Leveraged Buyout

What is a Leveraged Buyout?

The use of leverage, which makes it possible to concentrate an ownership position, has been a central feature of the PE model. The leveraged buyout (LBO) is a type of acquisition in which the cost of the acquisition is primarily financed by borrowed funds. A leveraged buyout usually takes place when a company is merged. The purchaser secures the debt with the assets of the company they’re acquiring and the company itself assumes the debt. In an LBO, a ratio of 90% debt to 10% equity is quite common.

Debt Structure of a Leveraged Buyout

In an LBO, private equity funds can utilize multiple types of debt as leverage. Although the debt structure, defined as the proportion of each type of debt used in a company acquisition, can be different for each LBO, the types of debt available for an LBO are the same. The most common types of debt are a revolver, bank debt, high-yield debt, and mezzanine financing, each of which has positive and negative aspects for both buyer and seller.

Revolving Credit Facility (Revolver)

A revolver is a type of senior bank debt, which functions as a line of credit. When in need of capital, the company will draw upon the revolver and then repay the debt once excess cash is available. The revolver provides companies flexibility with respect to their capital needs and allows them access to cash without seeking additional debts or equity financing. The downside of a revolver is its associated costs. The first cost is the interest rate charged on the amount withdrawn from the revolver, which is generally structured to charge a premium that varies based on the credit of the borrowing company. And the other cost is an undrawn commitment fee that compensates the bank for committing to lend up to the revolver’s limit, and is usually calculated as a fixed rate multiplied by the difference between the revolver’s limit, and any drawn amount.

Bank Debt

Bank debt has a lower interest rate than subordinated debt, but it is associated with strict payback plans, more onerous covenants, and limitations. These debts require full amortization over five to ten years, during which the bank can restrict the company’s flexibility to make further acquisitions. Even though bank debt is an effective way for a company to gain capital, one can see that the restriction of flexibility is an obvious drawback. If a company is looking for further acquisitions, then bank debt might not be the best debt type.

High-Yield Debt (“Subordinated Notes”, “Junk Bonds”)

High-yield debt is unsecured and named for its high-interest rate, which is in place to compensate investors for the risk taken in the debt. High-yield debt is popular because the company could gain more capital from investors, also with a flexible payment plan. Meanwhile, the higher interest rate is a downside.

Mezzanine Debt

Mezzanine debt is a middle layer in the LBO capital structure. It hybridizes the debt and equity and is junior or subordinate to other debt financing options. It takes the form of high-yield debt, but with an option to purchase a stock at a specific price, as a way of boosting investor returns commensurate with the risk involved. Similar to high yield debt, it allows early repayment options and bullet payments. The mezzanine debt ranks last in the hierarchy of a company’s outstanding debt. During a liquidation, mezzanine debt is paid after other debts have been settled, but before equity shareholders have been paid.

Seller’s Note

A portion of the purchase price in an LBO could also be financed by a seller’s note. In this case, the buyer issues a promissory note to the seller that it agrees to amortize over a fixed period of time. The seller’s note is attractive to lots of financial buyers because it is generally cheaper than other forms of junior debt and it is usually easier to negotiate with the seller than with a bank or other investors. Also, the acceptance of a seller’s note suggests the seller’s faith and confidence in the business. However, the seller’s note is usually unattractive to the seller because of the high risk arising from the absence of control over the business. Moreover, the seller’s receipt of proceeds from the sale could be delayed.

Securitization

Securitization of the cash flows attributable to particular assets, such as receivables or inventory, provides another source of financing when there is a secondary market for securitization of such assets.

Common Equity

Equity capital is contributed by a fund that pools capital raised from various sources, including pensions, endowments, insurance companies, and wealthy individuals.

Example

LBOs can be extremely successful in economic downturns. We can look at the example of Blackstone’s LBO of Hilton Hotels in 2007 – right before the financial crisis. Blackstone Group took Hilton Worldwide (then Hilton Hotels Corporation) private in an all-cash LBO deal worth $26 billion, out of which $20.5 Billion (78.4%) was financed through debt and $5.6 Billion through equity. The economy plummeted and travel was especially hard-hit. Blackstone initially lost money, but it survived the financial crisis thanks to its management and debt restructuring. In 2018 when Blackstone Group finally sold the last remaining stake in the company, it had realized profits close to $14 Billion (almost 3x returns), which makes it one of the most successful LBOs in history.

Conclusion

An LBO is a financial transaction in which a company is purchased with a combination of equity and debt. The company’s cash flow is the collateral used to secure and repay the borrowed money. The purpose of an LBO is to allow a company to make a major acquisition without committing a lot of capital.

LBO benefits both the buyer and seller if completed correctly. When deciding the type of capital that a company should use for an LBO, it is important to consider both the benefits and drawbacks. The specific debt structure can impact the success of current and future investments.