Credit Insights: VTBs in Financing Transactions – Key Considerations

Welcome to Credit Insights, a periodic series where members of Torkin Manes’ Banking & Financial Services Group examine and discuss technical aspects of lending transactions with a focus on the legal documentation and best practices in transaction execution. In this initial article in our series, we examine VTBs.

The VTB

The standard Canadian mid-market buyout transaction involves both a senior loan with a Canadian bank and the buyer contributing equity to fund the purchase price. However, in recent years, with banks becoming more conservative, and with the rise of independent sponsors and search funds, there has been an increased use of “vendor-take-back” promissory notes (“VTBs”) to fund the purchase price where the combination of senior debt and equity is insufficient or suboptimal to fund the entire purchase price.

Buyers use VTBs to take on additional leverage, with a portion of the purchase price being deferred to a future date and the VTB evidencing that payment obligation. The VTB element of a transaction often has a significant economic impact and is frequently highly negotiated, particularly where the acquisition is financed by an institutional lender that will want to ensure its loan is senior, both in terms of security/collateral priority and repayment, to the VTB. This can lead to significant tension with sellers who do not fully appreciate that their VTB interest sits “behind” that of the senior lender.

 Considerations in VTB Transactions

From a big picture perspective, the issue can be described simply as, the seller likely had not appreciated, and in any event, certainly had not agreed to, the nature of the restrictions on the seller’s rights under the VTB required by the purchaser’s lender. This mismatch between seller expectations and bank requirements often does not arise until late in the transaction when the seller is presented with a draft of the lender’s required form of intercreditor agreement (often called a “subordination and/or postponement agreement”). At this point, it becomes glaringly apparent to the seller that the payment of the VTB note is not as certain as the seller had believed it was when it signed the letter of intent with the buyer.

Importantly, the VTB constitutes leverage over the assets of the target company, not leverage over the “buyer” itself. Because the standard Canadian buyout transaction involves the buyer creating a “newco” and that “newco” amalgamating with the target entity following closing, the senior lender’s loan and the VTB are secured by the same assets: the assets of the target entity.

The Restrictions

While sellers may appreciate that their VTB interest is subordinated to the senior lender, the scope of the senior lender’s restrictions on payments to the seller under the VTBs often goes beyond what the seller anticipated. Senior lenders often place restrictions on the following:

• Scheduled VTB payments upon the occurrence of any default (not just a material default or financial covenant default) by the purchaser under the credit agreement
• The seller’s ability to take security in the assets of the target company (not only the general question of whether any security is permitted, but more specifically whether there are any restrictions on either the nature of the permitted security and/or the entities over which security can be granted)
• Any amendments to the seller’s debt/security documents

Senior lenders may also require that any payments received by the seller from the target entity while the senior credit agreement is in default be held in trust for the bank. The result is that where the target entity is over-leveraged or under performing, a seller holding a VTB may find its right to payment under the VTB delayed indefinitely.

Resolving the VTB Impasse

Perhaps the most useful piece of advice for avoiding difficult negotiations around VTB payment is to push lender’s counsel to provide the draft intercreditor agreement as soon as possible. This allows buyer’s counsel to provide initial comments and get ahead of any issues it knows may be problematic for a seller and for the bank to obtain internal credit approval for any changes to the intercreditor agreement. It also allows sellers and their counsel to raise issues and become comfortable with the intercreditor agreement without negotiations materially impacting the desired closing timeline. When dealing with less sophisticated sellers, buyers should aim to educate them early on as to what a senior lender typically requires in a leveraged transaction.

On the loan documentation side, the buyers should ensure that payments under the VTB are permitted, to the greatest extent possible, under both the intercreditor agreement and the main loan agreement. Both sellers and buyers will want to ensure that postponements should only be triggered by a ‘material’ default, such as defaults relating to payment, financial covenant compliance and/or insolvency. Sellers can also ask for default interest when their loan is postponed, as well as cross-default provisions to cover situations where a default occurs under the senior credit agreement. In tightly negotiated VTBs, often with multiple levels of senior debt, sellers often attempt to negotiate for a fixed, and limited, standstill period regardless of whether there is an ongoing default under the credit agreement at such time.

Conclusion

Ultimately, there is no panacea other than negotiation between the seller, buyer and senior lender. Where intercreditor issues around the VTB are not discovered until later in the process, these negotiations can make for a difficult closing process and potentially delay the closing of the transaction. As with most things, getting ahead of the potential issues and understanding all parties’ interests and needs, is the best way to ensure that negotiations over the VTB do not impact closing.

For more information about VTB transactions or any other matter related to banking and financial services, please visit our website or reach out to a member of our Banking & Financial Services Group.