A company or private equity sponsor that desires to purchase another company may seek debt financing sources to fund the acquisition. The buyer will approach banks and direct lenders to sign commitments to provide debt financing for the acquisition. Prior to issuing a commitment, the banks and direct lenders will conduct extensive diligence of the target company and negotiate commitment papers with the buyer.

The documents known as the “commitment papers” include the commitment letter, fee letter, engagement letter, and fee credit letter. In a typical private equity leveraged buyout, the financing arrangement will provide for term loans, revolving credit facilities, and bridge loans. The bridge loans would only be issued in the event that bond financing cannot be arranged.

While committed financing has historically involved traditional banks, direct lenders have become increasingly active in this space. Direct lenders are non-bank financial institutions that provide large loans directly to companies, bypassing the syndicated banking market. Direct lenders face less regulatory supervision compared with traditional banks, but they may charge higher interest rates and subject companies to stricter financial maintenance covenants.

The commitment papers will set forth key structural and economic terms of the contemplated debt financing, including principal amounts, interest rates, maturities, and fees. It will also state the documentation precedent being used for drafting the loan agreements.

A number of different fees may be negotiated by the lenders. An arrangement fee would only be payable to the lead banks. An administrative agent fee is an annual fee payable on a quarterly basis to the bank managing the syndicate of lenders. A ticking fee may be triggered if there are delays in closing the M&A transaction. The ticking fee increases over time, incentivizing the parties to promptly complete the deal. If the acquisition agreement is terminated, the lenders may be entitled to a breakup fee.

The commitment papers will typically include flex rights, which provide the lenders flexibility to adjust certain terms in order to achieve a successful syndicated financing. The main categories of flex rights are economic flex, documentary flex, and structural flex. Economic flex, also known as pricing flex, allows for changes to the interest rate. This provides flexibility in the event of market changes between the signing and closing of a merger. Documentary flex provides flexibility for additional exceptions to covenant restrictions on the borrower. It also allows lenders to tighten financial ratios related to restricted payments capacity. Structural flex allows the parties to pivot to a different capital structure than the one set forth in the commitment papers.

The process of conducting due diligence on the target company involves reviewing the target company’s existing debt obligations. It is important for the lenders to understand whether the existing debt obligations of the target company will be repaid prior to the merger closing or whether the existing debt will be retained.

Before signing the commitment papers, each lender’s credit committee will have to review and approve the proposed debt financing commitment. Sufficient time should be built into the timeline for obtaining credit committee approvals.