IN THIS CHAPTER
Seeing how leveraged buyouts are structured
Distinguishing between the different forms of debt in a leveraged buyout
Understanding seniority and maturity concepts in leveraged buyout deals
Constructing a leveraged buyout model from start to finish
Investment bankers earn their keep by helping client firms make fundamental changes in their structures and operations. Advising firms on the process of structuring leveraged buyouts (LBOs) is an important tool in the investment banker’s toolbox.
Leveraged buyouts are deals in which a buyer borrows money (usually a large sum) and uses that money to purchase a target. LBOs are favorite tools by investment bankers and other financial wizards because the returns can be enormous. When you buy another company using borrowed money, the income generated relative to the amount of cash you put at risk can be very large.
Investment bankers also love LBOs because they’re tricky deals with lots of moving parts. Companies that want to do LBOs may not have the expertise in all the areas needed to pull off a successful LBO, ranging from borrowing money, lining up investors, measuring a company’s cash flow and convincing the target company to sell. Investment bankers have the expertise in many of those areas to help (and, of course, charge fees along the way).
You can discover what LBOs are for and how investment banking plays a big role in them in Chapter 5. We dive deeper into LBOs in this chapter, filling you in on some of the nuances that make them so lucrative. You discover how different types of debt can be used in LBOs to make them be successful. You see how debt can be structured in different ways to make LBOs pay off. Finally, you get a front-row seat to how investment bankers put LBOs together.
As the name suggests, the structure of an LBO is predicated on debt, debt, and more debt. The primary reason for all this debt is that the interest payments on debt are tax-deductible expenses and reduce a company’s tax bill, while dividend payments to shareholders are not tax-deductible payments. If the reconstituted firm can use the debt wisely, it can create a lot of value for its equity holders (the investors who put their money into a deal, which will be combined with borrowed money to buy the target), and the private equity sponsor (the company that accumulates investment dollars from investors to be used to buy out firms) can earn a very healthy rate of return on its invested capital (the total amount of debt and equity plowed into the buyout price of the deal).
LBOs are structured using several different types of financing, including bank debt (both revolving and traditional debt), junk bonds, mezzanine financing, and good old-fashioned equity. We cover all these forms of financing in this section.
LBOs are generally financed with two different kinds of bank debt: revolving credit and traditional term loans. Nearly all LBOs will contain both kinds of bank debt in the firm after it has been recapitalized or injected with the investment dollars of the equity investors and the debt borrowed from lenders.
Revolving credit for a firm functions just like a credit card for an individual. Credit cards for consumers are not meant to buy large-ticket items, like houses, but to be a way to pay for day-to-day costs and repaid quickly, like at the end of the month. Similarly, a company’s revolving credit is not to be a permanent source of funds — to purchase assets such as plant and equipment — but is a source of funds for temporary working capital needs. One common use for revolving credit is to purchase inventories or raw materials. The revolving credit line is accessed when the funds are needed and then is paid down when cash is available.
Unlike credit card debt for individuals, revolving credit is the cheapest form of capital for a firm and is usually issued at a floating rate, such as the prime rate plus a certain percentage. The prime rate is the rate that commercial banks charge their very best customers.
Most traditional term loans are similar to loans many of us have on our cars and homes. If you own a house, you probably borrowed from a bank or mortgage lender with the agreement that you’d pay the money back in a set number of years. Similarly with traditional term loans, money is loaned to the company for a specific time period — the term — and the loan is paid back over the term of the loan in equal payments on a periodic basis (generally quarterly).
The payments throughout the life of the loan are the same size, and a portion of each payment represents interest on the loan plus a repayment of principal. The process whereby a term loan is paid down via equal payments is called amortization. Early payments on an amortized loan have a higher portion that represents interest. As the amount of the loan gets paid down, the portion representing interest declines and the portion representing principal increases.
Some term loans, however, are structured differently and may require the firm to pay only interest on the loan during the term of the loan and pay the principal back in the form of a large payment — a bullet payment — at the end of the term.
