29 Apr Leveraged Buyouts Offer Mix of Debt and Equity
Leveraged buyouts (LBOs) continue to be a popular choice in the merger and acquisition environment. This type of financing is characterized as one in which purchase of the target company is financed through a mix of equity and debt, and the cash flows or assets are then used to secure and repay the debt.
The key is that the debt typically has a lower cost of capital than does the equity. Therefore, the returns on the equity will rise with the increased debt. This allows the debt to effectively serve as a “lever” to increase returns, which explains the name “leveraged” buyout.
Popular in the mergers and acquisitions arena, leveraged buyouts pop up frequently when a financial sponsor ends up acquiring a company. You may have also heard the term used to describe situations when corporate transactions are partially funded by bank debt.
An LBO can take many forms, including, but not limited to:
- management buyout;
- management buy-in;
- secondary buyout; and
- tertiary buyout.
You may also come across LBOs under a number of circumstances, including restructuring situations, growth situations and insolvencies, as well as companies experiencing stability. Although they most often occur with private companies, it is possible for an LBO to take place with a public company. This is also known as a PtP or Public to Private transaction.
LBOs enjoy popularity in the mergers and acquisitions environment because they are often capable of delivering a win-win for both the bank and the financial sponsor. Banks can make significantly greater margins by supporting the financing of LBOs compared to typical corporate financing. Financial sponsors, on the other hand, gain the ability to increase the returns on equity by bringing the leverage into play.
Private equity firms and LBOs
Hundreds of leveraged buyouts by private equity firms take place each year. Typically, these firms offer to buy a controlling stake in the target company utilizing leverage they received from banks, all based on the financials of the company. It is not unusual for these firms to have little of their own skin in the game when purchasing the business, resulting in tremendous returns.
You will generally see this type of buyout referred to as a sponsored leveraged buyout, meaning the equity player is the sponsor.
Private equity firms generally receive sizable fees at the start, along with additional consulting fees while operating the target company, and the lion’s share of the investment profits. You can expect average annual management fees to run from about 1.5 to 2.5 percent, and average profits shares to be about 20 percent. At the same time, management is left with less than 20 percent stake in the company.
More Management Control
If a business is financially stable, another approach using a similar financing technique could offer management considerably more operating control. In this scenario, management is able to retain 85 to 100 percent ownership in the targeted company.
This type of buyout is known as a non-sponsored leverage buyout and is not unlike other types of business financing. However, to be successful, this type of LBO depends on:
- A quality company and management team, giving lenders and investors necessary confidence.
- Agreement on purchase price, a process that can be as simple or complex as the parties make it. Most small-to-medium-sized firms are valued somewhere in the range of 4 to 7 percent of cash flow, so a purchase price in this range can help to make the LBO
- An understanding of financing options beyond the ability to get debt from banks and equity from buyout funds. These include subordinated debt lenders, corporate development companies, hedge funds or other specialty funding sources.
Even if the financing falls short of what is wanted by the owner, management and the owner can go forward with the transaction. However, in these cases, the owner may keep a portion of the business until equity is repaid.
Variations in Debt Ratio
The level of debt a bank is willing to provide an LBO varies greatly based on the quality of the targeted assets, measured by stability of cash flows, hard assets, growth prospects, and history. Also factored into a bank’s decision is the history and experience of the financial sponsor, along with the amount of equity the financial sponsor is able to supply.
Companies that feature extremely stable and secured cash flows may be able to receive debt volumes of up to 100 percent. But typically, companies are looking more realistically at 40 to 60 percent of purchase price. Variations among regions and industries of the target company are not uncommon.