The Leveraged Buyout
Finding a suitable target for a typical LBO is very much about finding companies that has unused debt capacity. Here cash flow plays an essential role. In a LBO model, free cash flow is used to pay down debt.
LBO model valuation
In theory the value of the equity in the firm will increase as debt is amortized. Also, in the post-LBO firm managements share ownership significantly increases their incentives to work hard in order to maximize their own wealth provided by their equity stake. This is sometimes referred to as a “carrot” effect on the management.
The heavy debt burden also forces managers to run the company efficiently in order to avoid distress. This is referred to as a “stick”. Both the “carrot” and the “stick” ensure that management is doing their best in order to run the company as efficient as possible.
In addition to this third-party investors such as the PE firm acquire a large equity stake in the target company. This provides these investors incentives to motivate and monitor managers. In order to do this PE firms often hold chairs in the board of the company.
According to the source (Citigroup corporate and investment banking 2006) initial capital structure typically consists of 75% debt and 25% equity. These numbers varies from deal to deal and also depends on macro economical factors and debt issuer’s willingness to take on risk.
The same goes for stated IRR in the figure as it also differs depending on demands from investors. However, an IRR of 25-30% seems likely to be accepted by most PE investors.
The different debt layers in the figure represents the various sources of debt ranging from high cost debt such as High-Yield / PIK note financing in debt layer 1 down to low cost financing such as a revolving credit facility and term loans in layer 5. The “revolver” in layer 5 is typically undrawn at the exit of the deal. However a certain amount of debt is often left after exit due to tax shield benefits.
From time of entry throughout the time until exit, debt is repaid. As the enterprise value remains constant, these transactions result in a considerable equity growth. Equity growth together with value creation activities conducted by management and sponsors are translated to proceeds for investors at the time of exit. In order to keep cash flows maximized during the holding period, no dividends are paid out to shareholders. Further, the key return drivers of an LBO can be categorized as follows:
Characteristics of a typical LBO Model
• Leverage on acquisition and subsequent debt pay down. This is done through maximizing of free cash-flow through strict CAPEX, R&D and working capital discipline
• Increased firm value through EBITDA growth between time of investment and exit. Possible through sustainable earnings growth, cost control and possibly restructuring upside or synergies with other companies in the portfolio of the financial investor
• Increased firm value through multiple-expansion between time of investment and exit. Driven by evolving industry fundamentals (e.g. cyclicality of industry), quality of assets, enhanced organic growth outlook and improved equity capital market conditions
• Limited duration of investment. Value is created by, buying in weak markets and exit during robust M&A and equity market within a 3-7 years period. Here, tradeoff between time to exit, total proceeds and IRR is important.
The LBO Financing Structure
Traditionally in an LBO valuation transaction, debt has typically been around 75% of the financing structure. However, today financing with debt levels somewhere close to 50% is more common. Given the high levels of debt included in transactions like this, the ability for PE funds to lend money is crucial.
Interest rates for loans issued by investment banks through a syndicate of lenders consist of two parts: The first part is the official interbank offer rate for short term loans in (e.g.) Sweden. The Stockholm Interbank Offer Rate is referred to as STIBOR. STIBOR is the interest rate banks are charged when borrowing from other banks for maturities longer than overnight. The rate is determined by The National Debt Office (Riksbanken) and fluctuates over time. In order to hedge interest rates on loans in an LBO model an instrument called Interest Rate SWAP, or just SWAP, is utilized. SWAP instruments are OTC contracts provided by investment banks and financial institutions. SWAP rates are fixed during the instruments term and the actual rate differs depending on the term of the contract. Common terms for SWAP instruments are 1, 3, 5 or 10 years.
On top of the SWAP rate banks charge a spread or margin on their loans. This spread/margin is the premium that the bank charges in order to make a profit. Spreads are negotiated for each debt facility and is highly dependable on the current capital market as well as the risk associated with each loan. For example, if the spread is 2.50% for a revolving credit facility and the current SWAP rate is 3.16%, the actual cost of the loan is 2.50%+3.16%=5.66%.
The debt part of the LBO Model financing structure often includes a broad array of loans, securities or other debt instruments with varying terms and conditions that appeal to different classes of investors. The financing structure is unique for each deal. Each credit facility is negotiated and therefore the cost and size of the different facilities differs from deal to deal. However a similar financing structure is applied to all buyouts.
The LBO Model structure comprises of the following sources of finance:
- Senior debt or first lien secured debt such as a revolving credit facility and term loan facilities. This is the cheapest type of debt
- Mezzanine debt, ranked between traditional debt and equity
- High-Yield Bonds, referred to as corporate bonds
- Equity contribution, the lowest ranked source of finance and therefore the most expensive
Senior debt is the main financing source in an LBO Model and typically has a term of 5-10 years. It consists of bank loans with a higher ranking, lower flexibility and lower cost of capital than the other sources of funds. As it ranks higher than other securities in regards to the owner’s claims on assets and income in the event of the issuer becoming insolvent, it has a lower cost than lower ranked debt such as mezzanine, high-yield bonds and equity contribution.
Interest rate is SWAP plus a spread of 2-3% with the credit spread tied to the appraised fair market value of land and buildings, enterprise value as well as the liquidation value of machinery and equipment.
