Debt Structure

A core expertise among PE funds is their ability to access cheap financing through their excellent relationships with investments banks. (Stowell, 2010, p.283) Banks are also typically interested in providing debt in LBO transactions as such transaction yield higher interest rates compared to the regular corporate lending. Historically, debt structures utilised in LBO transactions have varied quite substantially. However, it is rather unusual that bank debt form the minority of the debt structure (Rosenbaum & Pearl, 2009, p.179). Exhibit 45 displays the senior debt multiples of EBITDA for European LBO’s between 2005 and 2015.

Exhibit 45. Senior Debt/EBITDA Multiples in European LBO’s

Source: Capital IQ (2016), Own creation

From exhibit 45, we can infer that the Senior Debt multiples follow the same pattern as the average debt multiples of exhibit 44. In years of low debt multiples, as in 2009, the receptiveness of the loan market declined significantly and instead many PE firms turned to the high yield bond market to access funding. More recently, resulting from the increased stability in European stock markets and the low interest rate environment, we can observe an increasing trend in the multiple of senior debt to EBITDA. The senior debt of EBITDA multiple shows a consistent surge since 2011 and in 2015, it equalled a ratio of 4.2x.

In line with a typical debt structure of a LBO transaction, as described in section 3.5, and the favourable lending environment for receiving senior debt, we will in our LBO case assume the following debt structure: 54% of the total capitalisation and 84% of the total debt will be comprised of senior secured debt corresponding to a 4.2x multiple of EBITDA in 2015. The remaining 10% of the capitalisation and 16% of the total debt are assumed to be composed of subordinated debt. This is because we consider senior debt to be superior to other debt alternatives, such as high-yield bonds, due to size and public disclosure requirements associated with such instruments (Rosenbaum & Pearl, 2009, p.184). The debt will be formed by a

100

syndicate of reputable investment banks in order to increase the benefits of diversification. We consider utilising such debt syndicate a realistic assumption with regards to our case and outlined assumptions.

Next, we will structure the senior debt into two tranches, amortisation term loan A (TLA) and institutional term loan B (TLB) and both will be collateralised against Rezidor’s receivables, inventory, and property, plant and equipment in order to get the lowest interest rates. TLAs are considered to be less flexible than TLBs due to stricter amortisation schedules and larger shares of mandatory repayments during its maturity. For this reason, TLBs typically constitute a larger share of the debt structure in LBOs. Accordingly, we will assume a relationship where the TLB constitutes 70% of the senior debt and where the TLA accounts for the remaining 30%.

The TLA will have an assumed maturity of 5 years, which is in accordance with the length of the holding period, and will include a predefined amortisation schedule with annual principal repayments during its lifetime. The amortisation schedule could be outlined in other ways, but referring to the typical TLA amortisation schedule as displayed in Rosenbaum & Pearl (2009), we assume the following structure: 5% of the TLA will be amortised in 2016, 10% in 2017, 20%

in 2018, 30% in 2019 and the outstanding 35% in 2020. (Rosenbaum & Pearl, 2009, p.183) With reference to the applicable interest rate assumptions, as addressed in section 3.5, TLAs are usually priced based on a floating interest rate, made up by a base rate plus a spread depending on the borrower’s credit ratings. According to Vernimmen et al. (2014, p.844) the average spread on senior debt used in LBO’s between 2008 and 2014 has been between 400 to 600 basis points (bps).

Considering recent transactions within the Nordic region and the hotel industry, we believe this to be a fair approximation of the pricing terms and we deem the terms to be applicable for our case. Taking the example of Scandic Hotels, which until October 2015 was the target of a LBO executed by the Swedish PE firm EQT, we could find that the term loans in SEK¹⁹ were priced based on STIBOR²⁰, in addition to a spread ranging from 200 to 400 bps per annum (Scandic, 2015b). Scandic’s net debt multiple of EBTDA in 2014 amounted to approximately 6.0x, making the case fairly comparable considering our assumed leverage of 5.0x in our LBO of Rezidor.

(Scandic, 2015a) Consequently, we will assume an equal base rate for our TLA and TLB loans.

As for the additional spread, we will first estimate Rezidor’s credit rating using Moody’s credit

19 Term Loans were renegotiated in 2014 (Scandic 2015b).

20 Stockholm Interbank Offered Rate.

101

rating model for the hotel industry. Having derived the appropriate credit rating, we will assume a spread that firms with the same rating usually get.

In general, when rating agencies such as S&P and Moody’s assign credit ratings on senior debt, most of their ratings vary between BB+ to B+ (Damadoran, 2004). As for the hotel industry in particular, Moody’s are considering business models with high proportions of owned and leased hotels to be more risky. This is because owned and leased hotels require a more capital intensive and have lower margins than franchised and managed hotels. (Moody’s, 2015).

Moody’s rating methodology for hotel companies considers aspects such as a company’s competitive position, diversification, profitability, cash flows and financial policy. By benchmarking Rezidor against the given criteria, which are illustrated in exhibit 46, we arrive at an estimated credit rating of Baa. In general, firms such credit of creditworthiness is usually granted a spread of 433 bps on such a five-year maturity loan, exhibit 47, which are terms that we believe are acceptable (Koller et al., 2010, p.259). Hence, as a result from the assessment of Rezidor’s creditworthiness, the terms of the TLA loan will have an assumed interest rate of the floored STIBOR plus a spread of 433 bps.

Exhibit 46. Estimation of Rezidor’s Credit Rating

Source: Moody’s (2004), Own creation

Exhibit 47. Yield spreads and Credit Ratings

102

Source: Koller, Goedhart, and Wessels (2010), Own creation

TLB will be subordinated TLA in terms of seniority and will therefore be structured as a bullet loan with a longer maturity of 8 years and mandatory principal repayments of 1% per annum (Rosenbaum & Pearl, 2009, p.183-184). Thereafter, the outstanding amount of the TLB will be repaid as a bullet payment at the end of maturity or at the time of exit. As amortization term loans are perceived to be less risky than bullet term loans, we will apply a slightly higher interest rate will be on the TLB compared to TLA. This aspect is reflected by the imposition of a higher spread, assumed as 600 bps, whereas the base rate STIBOR will be the same.

Concerning the subordinated debt, which accounts for the remaining 16% of the debt capital structure, it will have an assumed maturity of 10 years and will be structured as a bullet term loan with no mandatory repayments during its lifetime. The interest rate will be assumed as 10% as this can be considered typical for debt compositions of such kind in LBOs (Damadoran, 2004). An overview of all interest rate assumptions is displayed below, exhibit 48.

Exhibit 48. Interest Rates Summary

Source: Bloomberg (2016), Own creation