams when assessing a new investment. It is an intense and highly concentrated period, lasting between a few weeks and a few months, when a prospective buyer digs deep into multiple key areas – including market dynamics, competition analysis, financial, tax, legal, environmental and other more technical areas specific to some industries. The ultimate purpose is to develop a deep understanding of the dynamics that impact (both positively and negatively) the business in question and to identify any red flags. 

In the context of an M&A transaction, the due diligence process is carefully built around the overall timeframe of the transaction and involves multiple specialist advisors, each focusing on their designated field, studying a large data room of information provided by the sellers, presenting their findings over a series of calls and eventually summarizing their views and conclusions in due diligence reports. 

Throughout this article, we take the time to go through the key aspects of the due diligence process from the perspective of a debt provider, and answer the following questions:

A. Why is there a difference between the buyer and the lender due diligence focus?
B. What are the key documents a lender information pack should include?
C. What other information can be included in the lender pack, but is not crucial?
D. What are some best practices to help lenders work through the diligence?

A. Why is there a difference between the buyer and the lender due diligence focus? 

Before a due diligence process begins, the buyer agrees the specific scope of their work with each specialized due diligence advisor, and the main questions and areas the advisors will be investigating in depth. These scopes start from a relatively standard (yet extensive) list of questions, but they are always complemented with specific buyer focus areas, depending on the dynamics of each situation they are evaluating. 

Therefore, the diligence process usually begins (long) before lenders are approached to review a transaction, and the scope of work is commissioned by the potential (or current) shareholder of the company. 

While generally both shareholders and lenders to a company have common areas of interest with regards to a company they are invested into, debt providers have slightly different focus areas by virtue of their fundamentally different risk/return profiles:

• Debt providers earn a pre-established interest on the debt they provide, and their debt is repaid in full upon the maturity of the debt facility (or earlier). They do not benefit from any upside if the company significantly overperforms their business plan – other than the fact that debt providers are, of course, happy when a company does very well, their financial return is the same regardless of the level of overperformance. On the flip-side, if the borrowing company underperforms its business plan, debt providers are still entitled to the same fixed interest and repayment at maturity – there is of course no discount on the interest or reduction in the debt amount in case a company runs into difficulties. Lenders are also the first ones in line to be repaid, having priority over the owners of the company, in the extreme case in which the company goes bankrupt. In other words: debt providers have limited risk but capped rewards 
• In contrast, as owners of the equity in a company, the shareholders hold the riskiest position in a company, whereby their returns are entirely dependent upon company performance. They fully benefit of an upside scenario – i.e. if the company significantly overperforms their business plan, it will have the ability to service its fixed obligations (servicing its debt, paying its bills, etc), and the remaining funds will accrue to the benefit of its shareholder. However, they also take the full risk in case of a downside scenario – there is no minimum return due to the equity holder, and they are the last to be repaid in case of a bankruptcy situation, meaning there is a real risk of significant losses. In other words: shareholders bear high risk but potentially unlimited rewards

As a result of their fixed returns, a lender’s priority will be to make sure that the company will always be able to service their debt during the life of the facility they provide, and that ultimately they will be able to repay the debt at maturity. Their main concern as they go through the diligence process will be to protect against a downside scenario. One of the most common questions lenders ask is “What are the key risks that would result in a deterioration of the company’s ability to service its debt, and can they be mitigated?”. 

Given the different angle lenders have, once we have decided that a transaction will require debt, it becomes very important to include lender focus areas in the due diligence scope of work. There will, of course, be significant overlap between the information relevant for both shareholders and lenders when it comes to understanding the specifics of how a company or a market operates. But making sure some items which are of particular importance to lenders, and perhaps of less importance to shareholders, are addressed in the ultimate due diligence findings will help save significant time and cost from a buyer’s perspective. It will also make the debt raising process quicker and more effective – as it greatly helps to address any potential lender concerns early on.

