1. Principle

The basic principle is to create a holding company, the sole purpose of which is to hold financial securities. The holding company borrows money to buy another company, often called the “target”. The holding company will pay interest on its debt and pay back the principal from the cash flows generated by the target. In LBO jargon, the holding company is often called NewCo or HoldCo.

Operating assets are the same after the transaction as they were before it. Only the financial structure of the group changes. Equity capital is sharply reduced and the previous shareholders sell part or all of their holding.

From a strictly accounting point of view, this setup makes it possible to benefit from the effect of financial gearing (see Chapter 13).

Now let us take a look at the example of the B&B hotel chain, sold in March 2016 by the investment funds Carlyle and Montefiore to PAI for an enterprise value of €823m. B&B generated 2015 sales of €344m and an EBITDA of €73m. The acquiring holding company was set up with €484m of equity and €339m of debt.¹

Holdco debt is made up of a 7-year loan for €339m with an interest rate of Euribor + 5%, Euribor being floored at 1% of preference shares that are in fact debts.

The balance sheets are as follows:

Note that consolidated shareholders’ equity, on a revalued basis, is now 41% lower than it was prior to the LBO.

The profit and loss statement, meanwhile, is as follows:

Holdco does not pay corporate income tax as dividends paid by B&B are tax-free coming from income already taxed at the B&B level.

2. Types of LBO transactions

Leveraged buyout (LBO) is the term for a variety of transactions in which an external financial investor uses leverage to purchase a company. Depending on how management is included in the takeover arrangements, LBOs fall into the following categories:

• a (leveraged) management buyout or (L)MBO is a transaction undertaken by the existing management together with some or all of the company’s employees;
• if new management is put in place, it will be called a management buy-in or MBI;
• when outside managers are brought in to reinforce the existing management, the transaction is called a BIMBO, i.e. a combination of a buy-in and a management buy-out. This is the most common type of LBO in the UK;
• the term leveraged build-up (LBU) is used to describe an LBO in which the new group continues to acquire companies in its sector so as to create industrial synergies. These acquisitions are financed primarily with debt;
• an owner buyout (OBO) is a transaction undertaken by the largest shareholder to gain full control over the company.

3. Tax issues

Obtaining tax consolidation between the holding company and the target is one of the drivers of the overall structure, as it allows financial costs paid by the holding company to be offset against pre-tax profits of the target company, reducing the overall corporate income tax paid.

In some countries, it is possible to merge the holding company and the target company soon after the completion of the LBO. In other countries this is not the case, as the local tax administration argues it is contrary to the target’s interest to bear such a debt load. Provided tax consolidation is possible between the target and Holdco, this has no material consequence. If tax consolidation is not possible because, for example, the Holdco stake in the target company has not reached the required minimum threshold, then a debt push down may be necessary.

In order to perform a debt push down, the target company pays an extraordinary dividend to Holdco or carries out a share buy-back financed by debt, allowing Holdco to transfer part of its debt to the target company where financial expenses can be offset against taxable profits. If the target company is still listed, an independent financial expert is likely to be asked to deliver a solvency opinion testifying that the target debt load does not prevent it from properly operating in the foreseeable future.

4. Exit strategies

The lifespan of an LBO depends both on the speed at which the LBO fund can improve the company’s performance and its capacity to sell it on to a third party or on the stock market. It is rarely less than two years in periods of euphoria and it can be as long as seven or eight years during lean times. There are several exit strategies:

• Sale to a trade buyer. Our general comment here is that in most cases financial investors bought the company because it had not attracted trade buyers at the right price. When the time has arrived for the exit of the financial buyer, either the market or the company will have had to have changed for a trade buyer to be interested. The private equity firm KKR Pincus exited its investment in SMCP in 2016 through a sale to the Chinese textile group Shandong Ruyi.
• Initial public offering. This strategy must be implemented in stages, and it does not allow the sellers to obtain a control premium; most of the time they suffer from an IPO discount. It is more attractive for senior management than a trade sale. In 2016, Maisons du Monde was IPOed by Bain Capital.
• Sale to another financial investor, who, in turn, sets up another LBO. These “secondary” LBOs are becoming more and more common and we also see tertiary or even quaternary LBOs such as B&B.
• A leveraged recapitalisation. After a few years of debt reduction thanks to cash flow generation, the target takes on additional debt with the purpose of either paying a large dividend or repurchasing shares. The result is a far more financially leveraged company.

