First published on the BSPE blog
By Dorina Barna and Boris Mihaylov
LBO stands for Leveraged Buyout and refers to the purchase of a company while using a significant amount of debt to finance the transaction. Usually, the assets of the company being acquired and sometimes those of the acquiring company are used as collateral for the financing. At its golden age, we could see purchases made up of 90% debt; nowadays as PE firms are being more risk-averse, the deals are typically financed with 50 to 75% debt depending on the target’s industry. Therefore, after the acquisition, the debt-to-equity ratio is usually between 1-3x. Some of the key players in LBOs include KKR, Carlyle, TPG, Blackstone and Apollo.
Private equity funds undergo leveraged buyouts as it allows them to perform large purchases and enables investors to properly assess a transaction in their aim to earn the highest possible internal rate of return (IRR). Most PE firms require an IRR of at least 20-25% in order to consider an LBO of a potential target. Therefore, the target is expected to generate a much higher return as compared to the interest paid on debt. Following the acquisition, the company’s cash flow is used to service and pay down the outstanding debt. Therefore, it’s crucial that the LBO target has stable cash flows, which can be used for debt repayments. Some other highly important factors when considering a potential acquisition are a good existing management team, large asset base (to be used as collateral), non-cyclical business and last, but not least relatively low capital expenditures. The overall return realized by investors is determined by the exit EBITDA multiple and the amount of debt that the company managed to pay off over the time horizon of the investment. During the holding period the company could undergo operational and restructuring changes to improve its EBITDA and operational margins, thus further increasing the company’s valuation at the time of the exit.
How is an LBO financed?
In this part of the article we will dive deeper into the way an LBO transaction gets financed, and more specifically what are the different sources of funds. As already highlighted in the previous section, an LBO is based on a combination of debt and equity. The latter is provided by the financial sponsor (private equity fund engaging in an LBO transaction), considering the debt part there are various options, the most widely used ones will be discussed in the following:
Bank debt (or senior debt): Usually, the buyer takes a loan from a bank, or a group of banks (called a syndicate) and uses it to cover a significant part of the purchase price, most of the cases accounting for 50% of the LBO’s capital structure. It is regarded as the cheapest financing instrument, as it has the lowest interest rate among all the financial instruments; a floating rate that is equivalent to LIBOR plus a premium, based on the credit rating of the borrower. Banks can also use a combination of financial solutions, e.g. a term loan to cover the cost of the LBO, and a working capital credit line (revolving credit line) for operations. The latter is different from the conventional loan, as it offers the possibility to be drawn and repaid at any time, while the company pays interest only on the amount that has been drawn plus a fee for the opportunity of withdrawing cash. The fee is due regardless of whether the company took out any money because the bank sets aside a fixed amount of money that the company could withdraw, should there be any need at any time during the time of the contract. However, bank debt may come with covenants and restrict the company from paying dividends to its shareholders, and they often require that the buyer use its own capital. Should the company default, the holders of the senior debt are the first to get their claims serviced, which is one of the main reasons why this instrument is considered one of the cheapest sources of funds. The payback time ranges from 5 up to 10 years.
There are two main ways through which it can be repaid. The first one consists of yearly payments, which are, in most cases, of equal size. The second option is a bullet payment, where the entire loan is repaid at maturity. Both options have their up and downsides, and the payment choice is tightly connected to the specifics of the deal.
Mezzanine debt (or hybrid debt): Usually takes up a small part of the LBO capital structure around 5% and is often financed by hedge funds and specialized PE funds. It is a method of obtaining funding without offering collateral. It requires a higher interest rate compared to senior debt as it involves a higher level of risk. Mezzanine debt could include warrants (equity instruments), hence bridging the gap between debt and equity financing. When certain conditions are met this type of debt could be converted into equity, thus providing investors in mezzanine debt with the opportunity to participate in the potential upside. During liquidation, it is only paid after all other debts-claims have been settled. This type of financing often takes place in conjunction with senior debt or bonds.
Bonds and private notes: The company can issue bonds and sell them to investors, who pay cash upfront for the face value and receive a coupon until the maturity date of the bond. The bonds used in a leveraged buyout are usually not investment grade and are sometimes referred to as junk bonds or unsecured bonds, they can account for anything between 0 and 15% of the capital structure depending on the specific deal. This type of financing could be raised in the private institutional market or the public bond market. Junk bonds and subordinated notes carry a high-interest rate but on the other hand, have less restrictive limitations or covenants relative to conventional bank debt. In a case of default, bonds and notes have priority over equity claims but are subordinate to senior debt. Payback period ranges from 8 to 10 years.
Management Rollover/Seller financing: The existing owners consisting of the management team, key figures or even the founders roll a part of their stake over into the new equity capital structure of the company. Such a financing option is attractive for PE funds as it reduces their equity contribution and aligns the management team with a goal of financial sponsors. Furthermore, it enables the incumbent owners to participate in the potential upside, and it may even be an appealing option in relation to possible tax savings. It is beneficial for all equity providers as it contributes to a higher level of liquidity of the investment. Seller financing is also an advantage to the buyer since sellers tend to be more willing than banks to provide financing. This type of financing is common in smaller transactions and management buyouts.
Equity (from GPs and LPs): usually takes up to 20-30% of an LBO and represents the private equity fund’s capital. Due to the increased risk, it requires a higher risk premium – an IRR of over 25%, since equity shareholders are paid last and in case of default, they may not receive anything.
In smaller transactions, involving less well-known companies, the financing options can be as simple as a single bank loan or seller financing. Meanwhile, larger transactions that involve well-known companies commonly use a mix of bonds, senior and mezzanine financing, as well as conventional bank lending.
Considering everything mentioned above, one must highlight that there is a vibrant palette of financial instruments that could be used to finance a leveraged buyout. The exact combination is tightly related to the individual transaction, economic outlook, various credit market conditions and even the type of acquisition and number of bidders. The instruments could be mixed in multiple ways so as to achieve the best possible result and the highest level of IRR.
A glance at the current situation
Many investors worry that the COVID-19 might trigger a financial crisis similar to the one in 2007-2008. Should there be a recession, which is quite obvious at this point in time, what is going to be the impact on the PE industry and their highly leveraged business?
On the one hand, credit markets had become tighter, but are not completely frozen as during the global financial crisis, when leveraged loan issuance sank by almost 80%. Still, the level of high-yield lending was already decreasing before the shock and only got worse since. In 2019, around three-quarters of all deals were leveraged at more than six times EBITDA. In the current circumstances, borrowers might have to contribute more equity in order to raise debt.
On the other hand, private equity might come out to be a big winner from the COVID-19 sell-off. Across funds dedicated to leveraged buyouts, growth equity, special opportunities and distressed funds, managers have more than $2 trillion of dry powder and more than $800 billion for buyouts alone. Private equity has never been so cash-rich, which combined with the increased number of opportunities to buy assets at a significant discount, would contribute to a growth in the number of deals.
Editor: Štěpán Koníř
Authors: Boris Mihaylov, Dorina Barna