Why Leveraged Buyout as a Deal Structure will not work for Digital acquisitions?

Introduction

• Leveraged Buyouts still continue to be the most preferred deal making structure for PE and other financial acquirers. This can be partly explained by the low cost of debt available due to the low interest rates and with equity rates at all time high.
• When we look at M&A happening in Technology space; the huge valuations is due to the increasing competition to buy these assets between strategic and financial acquirers.

What is a Leveraged Buyout?

• A leveraged buyout is a deal structure generally followed by Private Equity firms to acquire companies by using debt as a major consideration.The debt to equity structure will be between 70 to 30.
• The equity invested by Private Equity will come from the dry powder available in the funds created along with Limited partners.
• The most interesting part here would be that the debt would taken between the target company and the borrower and assets of the target company would be used as a collateral.

The benefits for PE firms with these deals would be:

• The amount of money that needs to be invested by them is very low.
• There is significant low risk for the PE firms incase the acquisition does not generate projected returns.If the cash flows generated by target company is less than the interest payments that is needed to be paid, then the bank can liquidate the assets of the target company to recover its investment.In such cases the target company files for bankruptcy and assets are liquidated.
• In case if the returns or IRR generated by this acquisition is very high, then the PE firm makes a high return on its investment after paying the debt holders. At the lower investment, a PE firm can generate higher IRR returns.
• As the capital structure of LBO is 80% debt and 20% equity, one also needs to take into account the types of debt that will be employed for the transaction as not all debts are treated equal.
• Generally the debt payout will have multiple tranches ranging from revolving credit loan to bank term loan to subordinated debt to junk bonds.As we go down the tranches, the debt yield will be high but generally most of these are not secured loans when compared to a bank loan.In some cases, the PE firms in order to raise more capital will also entice investors that their bonds are convertible to equity in future in order to get the projected high return.
• The reason why so many tranches are required is because banks would not be able to sponsor all debt especially when it feels that the target company is risky and may not be able to generate enough cash flows to return their interest payments.Hence PE firms search for other ways to raise debt.In many cases PE firms themselves credit such transactions under their Private Credits investments group where they generally look at return of 10-12% on the credit.
• As target company acquired should able to generate cash flows to service interest payments, it is important that the right target company is selected.Generally such target companies who are candidates for a LBO would be matured businesses with steady cash flows that are under valued and with low requirement of working capital or additional CAPEX investments.For example, Dell was taken private through a Leveraged Buyout.

Why do Target companies agree for a LBO?

• The big question is why would a target company be interested to get into a LBO especially when it knows that its assets are used as a collateral for raising debt and there is a possibility for the company to get bankrupt if it is not able to repay high interest payments from its cashflows.
• Generally most of the companies who agree for a LBO are Public listed companies who wants to go private.The reason why they want to go private is that they want to transform their business and this is not possible when they are constantly under the scrutiny and pressure of shareholders.Any consequence of their decision going wrong would lead to a crash in their stock prices.In addition these companies might also be looking to restructure their businesses by spinning off its assets which they think are no longer going to be core to their future.Any such decision would take a lot of time, costs and approvals from shareholders. So these company look for PE firms to buy over the stake of their shareholders for them to operate independently. At the same time, the Management of these business would be confident on the fundamentals of the business and a scope exists in adding value to the business and increasing EBITDA by reducing costs or selling non core assets to service interest payments of debt taken.
• One important caution that needs to be exercised is that the Purchase price should not be very high as this cause an undue stress on Target company to generate huge cash flows commensurate to the interest payments.
• The holding period of LBO are generally 5-8 years and by that time, significant turnaround should be possible to unlock value and increase cash flows.After the holding period, the PE firms can either exit the target company at higher multiple through an IPO or sell to other PE firms and cash out their investments

Why LBO deal structure cannot be successful for new digital companies?

• Most of these new digital and technology companies forecast huge revenue growth projections at the cost of margins.Hence the cashflows generated is negative and hence it would be difficult for them to repay their interest payments.
• In such cases, banks would not give loans to PE firms to raise debt. Hence the PE firms needs to look at subordinated debts or mezzanine debts to fund such transactions. These debts that are structured as junk bonds come at high yield rates but they do not expect regular interest or coupon payments on their investments like banks.The repayment structure would be more of bullet payment where most of the repayment happens at maturity.
• Due to the low interest rates and booming stock markets, the PE firms rely on the demand for technology offerings, booming GDP and the growth projections of the target company to fund their investments.The valuation is on the revenue multiples rather than EBITDA multiple.
• The PE firm is confident that they can exit the investment either by selling the asset at higher multiple to PE firms or corporate acquirers or even take them to IPO.
• It is not possible for technology firms to continue to grow at high rates.If these are SaaS companies then their subscription revenues and profits are a major indicator for investment.These companies would have a dip in their growth rates which could have a ripple effect on the lenders who have financed such deal.A systemic crash on the growth rate of Technology companies have the possibility to fuel a slowdown or crash as seen in dotcom bubble.

Conclusion

• Using LBO as a deal structure by PE firms for new age technology and digital firms may not work as these companies are valued on their revenue growth rather than cashflows.
• The assumption by PE companies that these assets can be sold at higher exit multiples need not work always and any correction in their growth rates that are company or macroeconomic specific will lead to a systemic crash similar to a dotcom bubble and crash.