20.5 Debt 571Credit Enhancements Under the Acquisition Loan Facility Agreement
Because of the highly leveraged nature of acquisition financing, lenders might re-
quire a comprehensive collateral and guarantee package from the borrowers and
the target, as well as any material subsidiaries. Credit enhancements can increase
the availability of acquisition financing and reduce its cost.
As said above, it is characteristic of acquisition financing that the acquired
business is expected to pay for itself. The cash flows generated by the acquired
business will be used to service the debt raised by the acquirer.
Whether the target can provide collateral and guarantees in advance is never-
theless constrained by financial assistance rules. For example, the Second Com-
pany Law Directive provides that a company may not provide security with a view
to the acquisition of its shares by a third party.^73
In addition, provisions of the applicable company law may restrict a subsidi-
ary’s right to give a guarantee or provide collateral for the security of its parent’s
obligations. Such transactions do not always fall within the capacity of the sub-
sidiary company, and they are not always compatible with its stated objects. Fur-
thermore, there can be explicit provisions of company law restricting such transac-
tions (for counterparty corporate risk, see Volume II).
However, common credit enhancements can be used even in the context of ac-
quisition loan facility agreements.
It is characteristic of acquisition financing that there is a conflict of interest be-
tween the ultimate owners of the acquisition vehicle/target on one hand and the
lenders on the other. While the lenders provide the largest part of takeover financ-
ing, the ultimate owners of the acquisition vehicle/target enjoy the benefits of con-
trolling it under the protection of shareholders’ limited liability. Lenders will
therefore take steps to align the interests of the ultimate owners with those of their
own. For example, the lenders can require them to provide a larger equity compo-
nent and subordinated debt.
Structural Subordination
A leveraged buy-out can lead to structural subordination (section 6.3.2). Where
funds are borrowed by the acquirer (often a holding company or acquisition vehi-
cle), creditors of the acquirer rank behind creditors of the target (the operating
company).^74 Where the acquirer is an acquisition vehicle with no other assets of its
own, the risk exposure of lenders can be increased by lack of collateral. In princi-
ple, the acquisition vehicle could grant a security interests in the target’s shares.
However, even such a security would be structurally subordinated and of little
value in the bankruptcy of the target.^75 There are several common ways to reduce
structural subordination in the context of acquisitions.
(^73) Article 23(1) of Directive 77/91/EEC (Second Company Law Directive).
(^74) See Diem A, op cit, § 6 number 9.
(^75) See ibid, § 6 number 8.