• A debt to equity swap allowing debtholders to gain control of the company when its debt load becomes too heavy to be repaid by the company’s cash flows which, most of the time, have slumped compared to projections. Existing shareholders have refused to put in more equity to pay back part of the debt but they have agreed to allow a share issue to take place and to be diluted.
• A bankruptcy when cash flows generated by the operating company are insufficient to allow for enough dividends to be paid to Holdco and when debtholders and shareholders cannot reach an agreement on a capital restructuring (new equity, lower interest rates, longer repayment schedule, etc.).

If the company has grown or become more profitable on the financial investors’ watch, it will be easier for them to exit. Improvement may take the form of an internal growth strategy by geographical or product extension, a successful redundancy or cost-cutting plan or a series of bolt-on acquisitions in the sector. Size is important if flotation is the goal, because small companies are often undervalued on the stock market, if they manage to get listed at all.

That being said, a company whose LBO has failed as a result of an inability to pay off its debt is often in a pitiful state. The investment tap has been turned off, the most talented staff have seen the writing on the wall and have left and the remaining staff lack motivation. Turning such a company around presents a serious challenge!

1. Potential targets

The transactions we have just examined are feasible only with certain types of target companies. The target company must generate profits and cash flows that are sufficiently large and stable over time to meet the holding company’s interest and debt payments. The target must not have burdensome investment needs. Mature companies that are relatively shielded from variations in the business cycle make the best candidates: food, retail, water, building materials, real estate, cinema theatres and business listings providers are all prime candidates.

THE WORLD’S 10 LARGEST LBOs

The group’s LBO financing already packs a hefty financial risk, so the industrial risks had better be limited. Targets are usually drawn from sectors with high barriers to entry and minimal substitution risk. Targets are often positioned on niche markets and control a significant portion of them.

Traditionally, LBO targets were “cash cows” but, more recently, there has been a movement towards companies exhibiting higher growth or operating in sectors with opportunities for consolidation. As the risk aversion of investors decreases, some private equity funds have carried out LBOs in more difficult sectors or have specialised in heavy turnaround situations.

The mid-2007 crisis and the sudden disappearance of LBOs after the Lehman demise have prompted a return to the basics: targets with high, stable and predictable cash flows able to pay down their debt with a reasonable degree of confidence, i.e. smaller-sized companies rarely above €3bn, generating cash flows over which visibility is high.

2. The sellers

Recently, more than half of all targets have been companies already under an LBO, sold by one private equity investor to another, for the second, third or more times, such as B&B.

There are many European SMEs that were set up or grew substantially in the 1960s and 1970s, run by a majority shareholder-manager. These shareholder-managers are now reaching retirement age and may be tempted by LBO funds for the disposal of their companies, rather than selling them to a direct competitor (often seen as the devil incarnate) or seeking a stock market exit, which may be difficult. All the more so when the company bears the family name, which may disappear if it is sold to another industrial player.

Some sectors are so concentrated that only LBO funds can buy a target as the antitrust authorities would never allow a competitor to buy it or would impose severe disposals, making such an acquisition unpalatable to many trade buyers. The larger transactions fall into the latter category (Airbus’s electronic defence division, acquired by KKR).

