Leveraged Buyouts and Private Equity Financing
Leveraged Buyout is a commonly used deal structure used by Private Equity firms or firms’ management by taking the firm private and financing the transaction through leverage. Anyone who has worked in Private Equity or acquired a portfolio company or PE firm would have dealt with LBO deals. At the start of my career, I was fortunate to get involved in a leveraged buyout deal which helped me understand the contours of this deal structure and how it can help the buyer/PE firm drive returns. In this post, I give my insights on the characteristics of an LBO, what makes a leveraged buyout deal successful, and why many LBO transactions have recently failed. Finally, I will take an example of a fictitious company to help understand how an LBO transaction works, if correctly structured, can deliver multi-bagger returns to its investors.
Characteristics Of A Good LBO Target
What makes a target a good LBO candidate?
A firm with stable cash operating in a matured industry with low Debt and high cash reserves is a classic LBO target. In this post, I am considering a firm, Autocar, operating in the auto parts business. Most revenues come from providing spare parts to the dealers rather than the auto OEMs. Moreover, the replacement parts business is less cyclical than the OEM business because the latter depends on manufacturing new cars, which in turn depends on the economy. Thus, Autocar had secure and stable cash flows.
The founders of Autocar were driving reasonable compensation, and as the firm was listed publically, the firm traded at 7.3x trailing earnings. However, with its predictable cash flows and low capital expenditure (due to slow growth), Autocar accumulated substantial cash reserves. The founders were in a quandary on deploying this excess cash.
The founders can deploy this excess cash by:
- Paying down Debt, but as Autocar already had low Debt, this option is not good.
- Pay more dividends; this option is good as higher dividend payouts will increase their stock prices.
- Autocar can buy back stock, and this option is good as the firm’s stock price traded below the fair value.
- Autocar can invest organically by opening new stores, expanding to new locations, or acquiring competitors by looking at M&A.
However, an investment banker tracking Autocar believed it was an ideal LBO target. The investment banker went to the private equity firm because it didn’t have funds on its own to finance this transaction. One of the reasons behind the success of PE firms is their access to cash from LPs, the ability to raise cash at low-interest rates and then deploy it in suitable investments that yield a return that exceeds the cost of capital. Moreover, private equity firms had operating partners with domain competencies and management experience that helped their portfolio companies turn around their business operations.
LBO Deal Structure
How will the Autocar LBO deal work?
Autocar trades at 25.38 per share. The PE firms value Autocar intrinsically at 38 per share at a premium of 50%.
Autocar’s Outstanding shares = 11.78 million
Market cap = (11.78*25.38) = 299 million
Price to payout equity investors = 11.78*38 = 447 million
The founders had share options, and the PE firm had to accelerate these options to vest and paid 10.1 million to buy out these options.
Transaction fees paid to bankers and independent valuers = 10 million.
Purchase price = 447+10.1+10 = 467.8 million.
When acquiring a public firm, acquirers go to an independent banker to arrive at the fair opinion of the target to ensure that they pay the target firm its fair value and to avoid future shareholder lawsuits. The investor paid 3 million to the independent appraiser, and I have included this payment in the transaction fees.
The Private equity firm creates a shell (“Newco”) jointly owned by the PE firm, investment banker and the founders of Autocar.
Funding for this deal was as follows:
Raising Bank Debt = 125 million at 14% interest
Senior Notes (Credit rating of B+) = 113.6 million at 11.25%
Junior notes (credit rating of B-) = 89.8 million at 12.25%
Total Debt = 125+113.6+89.8 = 328.4 million
Preferred Equity (13.5% dividend yield) = 26.2 million
Common equity = 25 million
Total Equity = 51.2 million
Total Financing = 51.2+328.4 = 379.6 million
The investors used Strip financing to fund this transaction. Strip financing is a technique where investors buy a strip of multiple securities (debt, equity and preferred stock) simultaneously. Here, the PE firm used strip financing as follows:
- Senior Notes (Credit rating of B+) = 113.6 million at 11.25%
- Junior notes (credit rating of B-) = 89.8 million at 12.25%
- Preferred Equity (13.5% dividend yield) = 26.2 million
- Common stock = 16.5 million
Thus, the PE firm held 66% (16.5/25) of the equity. The bankers bought 4.5 million equity, and the founders paid 4 million. This 4 million came from 10.1 million management options the PE firm paid to the founders.
The purchase price is at 467.6 million, but the investors raised 379.6 million because Autocar’s cash reserves came from the balance. Autocar, in its balance sheet, has 130 million cash reserves and the investors used 88.2 million to fund the difference.
Let us look at Autocar’s Balance sheet.
Cash = 130 million
Financing from Investors = 379.6 million
Total Funds = 509.6 million
Purchase price = 467.6 million
The NewCo owned the difference of (509.6–467.6 = 41.8 million) cash. The Newco gave 447.8 million to Autocar’s equity investors and dissolved Autocar.
The effective price investors paid to acquire Autocar is 32.22/share (379.6/11.78) instead of 38/share, as they used Autocar’s cash reserves to fund the remaining amount.
Before LBO, Autocar’s balance sheet looked as follows:
Debt = 15.4 million
Equity = 187.5 million
Debt to Capital ratio = 7.6%
After LBO, the following changes happened in Autocar’s balance sheet:
Addition of 328.4 million debt (loan from bank + senior notes +Junior notes) to existing 15.4 million = 343.8 million
Equity = Common equity (25) + preferred stock (26.2) = 51.2 million
Debt to capital ratio after LBO = 87% (343.8/343.8+51.2)
Thus the firm’s leverage increased from 7.6% (before LBO) to 87% (after LBO).
