Transaction Structuring: Types of Debt in a Leveraged Buyout

 

In a leveraged buyout (LBO), the company uses leverage, or debt, in order to acquire another company or one of its parts. In an LBO, private equity funds can use multiple types of debt or capital as leverage. The most common types of capital or debt used are a Revolver, Bank Debt, and High Yield Debt. Each of these can have advantages and disadvantages for the buyer and seller.

Revolver

A revolver is a type of debt that works when a senior banks debt, functions like a line of credit. When the company is in need of capital, they will draw the revolver to meet the credit limit and then repay the revolver with excess cash when it is available. Using a revolver is advantageous in that it provides companies flexibility with capital and allows them to not seek additional finances.

The drawbacks of a Revolver, however, are its associated costs. The first cost is the interest rate charged on the amount withdrawn from the revolver. This is generally structured to charge a premium that varies based on the credit of the borrowing company. The other cost is an undrawn commitment fee. This fee compensates the bank for the loan and is based on the difference between the revolver limit and the amount drawn.

Bank Debt   

Bank Debt is another type of debt used in an LBO. Bank Debt is generally a lower interest rate security, but is associated with a strict payback plan. These debts are arranged over a five to ten year period and in that time the bank can restrict a company’s ability to make other acquisitions.

Although this structure is an effective way for a company to gain capital, some see the restrictions as a drawback. If a company is seeking to make further acquisitions without the strict financial schedule, then Bank Debt may not be the best type of capital.

High Yield Debt

The other popular type of debt used for capital in an LBO is High Yield Debt. This type of debt is unsecured and named for its high interest rate. The high interest rates are in place in order to compensate investors for the risk taken in the debt. These debts are popular because in a High Yield Debt investors are willing to provide more capital than banks. This type of debt also provides the company with a flexible payment plan.

This High Yield Debt has many advantages, however has a higher interest rate than that of a Bank Debt.

When deciding the type of capital that a company should use for an LBO, considering the benefits and drawbacks are important. The specific debt structure can impact the success of the investment and future investments for a given company.

For more information on leveraged buyouts, read our recent blog post.

 

First of all, what is a Leveraged Buyout (LBO)?

A leveraged buyout (LBO) is when a company uses leverage, mostly debt, to acquire another company or one of its parts. Private equity groups generally invest a portion of their equity and then use leverage, like debt, to fund the remainder of the purchase. While this process may seem daunting, when broken down into steps this becomes a more manageable and understandable process.

The process of a completing an LBO can be both complicated and full of risks. When considering an LBO, a company must do research to understand the cost, risk, and strategy for the company. The following steps are crucial in the LBO process:

1.     Determine the Cost

It is important to determine what the maximum purchase price is based on leverage levels and projected returns. You need to build a model. If you have never build a model before, start with a software such as Business ValueXpress. BVX integrates Price, Terms and Deal Structure, and uses optimization techniques to satisfy the needs of all parties to an M&A transaction.

2.     Determine the Buyout Scenario

Although buyouts can occur in a variety of scenarios, it is important to consider what type of plan your LBO is. Four of the more popular plans are repacking, splitting up, portfolio plan, and the savior:

– Repackaging a company is the process of buying up the remainder of a corporations stock in order to make it private. Once the company is repackaged into a more successful model, it can be returned to the market at an increased multiple. See Multiple Arbitrage.

– Split Up is a strategy where it is determined that a company’s parts are more value than its sum. In this instance a company will be dismantled and each portion will be sold for a higher profit.

– Portfolio Plan is when the acquired company and the current company are more valuable when combined. This is essentially merging both companies’ best aspects to make one stronger corporation.

– The Savior Plan, usually regarded as risky and too late, occurs when a company is in distress and a white knight comes in to turn the company around. If done properly, this can be very lucrative. If done improperly, this can lead to disaster.

These are just four LBO plans of many. Most importantly, knowing which direction you will take the company post-transaction is crucial in creating a plan and setting goals for a successful LBO.