Finally, some listed companies that are undervalued (often because of liquidity issues or because of lack of attention from the investment community because of their size) sometimes opt for public-to-private (P-to-P) LBOs. In the process, the company is de­listed from the stock exchange. Despite the fact that these transactions are complex to structure and generate high execution risk, they are becoming more and more common thanks to the drop in market values. The LBO on Alliance Boots was the largest worldwide P-to-P in 2007.

3. LBO funds are the equity investors

Setting up an LBO requires specific expertise, and certain investment funds specialise in them. These are called private equity sponsors, because they invest in the equity capital of unlisted companies.

LBOs are particularly risky because of their high gearing. Investors will therefore undoubtedly require high returns. Indeed, required returns are often in the region of 20%–25% p.a. In addition, in order to eliminate diversifiable risk, these specialised investment funds often invest in several LBOs.

In Europe alone, there are over 100 LBO funds in operation. The US and UK LBO markets are more mature than those of Continental Europe. The Asian market is nascent. For this reason, Anglo–Saxon funds such as BC Partners, Blackstone, Carlyle, Cinven, CVC, TPG and KKR dominate the market, particularly when it comes to large transactions. In the meantime, the purely European funds, such as Eurazeo, Industri Kapital and PAI, are holding their own, generally specialising in certain sectors or geographic areas.

To reduce their risk, LBO funds also invest alongside another LBO fund (they form a consortium) or an industrial company (sometimes the seller) with a minority stake. In this case, the industrial company contributes its knowledge of the business and the LBO fund its expertise in financial engineering, the legal framework and taxation.

Most of the private equity sponsors contribute equity for between 40% and 50% of the total financing. Not so long ago, their contribution was between 30% and 40% and sometimes as low as 20%! In order to facilitate the transfer of cash, part of the equity could also take the form of highly subordinated convertible bonds, which will be converted in the event of the company experiencing financial difficulties. Interest on such bonds is tax-deductible.

Materially, LBO funds are organised in the form of a management company (the general partner) that is held by partners who manage funds raised from institutional investors⁴ or high-net-worth individuals (the limited partners). LBO funds then call on the limited partners for the funds that they have committed to bringing, as investments are made.

When a fund has invested more than 75% of the equity it has raised, another fund is launched. Each fund is required to return to investors all of the proceeds of divestments as these are made, and the ultimate aim is for the fund to be liquidated after a given number of years, most of the time 10 years.

The management company, in other words the partners of the LBO funds, is paid on the basis of a percentage of the funds invested (c. 2% of invested funds) and a percentage of the capital gains made (often close to 20% of the capital gain) above a minimum rate of return of 6% to 8% (the hurdle rate), known as carried interest.

Some funds decide to list their shares on the stock market, like Blackstone did in 2007,⁵ while others such as 3i and Wendel are listed for historical reasons.

4. The lenders

For smaller transactions (less than €10m), there is a single bank lender, often the target company’s main bank or a small group of its usual bankers (club deal).

For larger transactions, debt financing is more complex. The LBO fund negotiates the debt structure and conditions with a pool of bankers. Most of the time, bankers propose a financing to all candidates (even the one advising the seller). This is staple financing.

The high degree of financial gearing requires not only traditional bank financing, but also subordinated lending and mezzanine debt, which lie between traditional financing and shareholders’ equity. This results in a four-tier structure: traditional, secured loans called senior debt, to be repaid first; subordinated or junior debt, to be repaid after the senior debt; mezzanine financing, the repayment of which is subordinated to the repayment of the junior and senior debt; and, last in line, shareholders’ equity.

Sometimes, shareholders of the target grant a vendor loan to the LBO fund (part of the price of which payment is deferred) to help finance the transaction. Assets of the target can also be securitised⁶ to raise more financing. Lastly, in the halcyon days of LBOs (2005 till mid-2007), other products were created but they have since disappeared (equity bridge, interim facility agreement, etc.).

