Bridge Loans Make Large Acquisitions Possible

For many companies, financing an acquisition is a two-step process.  The long-term strategy might call for raising cash using syndicated term loans and revolvers, bonds, equity, and asset sales. However, many companies use bridge loans to initially fund acquisitions, then repay those loans with other financings and/or assets sales.  In fact, according to Reuters, the largest syndicated loan in the U.S. in 2008 was the $14.5 billion one-year bridge loan backing Verizon Wireless' acquisition of Alltel Corp.

What is a Bridge Loan?

A bridge loan is a term loan where the expected source of repayment is a specific event, typically a debt or equity financing and/or asset sale.  These loans typically have a bullet maturity (i.e. no amortization) of 1 year or less.  As an incentive to borrowers to refinance bridge loans quickly, they typically include interest rate increases and "duration fees" tied to how long the loan is outstanding.  For example, the Altria bridge loan (described below) calls for the interest rate to increase by 0.25% and for an additional 0.75% fee if the loan is not repaid within 90 days (with additional step-ups and fees each 90 days thereafter).  Bridge loans are typically underwritten by a small group of banks rather than being widely distributed in the syndicated loan market.  These underwriting banks typically also manage the "takeout financing" (e.g. the bonds issued to repay the bridge loan).

Altria Uses a Bridge Loan

On September 8, 2008, Altria Group, Inc., the parent company for cigarette maker Philip Morris USA and other companies, announced an agreement to purchase UST Inc., a leading manufacturer of smokeless tobacco.  The transaction, scheduled to close within 4 months, called for Altria to pay UST shareholders $10.4 billion cash and to assume $1.3 billion of UST debt.  The company's plan was to finance the purchase with $11 billion of long-term, public bonds.  However, at the time they announced the acquisition, they also announced a $7 billion dollar commitment (split between J.P. Morgan and Goldman Sachs) for a 364 day bridge loan which, when added to the company's existing unused credit facilities, could fund the entire purchase.

Here's the timeline:

• September 8 - Altria announces agreement to buy UST and $7 billion loan commitment.
• November 4 - Altria issues $6 billion in 5, 10 and 30 year bonds.
• December 18 - Altria issues $775 million in 18 month bonds.
• December 19 - Altria closes (but does not draw down) on $5 billion 364 day bridge loan (reduced from the original $7 billion commitment).  The bank group expands from JPM and Goldman to include 6 other banks.
• January 6 - Altria closes on the purchase of UST and draws down $4.3 billion from the bridge loan.
• February 3 - Altria issues $4.225 billion in 5, 10 and 30 year bonds (bringing the total bond issuance to the planned $11 billion) and repays the bridge loan.  The 8 banks that underwrote the bridge loan are all joint book-running managers on these bonds.

Inventories Explode

Over the past 15 year, many businesses have adopted sophisticated inventory tracking systems and just-in-time inventory policies.  As a result, they have gotten much more efficient in their use of inventory, as shown in this chart:

Source: Wachovia Economics

This long downward trend in the inventory-to-sales ratio has recently and dramatically reversed.  What happened?

As we noted in an earlier post, companies are often slow to respond to lower sales, waiting to cut production and/or reduce purchases.  As managements "catch up" to the current sales reality (or as sales improve), we would expect the inventory-to-sales ratio to return to normal, lower, levels (with the associated benefits for corporate cash flow).

More on General Motor's Predicament

How did General Motor’s run through so much liquidity so fast? Static measures like cash and liquidity don’t really give us the full answer. We need a more dynamic view of what’s driving GM’s liquidity; something that focuses on uses and sources instead.

Here’s a table that shows where GM has been using and sourcing its liquidity for the nine months ending in September of this year.

Cash income has been the biggest use of liquidity, caused by the steep drop in vehicle sales that began earlier this year. Working capital has been a use largely because of decreasing accounts payable – a sign that suppliers are cutting back on the credit they give GM. Capital spending is another major use, as the company invests in new models. Credit market conditions forced GM to pay down much of its short-term debt, draining away even more liquidity.

GM met those demands for liquidity through liquidating assets, mainly by selling marketable securities and letting its portfolio of vehicle leases run off. The next biggest source was borrowing under its committed bank lines. But the most important source of liquidity by far was drawing on cash reserves.

GM found the sources it needed to survive, but only by consuming crucial liquidity reserves. That’s not sustainable. As of September 30, 2008, the company had only $7.2 billion in operating lease assets, $300 million in marketable securities, $16.0 billion in cash and equivalents, and $100 million in unused bank lines – at best enough last another nine months.

So it seems GM has been telling the truth. It really does need help to survive the next year. The challenge for them will be to put their liquidity on a sustainable basis, along with the rest of their financing.