Senior debt is somewhat flexible with varying collateral and covenant packages as well as amortization schedules. It often comprises of 25-50% of the total deal. The debt is used to finance property and equipment as well as other long-lived assets, acquisitions, buyouts and stock repurchases. Main lenders are commercial and investment banks, mutual funds, structured investment funds and finance companies.
A traditional cash flow revolving credit facility also called “revolver” is a senior debt secured by inventory and accounts receivable which is the most liquid operating asset. It is a line of credit extended by a bank or group of banks that permits the borrower to draw varying amounts up to a specified aggregate limit for a specified period of time, often 5 years or more.
It is unique in that amounts borrowed can be freely repaid and re-borrowed during the term of the facility. A revolver requires the borrower to maintain a certain credit profile through compliance with financial maintenance covenants contained in a credit agreement. It is common for companies to utilize a revolver or equivalent lending arrangements to provide ongoing liquidity for seasonal working capital needs, capital expenditures, letters of credit and other general corporate purposes. A revolver is most often not used to fund the purchase of the target in an LBO. Also it is usually undrawn at close. Revolvers are typically arranged by one or more investment banks and then syndicated to a group of commercial banks and finance companies. In order to compensate lenders for making this credit line available to the borrower, a nominal annual commitment fee is charged on the undrawn portion of the facility. The revolver often comprises of 5-15% of the total deal but depends on the fluctuations in working capital. Typical interest rate is SWAP plus a spread of 2.0-2.5% cash interest only, with credit spread tied to value of current assets, financial performance and risk measures.
A term loan, called “leveraged loan” when non-investment grade, is a loan with a specified maturity that requires amortization according to a defined schedule. Like a revolver, a traditional term loan for LBO financing is structured as a first lien debt obligation and requires the borrower to maintain a certain credit profile through compliance with financial maintenance covenants contained in the credit agreement. Unlike the revolver a term loan must be fully funded on the date of closing and once principal is repaid, it cannot be re-borrowed. Term loans are classified by an identifying letter such as A, B or C etc. in accordance with their lender base, amortization schedule and term.
Term loan A, called “TLA”, are commonly referred to as amortizing term loan because it typically require substantial principal repayment throughout the life of the loan. Term loans with significant annual required amortizations are perceived by lenders as less risky than those with a looser repayment schedule. Consequently, term loan A’s are often the lowest priced term loans in the capital structure. Term loan A’s are syndicated to commercial banks and finance companies together with the revolver and are often referred to as “pro rata” tranches because lenders typically commit to equal percentages of the revolver and term loan A during syndication. Term loan A’s in the LBO financing structure often have a term that ends simultaneously with the revolver.
B term loans, or “TLBs”, are commonly referred to as “institutional term loans” due to the fact that they are sold to institutional investors. Term loan B’s are used to a greater extent than term loan A’s in LBO financings. Typical, term loan B’s are larger in size and has a longer term than term loan A’s. A reason for the longer term is that, bank lenders prefer to have their debt mature before term loan B’s. Term loan B’s are generally amortized at a nominal rate such as 1% per annum. The rest is repaid as a bullet at maturity. Common tenor for term loan B’s is up to seven years. As institutional investors prefer non-amortizing loans with longer maturities and higher coupons, TLBs are more suitable for them to invest in than term loan A’s.
Mezzanine debt is a highly negotiated instrument between the issuer and investors. It is tailored to meet the financing needs of the specific transaction and required investors return. As such it allows for great flexibility in structuring terms. It provides incremental capital at a cost below that of equity, which enables stretching of leverage levels and purchase price when alternative capital sources are inaccessible. Mezzanine debt has embedded equity instruments, usually warrants attached to it.
The issuance of corporate bonds is an additional more expensive source of finance if senior debt is used up. Because of the inherent high leverage levels associated with an LBO, these bonds are usually deemed non-investment grade. This is a rating of “Ba1” or below from Moody’s Investor Service and “BB+” or below when using a rating scale from Standard and Poor’s. Due to this, bonds issued through an LBO are often referred to as “high-yield” or in some cases “Junk” bonds because of the relative high risk associated with this type of investment. Typical term of the bonds is 6-10 years and they mature after the senior debt. Issuance of bonds is a flexible instrument that can be structured as a debt security with fixed equity coupon and equity-linked features such as warrants.
High-Yield debt is often structured as 20-40% of total deal cost. It has yearly payments of interest and repayment of principals at maturity. Interest rate is SWAP plus a spread. Size of spread is tied to cash flows and depends on the investment grade of the bond. Main lenders are pension funds, insurance and finance companies, debt and mutual funds, hedge funds or other institutional and private investors. High-Yield debt is usually publicly traded.
Equity stake in an LBO model today usually comprises of 50-60% of the total capital. However this figure varies through time and is highly dependable on bank covenants. As dividend and liquidation rights are subordinated to the interest of the debt lenders, equity contribution provides a cushion for lenders and bondholders in the event that the company’s enterprise value deteriorates. Shareholders often receive their invested capital back at the time of exit, typical after 3-7 years. Management often invests in equity with the LBO sponsor. In most buyouts, a PE firm is the LBO sponsor. Sponsors typically seek a 25-30% compounded annual total return over five years. For large LBO’s several sponsors may team up to create a consortium of buyers, thereby reducing the amount of each individual sponsor’s equity contribution. This is known as a “club deal”.