3.     Set a Target Exit time

On average, the holding period for a company that has gone through an LBO with an institutional buyer is three to seven years. It’s critical to understand your objectives and determine where you’re trying to go. Your exit timing will need to include the 6-12 months that it will likely take to divest your investment.

4.     Consider Exit Strategies

Based on the chosen buyout scenario and exit time, it is important to consider what the exit strategy will be. Two of the most popular exit strategies include, sale to a strategic buyer or another LBO.

Sale to a strategic buyer is very common and is viewed as quick and simple. This buyout occurs because the strategic buyer will determine that the company offers synergy to its existing business.

– Another leveraged buyout is a strategy in which a different private equity group, family office, or high net-worth individual buys the company in the same manner the original did. This strategy can be difficult as the new sponsor will be more challenging to bargain with.

 

Understanding the complexities of an LBO is important. There are many risks in taking on such a project; however, if done effectively in a strong market it can yield significant rewards. Following these steps and analyzing the business acquisition can make the LBO process easier to navigate and understand.

Thinking about buying a business? Thinking about selling a business?

No matter which side of the fence you are on, it is important for you to start by understanding the true range of value for the business. The market value of a small business can vary greatly from the book or tax mitigated value because most small businesses are managed to minimize taxable income. While this benefits the current owner, the cash flow will look less appealing to a potential buyer so it is important to perform a financial recast to calculate the true earnings of the business.

This recasting process will provide the buyers with an income amount more reflective of earnings. The easiest way to think about the recasting process is to consider this to be a way of demonstrating the financial results of the business “as if” it was owned by the buyer (taking into account tax-motivated or other discretionary transactions that reduce corporate earnings).

In this recasting process, an analyst will start from the beginning with the tax reported sales and expenses because any prospective buyer will want to be sure that the revenue and adjusted earnings that are stated ultimately tie-back to the tax returns. Then the analyst, with the help of the business owner, their CFO and/or accountant, will identify any discretionary expenses that are exclusively for the benefit of the business owner.

There are many legitimate tax-deductible expenses that are not necessary in order for the business to operate successfully. The most popular expenses, which would need to be recast, or “added-back” to calculate EBITDA (Earnings Before Interest Taxes Depreciation & Amorization) are:

1.     Owner Salaries and Bonuses – normalize to one owner (if multiple) at FMV Salary
2.    Rent of Facilities – is rent above or below Fair Market Value? – Normalize to FMV
3.    One Time Professional Fees – non-recurring one-time related expenses
4.    Other Income and Expenses – typically the dumping ground for expenses that cannot be coded elsewhere
5.    Health Insurance Benefits, Life Insurance, Key-Man Insurance & Disability Policies for the Owner
6.    Automobiles – are they needed for the business and/or do they cost FMV for what someone would actually need? (do you need a Ferrari or would a Taurus do?)
7.    Consulting Fees – consulting fees paid to family, friends and/or advisors that would not be needed by a buyer
8.    Discretionary Expenses – any discretionary travel, lodging, and entertainment expenses that are not directly related to business profits
9.    Outside Investments – any funding provided by the business in support of outside, external ventures or property for which financial benefits flow to the owner

Basically, any expense that benefits the owner but is not needed for another owner to operate the company, should be added to EBITDA.

In addition to these Profit and Loss line items, there are also some Balance Sheet line items that may need to be adjusted in order to compare the business to industry standards. When adjusting the balance sheet consider items such as account receivables, inventory which is old/unsellable, shareholder assets/liabilities due, real estate not included in sale, and prepaid expenses.

As the seller it is important to have ample documentation to legitimize any add-backs because buyers will only accept adjustments that are credible and defendable. It should be expected that buyers and their advisors will do their due diligence and they will often request verification of journal entries so it is important to keep good records. There is a fine and very subjective line between legitimate and questionable recast adjustments and it is important not to include or present adjustments in a way that will negatively affect your credibility.

Ultimately, it is best to hire an experienced merger and acquisition advisor to advise you on the financial recasting process because this process can make a company substantially more compelling to buyers and as a result bring more value to the seller.

To learn more, you may contact us here.

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