B. What are the key documents a lender information pack should include?

In broad terms, the lender information pack (or lender due diligence pack) is all the information shared with potential lenders, to help them evaluate a transaction. The information provided to lenders will always be a sub-set of the information that any financial sponsor (or other buyer) will be preparing for any transaction they evaluate. 

Must-haves in a lender information pack: 

• Financial Due Diligence (“FDD”) with much of the information summarized into an external due diligence report and complemented with additional data where required:
  • Minimum 3 years of historical financial data for P&L, Balance Sheet and Cash Flow Statement (complemented by the audited yearly and, to the extent available, quarterly accounts prepared by the company) with an overview and explanation of the main developments 
  • Longer-term financial performance (beyond the last 3 years) for top-line and profitability metrics, which ideally shows a stable and resilient performance through the last economic cycle, or a rationale as to why the company is more resilient currently compared to the last downturn. As lenders are focused on their downside risk, this piece of information is a particularly important piece in their analysis
  • Current trading including the most recent quarterly and monthly information available, to show where the company stands vs its budget; this can take various forms, either as a supplement to the wider financial due diligence report or a company-specific format 
  • An overview of the main KPIs, top-line contributors, costs and profitability metrics for the historical period which are relevant to the company and the sector it operates in
  • Details of the development of key cash flow items such as capital expenditures (with a split between maintenance capex and growth capex), movements in working capital, taxes and extraordinary items for the period 
  • Quality of Earnings (“QoE”) analysis with full details on the bridge between Reported EBITDA and (Pro Forma) Adjusted EBITDA – a particularly relevant piece of analysis. Given their conservative approach, lenders will pay particular attention to add-backs and adjustments to EBITDA (assuming that EBITDA is the basis for calculating the leverage in the credit documentation)
  • If relevant, details and an analysis on synergies or cost savings measures which the buyer includes in the Pro Forma Adjusted EBITDA (could be covered from a financial perspective here)
• Commercial Due Diligence (“CDD”) in the typical form prepared by an external consultant, where lenders generally look to understand:
  • Market or industry overview and development – both in terms of historical and expected growth for the next 3-5 years (this will be considered together with the growth assumed in the financial projections)
  • Analysis of the key competitors and the company’s positioning in its market 
  • Analysis of the customers (key focus areas will be on customer concentration, length of relationship with the customers, historical loss of a customer and the reasons around it, mechanics of agreements or contracts with customers)
  • Analysis of suppliers (key focus areas will be on supplier concentration, single or multi-sourcing dynamics, mechanics of supplier agreements, historical experience with and reliability of suppliers)
  • If relevant, details and an analysis on synergies or cost savings measures which the buyer includes in the Pro Forma Adjusted EBITDA (could be covered from a commercial perspective here)
• Legal Due Diligence (“LDD”): since it is a key focus area for the buyer as well, lenders will adjust to whichever form the buyer or shareholder chooses to perform this analysis. A full due diligence report prepared by a specialized advisor is the most common approach to review any potential risks around items such as material contractual agreements; Intellectual Property; ongoing, pending or past litigations; employee / worker arrangement dynamics. In case a due diligence report is not commissioned or updated for various reasons, many of these items would need to be covered in dedicated calls with lenders
• Pro Forma Structure where lenders look to understand:
  • Details of the envisaged Borrower entity (or entities) and its jurisdiction of incorporation – to ensure they are able to lend to that particular entity and have no negative tax implications. Depending on where lenders are located and what their investment mandates are, there may be specific circumstances which are particularly relevant for cross-border transactions or for companies which operate in multiple countries. The decision of a Borrowing entity is a key item to consider when starting the tax structuring workstream
  • The pro forma group structure including a clear picture of the entities which will be part of the lending group (or the restricted group). This is typically provided in a standard Tax Structure Memorandum (“TSM”), but it can be a simple short document in case a TSM is not commissioned for less complex transactions or add-on debt financings. Lenders will need to understand which companies in the structure will be bound by the terms of the debt they are looking to provide, as well as to ensure that they will have the standard single point of enforcement in an adverse scenario. If this is the first time that a company incurs debt, it is best to pay particular attention to this topic, and to involve your financing counsel in the discussions with your tax structure advisors, to ensure the structure that is being set up will work from a lender perspective. One additional point to keep in mind when first putting together the structure is creating sufficient flexibility in this structure for any potential events which may be relevant during the period of investment, such as raising junior debt at a holding company above the original lending group, understanding the flexibility and tax implications for a (debt financed) dividend payment, or catering for co-investment vehicles. Once the entire transaction is completed, and the debt is in place, it is much more difficult to make changes within a structure at a later stage
• Financial Projections often referred to as the Lender Model or the Financing Case, showing:
  • At least 5 years of projected financials, ideally including all 3 financial statements (P&L, Balance Sheet and Cash Flow), or otherwise a shortened version of the key line items, with sufficient information for lenders to be able to build their own projections. The cash flow statement will be a key lender focus, starting from EBITDA all the way down to free cash flow
  • In terms of the actual figures, the lender model from a buyer or shareholder perspective would be a conservative yet highly achievable case. In practice, this can be a toned down version of the more bullish equity case, supported by the due diligence findings and clearly proving that the cash flows comfortably support the amount of debt being raised. As lenders are focused on minimizing their downside risk, they will use the model provided to them as a basis to run potential downturn or disaster scenarios, to test the company’s resilience and to understand their worst-case risk profile 
  • As a general rule, a lender case is usually shown on a status-quo basis, meaning that it would not include any future acquisitions (unless they have already been secured or signed), assumptions around entering new markets or products which have not already started or are in a very advanced stage. The purpose is to show that the company can service its debt with its current operations and without requiring significant growth from yet uncertain or unproven sources