Bank term loans often carry various restrictive covenants (contractual terms that limit the actions of the firm; see Chapter 11). Covenants are intended to increase the probability that the bank loans will be paid back in full. Typical covenants restrict the ability of the firm to make additional acquisitions, to take on debt beyond a certain level, and to make dividend payments to shareholders. The whole idea behind covenants is to preserve cash flow so that the bank will be paid back. But covenants restrict the options available to management and can inhibit the ability of the firm to pursue some profitable strategies.
LBOs became extremely popular in the 1980s, and this popularity was driven by the development of the junk bond market. As the name screams out, junk bonds are bonds of lesser quality than the typical class of bonds that investors like to invest in, referred to as investment-grade bonds.
The difference between junk bonds and investment-grade bonds simply has to do with the perceived quality of the issuer, measured in part by the bonds’ ratings. Bond rating agencies — such as Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings — assign ratings to bonds just like teachers assign letter grades to students. Bond ratings range from AAA (the highest rating) down to C and D, which refer to bonds that are already in default on some of their payments.
The purpose of bond ratings is to provide investors with an idea of the creditworthiness, or the risk of the bond. Creditworthiness refers to how likely the lender is to receive his promised interest and principal payments. Like teachers’ grades, bond ratings are driven by both quantitative and qualitative considerations. Also, like teachers’ grades, bond ratings are extremely important. For instance, some institutional investors are only allowed to invest in investment-grade bonds and are prohibited from investing in junk bonds. In fact, if they hold a bond that is downgraded (or the rating is lowered) from investment grade to below investment grade or junk status, they must sell that bond from their holdings, even if it’s at a sizeable loss.
Although some individual investors invest in junk bonds, the market is dominated by large institutional investors such as mutual funds, foundations, and endowments. The analytical sophistication necessary to successfully identify junk bond investments is beyond the expertise of most individual investors. However, individual investors often invest in the junk bond markets through high-yield bond funds. They let the experts pick junk bonds and invest in a diversified portfolio of them.
The junk bond market is generally only accessible to those LBOs that are large in scope — that is, companies with market capitalizations in the high hundreds of millions of dollars or over a billion dollars. Smaller LBOs tend to be financed with mezzanine debt, described in the next section.
Just like the mezzanine level of a theater is between the main floor and the balcony, mezzanine debt is a form of financing that is between traditional debt and equity. In fact, mezzanine debt has attributes of both debt and equity and is often referred to as a hybrid form of financing. It’s very popular with LBOs that are in the middle-capitalization range (below $1 billion) — restructurings that are too small to have access to the junk bond market.
Mezzanine debt is typically structured as intermediate term debt — perhaps three to five years. Mezzanine debt usually has an equity kicker or equity sweetener. What this means is that the bonds will come with warrants attached in order to make them more attractive to the purchaser. A warrant is simply the right to buy a specific number of shares of the company’s stock at a predetermined price for a specified period of time. For example, a warrant may be issued that allows the holder to buy a share of stock in a company over the next three years at a price of $10 per share.
Warrants give the bondholder a great deal of upside potential and allow the bondholder to participate like a stockholder if the company is successful. The other advantage to warrants is that the holder has the right to either exercise the warrants (and buy the stock) or sell the warrants to someone else. Either way, the warrant holder can realize the value of the warrants. The warrants are also detachable, meaning the holder can sell the warrants and still retain the debt.
As you can see, mezzanine debt really does represent a middle ground between debt and equity. It has the characteristics of traditional debt, because the holders of mezzanine debt receive periodic interest payments. Yet, it has the characteristics of stock, because the holders of mezzanine debt can participate in the growth in the value of the firm through exercising their warrants and becoming stockholders.
Typical investors in mezzanine debt are large institutional investors such as insurance companies, commercial banks, mezzanine debt funds, and other private equity firms. But unlike investing in the equity of a typical LBO, this form of investment is passive, because the private equity firms buying mezzanine debt don’t take a management role in the restructuring of the company or in its operations going forward.
Mezzanine financing has some unique characteristics, including the following:
At the bottom of the capital structure, under this large mound of debt, are the equity holders (or stockholders). These individuals own the company and are entitled to the returns of the company only after all the debt holders’ claims have been satisfied in full. Typically, most of the equity is held by the private equity partnership — the firm that sponsored the LBO and put the deal together. A minority portion of the equity may be held by the management of the firm in an effort to properly incentivize the management to do what’s in the best interest of the equity holders, because they’re equity holders.
