Bank debt

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.

Junk bonds

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.

There is rampant grade inflation with bond ratings, just as there is grade inflation in colleges and universities. A letter grade of C is not “average” in either context. Investment grade bonds have ratings that are BBB– or higher by Standard & Poor’s and Baa3 or higher by Moody’s. Junk bonds are those bonds that are below investment grade. So a bond is either considered investment grade or junk. It seems that both bonds and college students all exist in Lake Wobegon, where everyone is above average.

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.

Just as many people feel teachers often are wrong with the grades they assign to students, credit agencies can be way off on their ratings. The financial crisis witnessed many investment-grade securities — many even rated AAA — failing and bondholders left with investments that were worth fractions of what they paid for them. Many investors learned the hard way that bond ratings are only one bit of information and they shouldn’t substitute bond ratings for careful due diligence on behalf of the investor.

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.

Mezzanine debt

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 are usually underwater when they’re issued, meaning that the current stock price is below the predetermined price (known as the exercise price). For instance, in our example, the current stock price might be $7 per share, and the exercise price of the warrants is $10 per share. It would not pay the holder to exercise their warrant and buy the stock today for $10, because they can purchase the shares without using the warrant for $7. But what happens if the company is very successful and the stock price rises dramatically? The warrants will become extremely valuable. Let’s say our company’s stock price rises from $7 to $21 in three years. The holder of the warrant would have the right to buy a share of stock that is worth $21 at a price of $10 — these warrants are very valuable because they’re $11 in-the-money (the stock price is above the exercise price). In our example, what this implies is that, upon exercise, the warrant holder will realize a gain of $11.

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.

The benefit to the company of issuing mezzanine debt with warrants attached is that they can issue that debt at a much lower interest rate than other debt that didn’t have warrants attached. Investors in mezzanine debt may be looking for annual returns in the 20 percent range. The bonds may be issued with an interest of only 8 percent. The other 12 percent return may come in the form of the value of the warrants. This type of financing also preserves precious cash flow for the firm. If the firm can limit the amount of cash that needs to be spent to make the interest and principal payments on the debt, it will help the cash flow of the firm. If the firm really wants to preserve cash, it will issue debt at a lower interest rate and attach more warrants. The more warrants attached to the debt, all else equal, the lower the interest rate that investors will be willing to accept on the debt.

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:

• How it’s negotiated: Unlike junk bonds, the terms of mezzanine financing are generally negotiated between the issuing firm and the purchasers.
• The difficulty of selling: Mezzanine debt is more difficult to sell than some other types of debt. It’s much less marketable than junk bonds, and it’s generally held to maturity by the entity originally acquiring the debt. If mezzanine debt is sold, it’s done in a private negotiation and typically involves significant price concessions on behalf of the seller.
• The connection with the LBO sponsor: A portion of the mezzanine financing is typically provided by the same private equity company sponsoring the LBO.
• Lower rights: Like junk bonds, mezzanine debt has lower seniority than traditional bank debt. In terms of claims to the assets of the firm, the holders of mezzanine debt stand in the claims line behind banks providing financing but in front of equity holders. Thus, the claims of mezzanine debt holders are subordinated (or below) the claims of other, more traditional debt holders. Mezzanine debt holders truly do have seats in the mezzanine of the theater of claims.

Equity

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.

Expected returns to equity holders in LBO transactions are quite high — higher than all debt holders to compensate equity holders for their place in the claims line. In the theater of claims, equity holders have seats high in the balcony.

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.

Risk of the LBO

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.

Market conditions

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.

In the wake of the financial crisis of 2008 and 2009, the LBO market basically disappeared for a period of time due to “tight money” and the freezing of the credit markets. Firms that had LBOs planned around the time of the outbreak of the credit crisis had to cancel their plans because credit was simply not available.

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.

An LBO that never happened shook the financial world in 2018 when CEO Elon Musk suggested in a tweet that he wanted to take Tesla private and had secured the funding for the transaction. The tweet initially boosted the Tesla stock price but also drew the ire of the U.S. Securities and Exchange Commission. The SEC accused Musk of securities fraud, and his settlement agreement removed him from his chairman role with the company.