C. What other information can be included in the lender pack but is not crucial?

The items mentioned previously are key requirements which lenders will absolutely need to start their diligence in earnest. There are, however, other items to be considered. These are not as crucial as the first category, but they can round up an information pack and optimize the overall debt workstream by reducing the number of lender follow-up questions. 

Other items to consider providing lenders to round up the information pack:

• Information made available by the sellers: Lenders expect to see sell-side information, in the form of a Management Presentation, an Information Memorandum as well as sell-side due diligence reports (on the same topics as many of the ones mentioned above) for a couple of reasons:
  • In the case of a formal ongoing sell-side process, the information is readily available when lenders are first approached, therefore they can already begin their diligence while awaiting buyer information 
  • Sell-side due diligence is often quite comprehensive, while often times the buyer due diligence will have a shorter form, and focus on identifying red flags and complementing the seller information. Of course, in cases where the sell-side information is not as comprehensive or simply not available (e.g. certain bilateral processes), the buy-side due diligence package will need to be much more detailed
• Buyer or sponsor investment thesis: in the form of a short document in the preferred format of the buyer or sponsor. It is by no means mandatory, and the information contained in it can be addressed verbally, however providing it in writing facilitates the lenders’ approval process as it can be directly used in their internal approval documents. If provided, this document can include:
  • Rationale for investing in the company 
  • Buyer or sponsor prior expertise in the sector or track record with similar transactions (more relevant for complex transactions)
  • Other relevant highlights or internally produced information that reinforce the strength of the company or mitigate certain risks (particularly important in situations where there is a significant area of concern which requires the appropriate background and messaging from the onset such as high customer concentration, challenging historical performance, cyclicality, etc)
• Other external reports prepared as part of the buyer diligence process: in addition to the reports already mentioned in the must-have’s section, a number of other reports can be included in the lender information pack, where available, such as:
  • Tax Due Diligence – quite commonly included in the package
  • Environmental Due Diligence – historically more common for businesses within a specific sector of concern (e.g. chemicals). However, since in the last few years commissioning these reports has become a matter of internal policy for many buyers, it is becoming increasingly common to make these reports available to lenders. As most institutions, lenders have certain sustainability commitments to their investors and may have specific questions or metrics they track before lending to any company. Therefore, sharing the reports with them will automatically answer many of these questions upfront
  • HR, IT, Operational or Technical Due Diligence – less commonly shared with lenders, apart from specific relevant circumstances

D. What are some best practices to help lenders work through the diligence?

The full information package includes a large amount of information which rarely arrives at the same time, and does not always provide lenders with everything they need to develop a full understanding of the company. 