(b) Junior or subordinated debt

High-yield bond issues are sometimes used to finance LBOs, but this technique is reserved for the largest transactions so as to ensure sufficient liquidity. In practice the lower limit is around €200m. An advantage of this type of financing is that it carries a bullet repayment and a maturity of seven to ten years. In accordance with the principle of subordination, the bonds are repaid only after the senior debt is repaid.

Given the associated risk, high-yield LBO debt, as the name suggests, offers investors high interest rates, as much as 800 basis points over government bond yields. There has definitely been an upsurge in high-yield bonds used to fund LBOs since late 2009, but this is a window of opportunity that could shut very suddenly in the event of a crisis.

Mezzanine debt also comes under the heading of (deeply) subordinated debt, but is unlisted and provided by specialised funds. As we saw in Chapter 24, certain instruments accommodate this financing need admirably. These “hybrid” securities include convertible bonds, mandatory convertibles, warrants, bonds with warrants attached, etc.

Given the associated risk, investors in mezzanine debt – “mezzaniners” – demand not only a high return, but also a say in management. Accordingly, they are sometimes represented on the board of directors.

Returns on mezzanine debt take three forms: a relatively low interest rate (5%–6%) paid in cash; a deferred interest or payment in kind (PIK) for 5%–8%; and a share in any capital gain when the LBO fund sells its stake.

Most of the time, mezzanine debt is made of bullet bonds⁸ with warrants attached. Mezzanine financing is a true mixture of debt and shareholders’ equity. Indeed, mezzaniners demand returns more akin to the realm of equity investors, around 10% to 14% p.a.

Subordinated and mezzanine debt offer the following advantages:

• they allow the company to lift gearing beyond the level acceptable for bank lending;
• they are longer term than traditional loans and a portion of the higher interest rate is paid through a potential dilution. The holders of mezzanine debt often benefit from call options or warrants on the shares of the holding company;
• they make upstreaming of cash flow from the target company to the holding company more flexible. Mezzanine debt has its own specific terms for repayment, and often for interest payments as well. Payments to holders of mezzanine debt are subordinated to the payments on senior and junior debt;
• they make possible a financing structure that would be impossible by using only equity capital and senior debt.

LBO financing spreads the risk of the project among several types of instruments, from the least risky (senior debt) to the most risky (common shares). The risk profile of each instrument corresponds to the preferences of a different type of investor.

(e) The larger context

Up until the summer of 2007, investors’ increasing appetite for risk meant that they were prepared not only to increase their investments in LBO funds, some of which had funds under management of over $15bn, but also to take out more and more LBO debt, which banks ceded back to them, either directly or indirectly, via CDOs or CLOs.⁹ The role of LBO banks had more or less turned into a role of structuring and distributing funds. This is how a typical LBO structure changed:

Up until 2007, the prices of the target companies acquired under LBOs rose in comparison to their EBITDA prices picked up again in 2014-2016:

5. The managers of a company under an LBO

The managers of a company under an LBO may be the historical managers of the company or new managers appointed by the LBO fund. Regardless of their background, they are responsible for implementing a clearly defined business plan that was drawn up with the LBO fund when it took over the target. The business plan makes provision for operational improvements, investment plans and/or disposals, with a focus on cash generation because, as the reader is no doubt aware, cash is what is needed for paying back debts!

LBO funds tend to ask managers to invest large amounts of their own cash in the company, and even to take out loans to be able to do so, in order to ensure that management’s interests are closely aligned with those of the fund. Investments could be in the form of warrants, convertible bonds or shares, providing managers with a second leverage effect, which, if the business plan bears fruit, will result in a five- to 10-fold or even greater increase in their investment. On the other hand, if the business plan fails, they will lose everything. So, only in the event of success will the management team get a partial share of the capital gains and a higher IRR on its investment than that of the LBO funds. This arrangement is known as the management incentive package.

In some cases, following several successful LBOs, the management team can, as a result of this highly motivating remuneration scheme, take control of the company,¹⁰ having seen its initial stake multiplied several times.