16 Jan Acquisition Financing: Capital Stack & Structure Options
Acquisition financing rarely procured from a single source. The acquisition of private or public companies requires a considerable amount of borrowed funds to pay for the purchase price of the company. Companies that generate a high level of cash flow attract leveraged buyout (LBO) transactions and become targets for private equity investors to purchase such companies. The article will present the debt structure embedded in a typical LBO transaction and describe the various components of debt financing in the capital stack.
Senior Debt–The LBO capital structure usually consists of 70% debt and 30% equity. Within an LBO capital structure, senior debt is the most senior tranche and is approximately 50% of the capital structure.6 The senior loan is divided between the revolving credit facility and term loan. The revolving loan is tied to current asset levels and is secured by the firm’s most liquid assets such as inventory and receivables. However, term loans are secured by longer-lived assets in the firm and can be tranched in A, B, C and D term loans. Typically, the A tranche, the most senior debt in the payment waterfall is amortized, and is paid off prior to making payments for other debt. Term loan A is usually amortized over a five to seven-year period. The remaining tranches are paid off at maturity and are not amortized.2 The interest rate charged on a senior debt is a floating rate that is equivalent to LIBOR plus (9 or minus) a premium or discount, based on the credit of the borrower.
Senior debt is considered the least expensive form of financing a company via LBO. Overall, senior debt has the lowest cost of capital relative to other tranches in the capital structure. The interest rate on senior debt is typically lower than that of other debt components in the capital structure. In the event of a liquidation, the senior debt must be paid off first before other creditors receive payment. Senior debt is also ranked higher than high-yield debt in the capital structure. The expected returns from a senior debt ranges from 5% to 12%, while the expected returns from mezzanine debt ranges from 13% to 25% and that of equity is usually over 25%.
Unsecured debt, also known as junk bonds, is the next layer in the capital structure. In general, unsecured debt has a seven to ten-year maturity range and is paid off in a single payment. Junior bonds are comprised of five types of loans. The first loan is a second-lien debt and is allocated in the same collateral pool as the first-lien bank debt. The second-lien debt is privately held with collateralized loan obligation (CLO) investors and hedge funds. The second layer of unsecured debt are high yield bonds.  The capital structure in LBOs includes 20% to 30% of high yield debt. Although, high yield debt has a higher financial cost than senior debt, high yield debt has less limitations on covenant agreements and interest-only payments with principal payment at maturity. Companies have options to secure better loan terms on high yield debt since the loans are callable by the company at a premium a few years after the LBO occurs. The maturity for high yield debt ranges from eight to ten years and provides early repayment options. In the event of a bankruptcy or liquidation, high yield bonds are paid before preferred and common stock.
Mezzanine financing, also known as quasi-equity, is debt subordinated to senior debt and is provided by the bank. Structuring a mezzanine financing in a LBO capital structure is a major consideration since it determines the position of the mezzanine debt in the company’s capital structure. In most cases, investors can agree to contractually subordinate mezzanine debt to the senior debt. However, in less common scenarios, mezzanine debt can take the form of structural subordination. In this scenario, the holding company does not guarantee the mezzanine debt.
Mezzanine debt maturity ranges from five to seven years and is normally issued with a cash pay interest rate of 12% to 18%. Compared to other subordinated debt, mezzanine debt requires a higher return. The more mezzanine financing is used in purchasing a company, the higher the expected equity return for equity holders.  Most mezzanine debt issuers prefer shorter maturities due to the high returns associated with the loan. Conversely, some issuers support longer maturity dates to secure more flexible redemption terms for investors.
Equity represents the private equity’s funds capital and is typically 20% to 30% of the capital structure. Equity has the highest risk reward potential since it is last in line for payment. Thus, equity holders require a high internal rate of return (IRR) on investment that ranges from 20% to 40%.6
- Senior debt lenders are prioritized in the event of a liquidation
- Interest rate is lower compared to subordinated debt
- Economic loss results in less risk compared to subordinated debt and equity
- Economic loss results in greater risk compared to senior debt
- Economic loss results in lower risk than with equity
- Higher interest rate than senior debt.
The following chart is an illustration of a typical LBO capital structure with a bank (senior) debt of 50%, high yield debt is 15%, mezzanine (quasi equity) is 15% and common equity is 20%.
The capital structure of companies includes leveraged loans, high yield bonds and equity. In a typical LBO transaction, senior debt is ranked as the first layer of debt in the company’s capital structure. Senior debt has the lowest risk and cost of capital; however, high yield and mezzanine debt have higher risks since the debt are not secured and are tied to the assets of the company. In general, a company’s capital structure comprises of approximately 50% senior debt, 15% high yield debt, 15% mezzanine debt and 20% equity.
 Joseph V. Rizzi, The Capital Structure of PE-Funded Companies (and How New Debt
Instruments and Investors Are Expanding Their Debt Capacity), 28 Journal of Applied Corporate Finance 60-68 (2017).
 Macabacus, Capital Structure of an LBO, (2018), http://macabacus.com/valuation/lbo/capital-structure
 MARIYA STEFANOVA, PRIVATE EQUITY ACCOUNTING, INVESTOR REPORTING, AND BEYOND: ADVANCED GUIDE for Private Equity Managers, Institutional Investors, Investment Professionals, and Students, (2015).
 Corry Silbernagel & Davis Vaitkunas, Mezzanine Finance, http://pages.stern.nyu.edu/~igiddy/articles/Mezzanine_Finance_Explained.pdf
 DONALD DEPAMPHILIS, MERGERS, ACQUISITIONS, AND OTHER RESTRUCTURING ACTIVITIES: AN INTEGRATED APPROACH TO PROCESS, TOOLS, CASES, AND SOLUTIONS, (2017).
 Street of Walls, Leveraged Buyout Analysis, (2013), http://www.streetofwalls.com/finance-training-courses/investment-banking-technical-training/leveraged-buyout-analysis/.
 Arthur D. Robinson, Igor Fert and Mark A. Brod, Simpson Thacher & Bartlett LLP, Mezzanine Finance: Overview, (2011), www.stblaw.com/docs/default-source/cold-fusion-existing-content/publications/pub1004.pdf?sfvrsn=2.
 Corry Silbernagel & Davis Vaitkunas, Mezzanine Finance, http://pages.stern.nyu.edu/~igiddy/articles/Mezzanine_Finance_Explained.pdf.
Jenn Abban contributed to this report.