LBO equity is typically held by private equity firms — both by the limited partners and the general partners. The typical investors in private equity partnerships are the usual institutional investors — pension funds, endowments, insurance companies, and funds of funds. But limited partnership shares are also held by wealthy and ultra-high-net worth individual investors. Because the risk of equity in LBO deals is quite high, these investors typically diversify their investments by purchasing stakes in many LBO deals.
Seniority and maturity are extremely important concepts when it comes to the suppliers of capital in an LBO. Seniority is where the provider of funds stands in the line of priority with regard to being paid (see Chapter 11). Like any line — well, other than the line to be drafted into the military or the line to be audited by the IRS — you want to be close to the front of the line. And in terms of supplying capital to LBOs, that principle is no different.
Another critical aspect of understanding the way debt comes into play with LBOs is maturity. Maturity refers to when the debt comes due and needs to be paid back. As was indicated earlier, a revolving credit line never matures, but it’s expected that it will be periodically paid down. That is, the amount of revolving credit will vary across time for the typical firm.
Term loans issued in LBO transactions typically have maturities between four and eight years. Junk bonds issued to fund LBO transactions typically have maturities that are longer than term loans but shorter than investment-grade bonds. At the time of issue, original-issue junk bonds typically have maturities between five and ten years. This contrasts with investment-grade bonds that are typically issued with much longer maturities — up to 30 years. Equity has no maturity and is, in essence, a perpetual claim.
Now, just because a particular form of debt has a specific maturity does not mean that the debt will be in existence until the maturity date. For instance, much like mortgage loans for individuals, term loans typically have no prepayment penalties — the company can retire the debt before maturity without incurring a penalty. On the other hand, junk bonds typically don’t allow the company to pay them off early. That is an advantage for junk bond holders, because issuers generally want to pay off debt early only if the cost of debt (the interest rate) has gone down. Akin to the situation with an individual and a home mortgage, refinancing filings generally take place when interest rates have fallen and the individual can obtain a less expensive mortgage.
The entire point of the LBO is to construct the investment so that the equity holders earn large returns on their investments by using high levels of debt to leverage (or magnify) these returns. In essence, the equity holders are using “other peoples’ money” to increase their returns.
This story of leverage should sound familiar, because it’s used in any number of contexts in the world of finance — both in corporate and personal finance. Leverage is great when it works, because it amplifies the returns that an investor can earn. It seems we’ve all heard from the braggart who bought his house with 5 percent down, effectively being leveraged 19 to 1. When the price of the house doubled, his return was tremendous. But leverage also can amplify losses, and the experience of the financial crisis reinforced this notion in a very painful way for many homeowners who purchased homes, only to find that a scant few months or years later the home was worth substantially less than the mortgage they owed.
Investment bankers build LBO models based upon pro forma cash flow statements. Pro forma simply means “for the sake of form” and refers to cash flow statements that are projected to be realized if things go as expected. These should not be best-case scenarios — if everything goes perfectly. Instead, they should represent models that project cash flows if things go as they likely will. As emphasized throughout this book, conservatism in projecting cash flows is a terrific quality for an investment banker and leads to more satisfied clients and investors. But, too often, investment bankers get overly zealous with their projections and make unrealistic assumptions that are likely to lead to disappointing results.
The first step in an LBO analysis is to project the cash flows of the firm over the expected time frame of the LBO — generally six to eight years. The specific cash flow definition generally used in the LBO market is earnings before interest, taxes, depreciation, and amortization (EBITDA).
LBOs are high-risk, high-return operations. Investors too often fixate on the enormous returns they might enjoy if everything works out according to plan. But in business, things don’t always work the way they’re supposed to.
The risk of an LBO refers to the variability or volatility of the EBITDA projections and how likely they are to be reached. The less variability in the EBITDA projections — that is, the more certain the analyst is that there won’t be negative surprises in EBITDA in the foreseeable future — the higher the multiples of EBITDA that the LBO will support. That is why simple businesses with stable cash flows (such as firms that produce consumer staples like food) are the best targets for LBOs, because their cash flows are more stable and less vulnerable to surprises due to downturns in the economy or technological innovations.