Whenever the firm increases leverage, it can use interest payments to reduce taxes, as interest payments are tax deductible. However, high leverage also exposes firms to default risk as the debt holders can force the firm to bankruptcy when they default on their interest payments. Although Autocar’s cash flows are predictable, a high leverage ratio exposes them to bankruptcy risk.
However, in this transaction, the PE firm held 203.4 million Debt, whereas the Bank provided 125 million Debt. Thus, the PE firm held 59% of the outstanding Debt and 66% of the equity. Thus, if Autocar defaults on interest payments, there is no way the PE firm can force it to bankruptcy because by doing that, it will hurt itself. Thus, the effective Debt that Autocar owned is bank debt and existing Debt before LBO (125+15.4), reducing the overall firm’s debt ratio from 87% to 35%. However, the PE firm can avail of tax reductions on its loan to Autocar.
Thus, this deal structure reduced the bankruptcy risk and helped investors save taxes. Further, as the investors acquired 100% assets of Autocar, they can step up the assets to their market value and then depreciate them. As tax authorities allow firms for accelerated depreciation, the combination of depreciation and interest payments meant that the investors did not pay any taxes five years after LBO.
Before LBO, Autocar paid 47 million in taxes; however, after LBO, they paid 5 million in taxes.
Further, despite the Debt issued by the PE firms being subordinate to senior Debt issued by Bank, the interest rates are lower than a bank loan because these are not Debt. As PE firms held equity, they did not demand a higher interest rate than a bank loan. However, if the PE firm doesn’t hold any equity, it will demand a higher interest rate than the bank loan resulting in lower earnings.
Thus, what LBO achieved was swapping public equity investors with private ones using a brilliant financing structure where it was able to get tax savings but at the same time didn’t face bankruptcy risk.
Value Creation From LBO
Before LBO, Autocar’s share price = 25.38
Market Cap = 299 million
Share price = 38
Premium paid = 50%
The investors paid a 50% premium for a firm with the same management, no additional synergies after the deal, and no additional sales growth.
Where was the value creation?
Investors paid lower taxes because of the combination of depreciation (caused by higher asset value post LBO) and interest payments (Debt to fund the LBO).
In 5 years, the investors could not use tax shields (as Debt was reduced), and they depreciated their assets. When investors repaid the Debt, they now owned the entire firm.
LBOs look complex (different types of Debt, preferred stock, etc.), but it is not.
Why? So that it qualifies as Debt for tax purposes even though the default risk is low. The reality of the financing is that the strips are technically Debt but are more like equity. Thus the PE firm structured the deal with senior debt, subordinated debt, junior debt, preferred stock, and so on.
Returns For Equity Investors
Now, with investors repaying all their Debt, let us look at the return for the equity investors.
The logical step for the equity holders is to take the firm back to the public by filing an IPO.
After LBO, the equity holders had 25 million.
After five years, Autocar’s Net Income = 46 million. Autocar’s predictable cash flows helped the PE firm to service debt. In addition, the PE firm’s operating expertise improved Autocar’s cost structure, improving operating cash flows.
Assuming that Autocar’s earnings multiple = 7.3x as before
Market price = 46*7.3 = 340.9 million
A 5-year holding translates to 69% CAGR for equity investors.
The PE firm, with 59% debt and 66% equity, generated 455 million with this investment giving it a 13.2% CAGR for five years. In addition, the PE firm received interest payments and dividends for these five years. When we combine these, the IRR for the PE firm is 23%.
Why have Recent LBOs failed?
The LBO deal gave the PE firm and its management a windfall. However, we see many recent LBOs fail.
What are the reasons?
- Identifying the LBO target is crucial. If the target has volatile cash flows, it cannot service the debt payments.
- As the LBO model became famous, more PE firms funded through this structure, increasing the demand for LBOs. At cheaper interest rates, the PE firms overpay to acquire the target. When that happens, investors need to raise additional debt to fund the deal resulting in lower returns.
- The tax structure also has changed with the IRS demanding seller pay taxes for depreciation when it sells the business or takes it public. Thus, tax savings due to depreciation no longer applies, which can further lower their returns.
Leveraged buyout deals are an excellent way to structure transactions using the miracles of modern finance to generate higher returns. However, for LBO to be a success, the following are essential.
- The PE firm has to identify a target with low Debt operating in a matured sector with predictable cash flows and high cash reserves. As the business risk is low, the firm can afford to add financial leverage to improve its value.
- Investors using Strip financing (a combination of Debt and equity) to finance this deal effectively helps in tax savings and reduces the bankruptcy risk. Recently, many investors have used tier financing by raising Debt in the junk market and raising interest rates. As junk markets are senior to equity, they can force the firm to bankruptcy when they do not receive their coupon payments.
- Quality of management is crucial. The management holds equity in LBO and has an additional incentive to run the firm effectively as they also are the stockholders. This incentive helps them to run the business effectively.
- As LBO target operates in matured businesses, investors can sell some of these assets to raise capital to repay the Debt. This option for the PE firm to break the business and divest non-core assets to raise cash helps them to generate higher returns.