A few pointers to help support the lender diligence process are:

• Make lenders aware of all the incoming information and the approximate delivery timeline early on : while not all reports and documents will be available at the same, it will help set expectations early on (particularly when working to meet a bid deadline)
• Diligence calls: generally lenders are offered a few calls to ask questions that come up as they review the information pack. It is common to provide the opportunity to speak to some of the due diligence providers (FDD, CDD, LDD) after submitting a list of questions in advance. Depending on the number of lenders and the process dynamics, you could opt between 1-on-1 calls with each lender, or a group call. Additionally, the lenders would also need a call with the buyers (or the company management) to discuss the plans for the business or assumptions of the lender model and to provide comfort on certain areas of concern
• Early drafts vs final versions: Particularly when time is of the essence, an early draft of a due diligence report is strongly preferred, as opposed to waiting for the perfect final version. Questions to ask before sharing an early draft of the report: 
  • Is the information likely to change materially if we wait another day/week?
  • Is the current information providing an accurate or a misleading view of the situation in hand?
  • Will the issue be clearer if we wait for additional data? If so, how long until this data arrives?
• Lack of information: A full list of information requests is easy to put together, but sometimes data is not available, either due to reporting systems issues, timing constraints, process dynamics or a combination of all these. A few steps to consider when lender-requested data is not available:
  • Is a subset of the data requested available? (eg only long-term revenue information is available, but not Operating Income or EBITDA)
  • What is the ultimate goal of the request? And can it be pieced together using other data readily available? 
  • What is the ultimate concern of the lender? And can it be mitigated in a different way? 
  • Generally, lenders are used to operate with imperfect information, but they will also be helpful in drawing the line between must-have’s and nice-to-have’s. Having an upfront conversation about the lack of available information will help set those priorities
• New items coming to light after information was already provided: If items come to light after contradicting information has already been provided to lenders, a few pointers to decide on next steps are:
  • Does the new information change our internal considerations of the investment and are there mitigating factors? Clearly among the first questions an investor would ask themselves
  • Does the new information materially impact the conclusions or findings until now? If so, then the diligence will need to be updated to reflect this accurately 
  • When to let lenders know? As soon as possible, particularly if the new finding is material and may change certain answers given in the past
  • Should the business plan be updated and when? Yes, if the lender case no longer reflects a realistic and achievable picture, then it should be updated for latest findings as soon as manageable

Conclusions (TLDR):

• Lenders have slightly different focus areas to shareholders – their priority is to understand and mitigate their risk in a worst-case scenario, and therefore their diligence will be highly geared towards this aspect
• There are some items which are crucial to provide to lenders to support their diligence process, and other items which are not mandatory or are situation-specific, but could be accretive to the overall process (if available).
• Running an orderly lender process, with clear timelines, open, timely and honest communication will greatly help build trust and manage expectations of all parties
• Here is our lender information pack checklist, to make sure you always have the right documents ready.

How Termgrid can support you

When it comes to sharing a lender information package, Termgrid provides optimal tools that enable our clients to streamline their debt financing activities and drive strategic insights through a centralized transaction data platform. Our Deal Execution platform helps execute and manage financing transactions end-to-end, enabling, amongst other functionalities, efficient file sharing with multiple institution at the touch of a button. 

The Termgrid platform is currently powering the capital market activities of 50+ sponsors from large cap to small cap.  We are helping firms without dedicated capital markets professionals save time and money on processes while building institutional knowledge.

If you’d like to hear more, get in touch with our team or schedule a demo here.

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