KENYA: DEMYSTIFYING LEVERAGED FINANCE TRANSACTIONS IN KENYA – PRIVATE EQUITY
Prior to the implementation of the Companies Act in 2015 (Companies Act) Kenyan law prohibited a Kenyan private limited company from providing Financial Assistance. This was a major impediment to the completion of leveraged buyout transactions in Kenya. However, the Companies Act removed most of these restrictions and it is now possible for buyers to use leveraged finance to effect mergers and acquisitions (M&A) transactions in Kenya.
This article focusses on the use of leveraged finance in Private Equity M&A transactions. However, there is now nothing to stop the use of leveraged financing in traditional M&A transactions where the target company’s assets are used to support borrowing or security for the purchase of its shares by an acquirer.
Leveraged finance is the use of an above normal amount of debt (secured in part or in full by the target company) to finance the purchase of shares of a portfolio company.
The leveraged buy-out structure has been widely used for many years in Europe and North America. However, private equity funds should consider utilising leveraged finance to effect acquisitions in Kenya to enhance their potential investment returns.
We set out below some of the common terms used (and their meaning) in private equity leveraged finance transactions:
- A disposal of a portfolio company (i.e. a previous Target as defined below) by a Private Equity Fund, through a sale to a trade buyer, a flotation on a public market or a secondary buyout by another Private Equity Fund.
- Financial Assistance. The granting by a Target (and its corporate group) of guarantees and/or security in support of debt used to fund the acquisition of its own shares or shares in its private holding company (as applicable).
- Intercreditor Agreement.An agreement entered into by various creditors to a corporate group, which ranks the priority of their debt claims upon an insolvency of the group. In almost all cases all intra-group debt and shareholder debt is fully subordinated to Senior Debt (and Mezzanine Debt if applicable, which will in turn be subordinated to Senior Debt).
- The use of borrowed capital (i.e. Senior Debt and Mezzanine Debt) as a source of funding for a transaction; the principal advantage of using leverage is that return on equity capital is boosted on a successful Exit.
- Mezzanine Debt. Debt which is drawn to fund a leveraged buyout which ranks behind Senior Debt in priority, but generally still benefits from security. Ranking of Senior Debt and Mezzanine Debt is generally either achieved through the use of an Intercreditor Agreement, or via Structural Subordination.
- Private Equity Funds.Private (i.e. not publicly traded) closed end investment funds which raise money from investors for the purpose of acquiring portfolio companies with a view to growing them and increasing profitability, generally prior to an Exit.
- Senior Debt.Debt which is lent under a Senior Facilities Agreement and which ranks in priority to all other debt claims against a company (other than those debt claims preferred as a matter of law). It generally benefits from a full guarantee and security package granted by the borrower (generally a SPV in a leveraged buyout transaction) and its corporate group (including the Target with effect from completion of the SPA).
- Senior Facilities Agreement.In the context of a leverage buyout, a loan agreement entered into by a SPV with senior lenders (generally one or more banks) for the purpose of drawing Senior Debt to fund the consideration payable under a SPA (and associated deal costs). Many Senior Facilities Agreements follow the preferred form published by the Loan Markets Association, with transaction specific amendments.
- A sale and purchase agreement under which a purchaser (generally a SPV, in the context of leveraged financial transactions) acquires a Target.
- A newly incorporated company formed by a Private Equity Fund to acquire a Target.
- Structural Subordination.Incurring Senior Debt and Mezzanine Debt at different levels (i.e. in different companies) within a corporate group, such that the Senior Debt is lent at a level which is closer to the Target.
Essential features of leveraged finance transactions in private equity transactions
A leveraged buyout transaction involves the acquisition of a company (Target) by a SPV, which is usually backed by a Private Equity Fund.
To make the most efficient use of the Private Equity Fund’s committed capital, Leverage is applied to the transaction in the form of Senior Debt (usually around 40-50% of the total sources of funding), and frequently also Mezzanine Debt (usually around 10-20% of the total sources of funding), which is generally subject to Structural Subordination and/or subordinated pursuant to an Intercreditor Agreement.
TO offer sufficient credit support to the providers of Senior Debt and Mezzanine Debt, Financial Assistance is given by the Target to such providers in connection with the transaction (it is this feature which distinguishes a leveraged buyout from other forms of M&A transactions).
A management buyout is essentially the same as a leveraged buyout and is generally only distinguished by the fact that senior management of the Target hold a significant stake in the SPV (directly or more commonly, indirectly) post-completion.
Tax considerations on a Kenyan leveraged finance transaction
Some of the key tax issues that will arise in a leveraged buyout, assuming that the Target is a Kenyan company, include:
- typical transaction taxes (namely stamp duty and capital gains tax) would arise in Kenya where the transaction involves the transfer of shares in the Target;
- pricing considerations will arise on the provision of security by the Target and/or its corporate group in favour of the borrower (the SPV) to finance the buyout. If the borrower is non-Kenyan whilst the provider of the Financial Assistance is Kenyan, Kenyan income tax laws require that the pricing for the provision of the Financial Assistance be at arms’ length in accordance with transfer pricing rules; and
- Kenyan stamp duties may be applicable the event securities are to be created in Kenya as part of the Financial Assistance.