08 Apr What amount of #equity is needed in an #LBO?
I dislike the safe, generalized answer to complex questions: “it depends.” While it is frequently overused, the annoyance typically comes when a poor explanation is provided for the potential deviation. When it comes to requisite equity in a leveraged buyout transaction, the pendulum can swing all over the map. It is sufficient to note that nearly all leverage requires some equity “skin.” It is as true as when you are acquiring a $200K home or a $200M corporation. The following are typical questions that occur when a buyer or seller is considering leverage as part of a buyout or recapitalization of the business:
What amount of equity (as a percentage of the overall deal) will be required to complete the leveraged buyout?
Where will the equity come from?
The lender’s primary goal will be to ensure the necessary solvency of the business going forward. How much equity is required is often dependent on several factors including the lender’s confidence in the continued operations of the business, the type of business, existing debt structures (including senior and subordination of existing and proposed debt), the industry and the general lifecycle of the business itself. Today’s lenders could include private investors, mezzanine lenders or SBICs.
Because continued company solvency requires a minimum amount of equity contribution to a deal, the required equity amount is dependent on many factors, including those imposed by the lender, the business of the seller and the overall state of the lending market. The type of market, the size of the business and purpose of the LBO also all play as factors to the transaction.
Senior, subordinated and equity parties in a transaction often play a complex game of give-and-take in LBOs. It is in the senior lenders’ best interest to maximize the amount of sub debt and equity to the deal. The subordinated lenders, on the other hand, will attempt to max the amount of equity required in the deal. Finally, the equity investors will nearly always attempt to minimize the amount of equity contributed, maximize the senior debt (as it holds the lowest interest rate) and bridge the difference with subordinated or mezzanine debt.
When it comes time to fund a leveraged buyout transaction, the overall state of the lending market is perhaps the biggest dictator in how much equity will be required in a transaction. When LBOs were sexiest in the 1980s, it was not uncommon for deals to be financed with as little as 3% to 5% equity in the deal. This occurred during a time when debt multiples were as high as 9x the corresponding EBITDA. Around the market drop in 2001, required equity hit as high as 35% while debt multiples to EBITDA were more conservatively between 3.5x and 4x. Today we are seeing a relative range, but 25% is a good benchmark with debt multiples (including senior and sub) in the 4x to 5x range on the ultimate high-side.
How the equity is obtained is a matter of negotiation. Some may require cash. Others may allow for equity to be rolled over as part of a company recapitalization. Again, the structure also depends on the deal and how hungry both lender and borrower are for consummating something. In short, leverage is not free. While quantitative easing may have pushed interest rates down, that doesn’t mean the cost of borrowing cannot be exacted in other ways. If you’re looking to acquire a company using a mix of debt and equity, be sure to bring the pound(s) of flesh required by the lenders.