White & Case explores the use of escrows in the leveraged finance market, offering issuers and investors practical guidance on the mechanics, protections and considerations necessary when entering into escrow arrangements.
What is an escrow arrangement?
Escrow Agreements, Agents & Accounts
An escrow agreement in a leveraged finance context is a contract setting out the terms and conditions by which an independent third party (an "Escrow Agent") holds and eventually distributes funds to an intended recipient once certain prescribed conditions have been fulfilled. Essentially, it is a mechanism for an issuer to temporarily transfer cash (or have cash transferred on its behalf) to a holding account operated by an Escrow Agent, pending satisfaction of contractual obligations, whereupon the funds are then released to another party.
In simple terms, an escrow agreement establishes an escrow account (or accounts) to be held by the Escrow Agent and sets out the terms and conditions under which the funds are to be disbursed by the Escrow Agent. However, in setting these parameters, a number of important practical and commercial considerations should be borne in mind, as discussed below.
Escrows for High Yield Bond proceeds
Escrow arrangements are frequently used as part of the closing process for high yield bond transactions. One of the reasons for this is market access. Despite a strong run in recent years, it is generally thought to be the case that capital markets are subject to potential disruption or "closure", such that there may not always be a supportive market for high yield bond issuances. To avoid such risk, an issuer may seek to raise funds for a future purpose and hold such funds in a safe and secure environment, having locked in pricing in the current market. This means that an issuer may seek to complete a high yield issuance before all of the necessary conditions for the use of those funds have been completely satisfied (hence the use of an escrow account). This also de-risks investment banks who may have offered bridge financing for a transaction, as closing a bond into escrow will decrease (or terminate) the chances of their bridge debt being drawn once the high yield bond has closed into escrow, at which point the cash is available in lieu of the bridge financing commitment.
Escrow arrangements are typically not required for a leveraged loan. This is because the funding regime under a loan agreement is typically more agile, with the relevant lenders either having quicker access to funds or an investment bank able to front for other lenders to shorten drawdown times, whereas, a significant portion of bondholders are pension funds, hedge funds and mutual funds, which may have longer lead times or logistical issues with funding a transaction within a shorter period.
Investment grade bond issuances may, but often do not, use escrow arrangements. The higher credit rating for an investment grade issuer means that investors may not seek the additional protections that an escrow arrangement may provide to a financing structure. In addition, because escrows are less common, an investment grade company may in fact not have sufficient flexibility to enter into a secured escrow structure, whereas high yield documentation often specifically facilitates the use of a secured escrow arrangement for future financings.
When are escrow arrangements used in high yield bond transactions?
An escrow is commonly used where the trigger for the use of proceeds of a high yield bond will occur at some future point, typically following the fulfilment of certain conditions.
Notably, escrow arrangements are often used in connection with M&A transactions. In this context, escrow accounts operate to hold a portion of the purchase price of an acquisition pending completion of the closing conditions. Where the purpose of the bond issuance is to finance an acquisition, escrow arrangements may provide a useful tool to manage the risk of regulatory concerns relating to competition clearance and the delay in such clearance being provided. As competition clearance can often take several months, an escrow arrangement can be used to ensure the funds are held pending such clearance and allowing closing to occur shortly thereafter.
Escrow arrangements have also been used in public-to-private M&A deals, in particular in countries where mandatory takeover rules apply. This locks in sufficient funding to purchase both initial acquired stakes, as well as any tendered shares (or shares in any mandatory sell-out or squeeze out) in the latter part of the takeover. Maintaining funds in escrow can also link in with "certain funds" requirements of applicable regulators for issuers launching such public-to-private transactions and proof of sufficient cash funding for the transaction.
Repayment of debt
Another common use of an escrow is where the use of a high yield bond is to repay other debt of an issuer which is not yet due, or is only repayable immediately at a premium. In this case, the escrowed funds are maintained until an agreed time for repayment of the relevant indebtedness. In addition, as the escrow funds are often held with a financial institution, the payment to the other creditor is often streamlined with the payment made by specialists in a financial institution, rather than by the issuer, which may be less familiar with large-scale payments. This is particularly true for complex escrows where there may be multiple payments required to creditors in varying amounts.
Payment of a dividend
There have been escrow agreements in high yield transactions where the funds have been earmarked for a dividend, contingent on the satisfaction of certain ratios or key performance indicators. Though not widely seen, this is typically used where the timing of the issuance does not quite synchronise with the publication of financial results but the issuer does not want to take market risk (as referred to above). An escrow agreement, in this case, allows an issuer to secure the funds, with investors protected if financial performance is not up to scratch.
How are investors protected?
One of the potential questions when contemplating the application of escrow arrangements is to ask: what is in it for the investor? The following are some of the main benefits of an escrow arrangement from an investor's perspective:
- An independent third party holds the funds – escrow agreements allow for the safekeeping of the escrowed cash until each party meets their contractual obligations, typically fulfilment of the release conditions for the escrow. This introduces an objective blocker to the disbursement and inappropriate use of the funds, allowing their release subject only to the occurrence of agreed upon circumstances. That said, it should be understood that the escrow agent will typically not actively investigate such conditions. The form of escrow release certificate will be pre-agreed, and must be delivered in such pre-agreed form confirming the release from the escrow is permitted (see below for a discussion of relevant conditions). The escrow agent will not typically then go behind this to verify completion of relevant conditions, otherwise this could place the escrow agent in a difficult position of having to take subjective calls which they may not be well placed to make.
- Drawdown conditions and timing – it is important that conditions to escrow release are clear such that the issuer can provide a clean confirmation that they are satisfied. The conditions will depend on the use of funds. As a general rule, in an M&A transaction, the conditions will be no more restrictive than those under the sale and purchase agreement (which the escrow conditions may also require is not amended in any manner materially adverse to the high yield bondholders). In addition, it is typically required that the issuer is not in insolvency. Another important part of the release conditions is the drawdown time period and the amount of time the issuer covenants to use the proceeds within. It is important to synchronise these aspects so that the escrow funds can be used in the specified manner in compliance with the wider transaction. This is often only considered late in the transaction, but bank transfers are not instantaneous and, for large amounts, can be complex with call backs required to verify instructions, often across multiple time zones. The key is to consider this up front and begin the coordination efforts early, so as not to agree to escrow conditions and timing that may cause challenges.
- The funds in escrow are typically secured – escrow accounts for high yield bond proceeds (or the funds therein) are typically secured in favour of the high yield bondholders. Therefore, if the release conditions are not met or the bond is defaulted, the cash cannot be released to the issuer and the investors have a secured right to receipt of the cash. If structured correctly, this will even be in the case of an insolvency of the issuer. This provides a safety net which mitigates against the risk of providing funding for a deal which may not ultimately close.
- Long-stop date and mandatory redemption – a long-stop date is included in the escrow agreement, by which time the conditions to release must be met. This protects investors who do not want an infinite exposure to a relevant transaction and whether or not it will close. The long-stop will typically tie into the relevant corporate event that the escrow is used for (i.e. long stop under sale and purchase agreement, maturity date of relevant debt etc.). If the conditions necessary to complete the deal have not been fulfilled prior to the long-stop date, typically the escrow will automatically close and the funds will be released to the high yield bond trustee or paying agent for a special mandatory redemption of the bond (see below on the relevant price).
A cash escrow also has certain further economic considerations which should be considered up front to ensure all funding aspects of a transaction, and what is offered to bondholders, are covered off to ensure there are no late surprises.
On a special mandatory redemption of the escrow funds to bondholders, the redemption price is typically principal (or the issue price if the bonds are issued below par) plus accrued interest, and potentially a premium. If included (which in the current market is uncommon), the premium is typically either 1% or 2%. If a premium is included, the timing for securing the funding of such premium may be a negotiated point, either at establishment of the escrow by payment into the escrow account or only on the occurrence of the special mandatory redemption. Where a special purpose vehicle is used for the financing, the source of the redemption premium must also be established (and may be backstopped by the sponsor).
Depending on the currency, negative interest may be an important factor in an escrow arrangement. For example, currently, deposits of Euro are subject to negative interest meaning that cash deposits are charged while sitting in escrow. This is significant as it means that: (i) the issuer or sponsor may have to top up the funds by depositing sums equal to the relevant charge(s); or (ii) the cash held in escrow may have to be re invested to earn interest and other income to compensate for the reductions in the relevant account, which may increase the risk on what is meant to be essentially a risk-free investment for bondholders during the escrow period.
A high yield bond escrow occurs only following the sale of the bonds, which means that the underwriters have been successful in marketing the transaction. There is then a question of whether the bond underwriting should be (i) paid to the underwriter immediately on the closing of the high yield bond or (ii) only once the escrow funds are released (often the route on a "no deal no fee" basis). Depending on the option, there may be additional considerations of ensuring there are sufficient funds in the escrow to repay investors. This can be an important commercial consideration to address up front to ensure transaction sources and uses (and commercial expectations) are balanced.
High yield escrow arrangements allow issuers to access the market and lock in capital markets funding while providing investors with protections to ensure they only fund the deal they bargained for. Having a clear line of sight to the overall funding objective and considering the practical and economic issues that may occur are key to establishing the right kind of escrow for a particular transaction, but in doing so, can calm the nerves for completion with funds ready to utilise quickly and efficiently to complete the deal.
Sebastian Modos (White & Case, Trainee Solicitor, London) contributed to the development of this publication.
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