Here, we will discuss a bit more on what goes in with a leveraged buyout and what are some of the positives and negatives which are associated with this type of business financing. First, what is a leveraged buyout? As the name suggests, it is a simple reference to the use of leverage (or debt) to fund the purchase of a business. A company will “lever-up,” taking a very small portion of their own funds to purchase a business, while borrowing the remainder which could represent a great deal of money.
Here is how a leveraged buyout will generally go down (in the simplest terminology possible):
1. A company is purchased using an inordinate amount of debt.
2. The holding company(many times a private equity group) will hold the company for for a limited period of time.
3. Sometimes cash is taken out prior to selling.
4. In 3 to seven years you hopefully will sell for a massive return (IPO or an M&A exit) and reap the rewards of a great return.
Who are some of the more well-known companies who have engaged in such transactions? Bain Capital (Mitt Romney’s little babe), KKR, Cerberus, Texas Group and even Berkshire Hathaway has engaged in them (yes, they are more than a buyout fund).
Ah, yes, but how do LBOs add value? This is a fairly controversial question, especially among academics, but tax shields play a huge factor in the value created through leveraged buyouts. The practitioners themselves will claim LBOs help in the following ways:
And what types of firms are generally the type of candidate that would fit an LBO? Mature and declining industries with low growth and steady cash flows who are in need of necessary cost discipline implementation. In some cases, leverage can also help in bargaining with unions, but this particular benefit has never worked with Chrysler.
Before I delve into the hard-line research on how leveraged buyouts actually can add value, let me first cite a few quotes from industry-leaders to the contrary (you know, just to spice things up a bit).
“[LBO funds earn returns] on fees, fees, fees. They invariably auction the business and are looking for strategic buyers. A strategic buyer is just someone who pays too much.“ –Warren Buffet [Emphasis added]
“Some buyout firms ply rape-and-pillage tactics.” -Forbes, 13 March 2006
“Private equity firms are a burden to the economy, to the community and a burden to the company and the employees.”
– Paul Maloney, Senior Organizer of UK union GMB
Now, that we have some peoples’ opinion on how LBOs are actually value destroying here are some results from a forthcoming paper by Harford and Kolasinski, stating that refutes the aforementioned statements. According to the paper, written by two B-school profs. at the University of Washington, LBO firms which were eventually sold to a strategic buyer actually create value. In addition, work by Cao and Learner support the same findings: LBOs really do add value and are not necessarily the result of “rape and pillage tactics.”
Here are some of the results:
LBO targets taken public again in IPO’s generally outperform benchmarks in three years post-IPO (Cao & Learner, 2008) LBO targets sold to public strategic buyers see the buyer’s stock price go up upon acquisition announcement and there is no evidence of long-run underperformance after the acquisition has taken place (Harford & Kolasinski, 2010).
In instances when the LBO target is owned by a PE fund CAPX tends to decline (but CAPX is generally less sensitive to losses for LBO targets than for public control companies. In addition, there is a seen an improved ROA after the LBO has taken place (generally amounting to about 2%). Bankruptcy rate is also considerably low (hovering around ~15% or so). Finally, bankruptcy is generally unrelated to special dividends (Harford & Kolasinski, 2010).
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:
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.
Mainstream, larger deals generally get much more press coverage and clout. For one, they are almost always larger, ranging in the $50 million plus range. While this may be the most compelling reason for the more rampant press coverage, there are other more disconcerting reasons for following such PEG deals. Such deals often involve much more leverage and have a fairly short time horizon. One of the non-traditional exceptions in this “larger” venue is Buffett’s Berkshire Hathaway who buys with the intent to hold forever. This is one of the reasons we are much more drawn to the middle-market M&A arena: it’s a place where longevity and sustainability is not necessarily sacrificed for short term gains, however large.
It is certainly easy to say “we are not all about short term” just as easy it is for a fraudulent company like Enron to profess, “our mission is about integrity.” However, this is generally true of middle-market investors and private equity groups. Many of them work with conservative pension funds which are looking for something that holds long-term sustainability. Buying and holding seems logical, especially when value is what has been purchased. Companies that produce steady month-on-month and year-on-year returns for investors should not only not be leveraged but they should be praised and sought after. Middle-market M&A firms are constantly looking for such deals, ready to pounce when the right one comes along.
Because just about every firm, company and corporation would like to have a fund to help expand and increase value in the company for its owners and investors, it almost goes without saying that long-term investors and partners look more inviting to owners of such businesses. And since, you are reading a blog about M&A, it only makes sense that we would suggest finding the services of a professional advisor when entering into talks with a private equity group. Of course we would say that. However, let me enumerate some of the benefits of doing so:
Of course matching sellers or wish to sell and buyers who want to buy is all dependent on what each side is looking for. However, if your company offers an opportunity for returns above the cost of capital or the next best alternative for a client, PEG or investor in our network, please let us know we can generally find a good match up. There are a number of companies which are poorly run and can be expanded with the help of some oversight from experienced managers within a private equity group. I personally hate leverage. So anything that avoiding levering-up to extract value is better than debting out a middle-market company and then leaving nothing left for the management left in place. In my mind it’s an unethical business practice at best.
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:
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:
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.
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.
So despite popular anti-LBO opinion, they can not only serve a purpose, but can also add value to organizations who engage in them. Perhaps it is our negative view on debt which turns us off to them. Or maybe it has something to do with the type of people who tend to engage in the — at least the stereotypes of those types of people. Or maybe it has something to do with what we are choosing to believe beyond the facts. I myself tend to believe that it is not the LBO that is adding the value itself, but the management put in place during the time an LBO takes place that adds the value. Or, the businesses just makes sense to someone who is able to see something that others do not–the diamond in the rough, so to speak. Whatever the case may be, LBOs certainly do have their place. Please let us know your opinion. Do LBOs add value or not?