Some markets are simply better for LBOs than others. When credit conditions are loose and the risk appetite of market participants is strong, the multiples of EBITDA that an LBO will support expand, and it’s an opportune time for private equity sponsors to participate in the LBO market. Investment bankers often refer to these kinds of markets as “easy money” periods. Alternatively, when credit conditions tighten and the risk appetite of market participants is weak, it’s a poor time for private equity sponsors to participate in the LBO market.
Market conditions can make a huge difference in the level of debt that an LBO deal will support. For example, according to S&P Capital IQ, during the fourth quarter of 2009, the average leverage of large corporate LBOs was slightly less than four times EBITDA. In the third quarter of 2012, the average leverage of LBOs expanded to nearly six times EBITDA. Over less than a three-year time period, the amount of debt supported by large corporate LBOs had expanded by nearly 50 percent! Now, remember, these numbers are averages. Some deals command much higher multiples based upon the specific circumstances of the firm. However, timing related to market conditions is extremely important when considering an LBO. At the time of the writing of this book in late 2019, the average leverage was six times EBITDA. The last time the multiple went over six times EBITDA was in 2007, and we all know what transpired then.
As you may expect, there is a direct relationship between how attractive the market values LBOs and the volume of LBOs that are brought to market. Given poor market conditions, the volume of LBOs fell substantially in 2009, because the terms of LBOs were simply not attractive. Volume has picked up as the multiples of EBITDA have increased, but LBO volume as of this writing still had not returned to the pre–financial crisis levels of 2006 and 2007.
When constructing an LBO deal, analysts will consider market conditions to determine just how much debt they think the market will support. Investment bankers want to construct a deal that maximizes the amount of debt capital and minimizes the amount of equity capital, while still putting together a package that will ensure the long-term success of the firm. After all, if the firm can’t generate sufficient cash flow and survive over the long run, the equity holders will lose because their positions will ultimately be worthless.
Let’s assume that market conditions are fairly good and will support a total debt to EBITDA multiple of six times. Let’s also assume that our crackerjack investment banking analysts have crunched the numbers and that the EBITDA level of our target firm is $300 million annually. This means that the total debt supported by the market for our hypothetical deal is likely to be in the range of $1.8 billion.
Now, it’s very likely that the debt that is issued in this LBO will be of different varieties. A typical LBO structure may have 50 percent to 60 percent of the debt consisting of term bank loans and a revolving credit commitment and the other 40 percent to 50 percent consisting of mezzanine debt (because this hypothetical transaction would be awfully small for the junk bond market).
Thus, our LBO capital structure might look like the following:
Revolving credit agreement (LIBOR plus 2%)
Five-year term loan at 8%
So what does $2.25 billion buy you? Well, in our example, it buys you an income stream of $300 million annually in EBITDA. That is, the LBO sponsor paid a total of $2.25 billion for the cash flows of the target firm that are estimated to be $300 million annually. Now, we’ve really simplified things here by assuming that EBITDA stays constant for the foreseeable future at $300 million, but in all likelihood, that number will expand over time. Let’s assume that over the next five years our firm can completely pay down the five-year term loan from cash flow. And that is generally what happens in LBOs — in the first few years nearly all the cash flows are used to pay down the debt. Given our assumptions, how much will our equity holders have earned on their investment?
The basis of all LBO transactions is quite simple. If, after taxes, the private equity sponsor can earn more on borrowed funds than those borrowed funds cost them, it pays to use leverage. If that isn’t the case, then leverage doesn’t pay. But the key point to remember is that the tax code encourages lending as interest payments are tax deductible. If a firm is in a marginal corporate tax bracket of 21 percent, the effective after-tax cost of debt with an 8 percent interest rate is not 8 percent. Instead, it’s 8 percent × (1 – 0.21) = 6.32 percent. So Uncle Sam encourages firms to borrow rather than to raise equity.
Our example is very simplistic, but a couple of very significant developments can take place to make our LBO much more attractive. An LBO is a moving target — the company that’s refinanced is changing, morphing, and hopefully growing. There are a few considerations investment bankers must consider when thinking about what can go right with an LBO, including the following:
Circumstances can go against an LBO, too, and spell trouble for a deal. Some potential problem spots for LBOs include the following: