Case Study Short Essay Examination Questions

Essay

Case Study Short Essay Examination Questions
Financing Challenges in the Home Depot Supply Transaction
Buyout firms Bain Capital, Carlyle Group, and Clayton, Dubilier & Rice (CD&R) bid $10.3 billion in June 2007 to buy Home Depot Inc.'s HD Supply business. HD Supply represented a collection of small suppliers of construction products. Home Depot had announced earlier in the year that it planned to use the proceeds of the sale to pay for a portion of a $22.5 billion stock buyback.
Three banks, Lehman Brothers, JPMorgan Chase, and Merril Lynch agreed to provide the firms with a $4 billion loan. The repayment of the loans was predicated on the ability of the buyout firms to improve significantly HD Supply's current cash flow. Such loans are normally made with the presumption that they can be sold to investors, with the banks collecting fees from both the borrower and investor groups. However, by July, concern about the credit quality of subprime mortgages spread to the broader debt market and raised questions about the potential for default of loans made to finance highly leveraged transactions. The concern was particularly great for so-called "covenant-lite" loans for which the repayment terms were very lenient.
Fearing they would not be able to resell such loans to investors, the three banks involved in financing the HD Supply transaction wanted more financial protection. Additional protection, they reasoned, would make such loans more marketable to investors. They used the upheaval in the credit markets as a pretext for reopening negotiations on their previous financing commitments. Home Depot was willing to lower the selling price thereby reducing the amount of financing required by the buyout firms and was willing to guarantee payment in the event of default by the buyout firms. While Bain, Carlyle, and CD&R were willing to increase their cash investment and pay higher fees to the banks, they were unwilling to alter the original terms of the loans. Eventually the banks agreed to provide financing consisting of a $1 billion "covenant-lite" loan and a $1.3 billion "payment-in-kind" loan. Home Depot agreed to assume the loan payments on the $1 billion loan if the investor firms were to default and to lower the selling price to $8.5 billion for 87.5 percent of HD Supply, with Home Depot retaining the remaining 12.5 percent.
By the end of August, Home Depot had succeeded in raising the cash needed to help pay for its share repurchase, and the banks had reduced their original commitment of $4 billion in loans to $2.3 billion. While they had agreed to put more money into the transaction, the buyout firms had been successful in limiting the number of new restrictive covenants.
Case Study :
-Why did banks lower their lending standards in financing LBOs in 2006 and early 2007? How did the lax
standards contribute to their inability to sell the loans to investors? How did the inability to sell the loans once made curtail their future lending?