16 Dec Common Types of LBO Debt: Assessing Various Options for Leveraged Buyout & Acquisition Finance
Leveraged finance, particularly in the private equity world, came under scrutiny when it was used heavily in the 1980’s. While the disdain from many groups has not ebbed, there remains a very strong case for leveraged finance and many instances where it can be a useful and needed tool in sourcing appropriate financing. Here we discuss some of the most common forms of leveraged buyout financing, how each form works and what parameters lenders use to determine the level of leverage to be extended in a given deal.
Senior Revolving Debt — Revolving debt is typically secured one of several ways. Senior revolving debt is often tied to a first lien on inventory, accounts receivable and other current assets. It can also have a first or second lien on property, plant, equipment and other fixed assets. Third, senior revolving debt can even hold a lien on certain intangible assets. Finally, liens or pledges are sometimes held against the the stock of the target company or perhaps some of its subsidiaries. Lenders will stop at nothing at working to securitize, in some way, the loan. Senior revolving debt is used frequently when companies are sourcing capital for financing an acquisition, working capital or letter of credit financing. Most frequently senior revolving debt is referred to as commercial paper and is generally provided by institutional lenders, including commercial banks.
Senior Term Debt — Fixed assets are most frequently used as a securitization instrument against any senior term debt. A first or second lien on current assets, intangibles or target company stock is also used. Typically provided by commercial banks and often combined with senior revolving debt, senior term debt is sometimes even subordinate to the senior revolving debt.
Senior Subordinated or Mezz Debt — Mezzanine (mezz) debt is debt–both secured or unsecured–by junior liens on some of the assets secured by more senior debt. It too is also used as a source for acquisition financing. Because mezz loans are either highly subordinated or not secured against any assets at all, the debt is frequently high-yield and sometimes referred to as “junk.” Mezzanine debt is frequently placed by investment bankers, with many of the purchasers being institutional funds, including insurance companies, pension funds, investment funds and other larger financial institutions.
Sale Leasebacks or Special Arrangements — The type and scope of various sales leasebacks are nearly as broad as they are deep. In most instances a lender will arrange for the purchase of a specific performing asset owned by the business, including facilities, equipment, key software code, data or other necessary assets that may be critical to the business and its operations. The arrangements could include installment purchases of anything from office copiers, to data servers or the data itself. The lender typically pays a large lump sum up-front for the assets (in many cases the critical assets) to the business and the business will lease-back these assets from the lender. These types of loans are used for acquisition financing, working capital, bridge loans for liquidity events and have a place among the fundless sponsors of the world. There are also those that use this type of financing as a way to complete a tax-advantaged structure off-shore in a way that benefits both the borrower and the lender. The downside here is that sale leasebacks–while not ultimately as expensive as giving away equity–are the most expensive of those mentioned thus far.
Seller’s Subordinated Notes or Warrants — Seller subordinated note or warranted can be either unsecured or secured in a first, second or even third position. In some instances, this type of debt instrument is convertible to common or preferred stock.
Employee Stock Ownership — In some instances, we have seen various types of debt be layered in with an ESOP as a method for financing an acquisition. With the right structure, this helps to assuage some taxes and premiums can sometimes be paid by the acquirer for the purchase of the business. There are several ways to creatively structure such a transaction.
The options above are not meant to represent the gambit, but they are certainly the most common methods for extending credit to those looking to perform acquisitions, perform a management buyout or to provide a liquidity bridge until the company decides to sell to the general market by broad auction sometime later. When any senior or subordinated lender–typically represented in an institutional setting–using leverage in a transaction, there are key considerations which are often part of gauging whether financing should be extended. Here are a few:
- The value of the collateral in the event of liquidation
- The viability of the financial projections and pro-forma financial statements of the borrower
- Is there enough existing and future cash flow to service both senior and junior debt in the transaction?
- Will any necessary asset liquidations occur in time and at the right level to properly amortize the term debt or decrease a revolver commitment?
- A look at the macro status of the industry and overall prospects of the company’s profitability going forward
- What is the amount of junior debt in a transaction?
- What is the capacity of the junior creditor to assist the borrower with additional funds in multiple scenarios?
- The amount of equity currently (or being brought to the table) in the deal
No two leveraged deals look or behave exactly the same. Determining the right structure of your deal will be dependent on many cogs both in and out of the business. It will also require a broad understanding of the overall market, and how a similar business might behave when highly levered. As always, it’s appropriate to have the assistance of multiple experts when proceeding with any transaction that involves a high degree of risk. LBOs certainly fall in that realm.