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What is LBO Financing?
In an LBO transaction, a private equity firm acquires a company or part of a company by investing a small amount of equity and majorly using leverage or debt to fund the remainder of the consideration. To finance an LBO, private equity firm primarily uses borrowed money to meet the cost of acquisition. The Private Equity firm uses debt to lift its returns. Using more leverage means that the PE firm will earn a higher return on its investment.
LBO Financing is a tough job. Even if on the surface, it looks easy, private equity funds need to go extra miles to finance an LBO transaction. In this article, we will look at the various options the private equity firms have for such LBO financing.
Top 6 Strategies for LBO Financing
When private equity invests in an LBO, it needs to put in a lot of borrowed money. Let’s have a look at how private equity firm finances an LBO.
#1 – Seller Financing
This LBO Financing strategy is often seen when the seller is pretty much interested in making the sale. That’s why the seller can be convinced to extend a loan which can be amortized over the years. Seller financing is also very helpful for the buyer because the buyer gets the comfort of paying off the debt when enough money flows into the business.
#2 – Equipment financing:
This is another form of LBO financing which is being used by the buyer. If the company own any equipment which are free and there is no way this equipment will be used in future, then part of the purchase price can be using this equipment. Moreover, if the equipment has equity that can be financed too.
#3 – Own funds:
In this kind of LBO Financing, the private equity invests 30% to 50% of the money in equity, meaning its own money. And the rest of the money is borrowed, meaning a form of debt. Now the percentage differs on the basis of a deal and also on the market conditions at a given time. However, almost every LBO falls in the range between 30% and 50%. Private equity borrowed debts from separate lenders and it is usually 50% to 70%.
#4 – Senior debt:
If as a private equity firm, you take senior debt, you need to rank it first; because before anything (all debt and equity), you need to repay it. The terms and conditions of this debt are also very strict. To take the debt, you need to show forth specific financial ratios and adhere to the standard the lender mentions. And this debt is also secured against the specific assets of the company. If the company is unable to pay off the debt, the lender will acquire these assets. As this debt is very much secured, the rate of interest for this debt is the lowest. As a private equity firm, you can take this sort of debt for four to nine years period and can pay off the debt at the end by a single payment.
#5 – Subordinated debt:
This LBO Financing using subordinated debt stands exactly below the senior debt. You can take this debt for a period of seven to ten years. And you need to repay the whole amount in one go at the end of the period. This debt comes next to senior debt because in terms of liquidation this debt gets preference after senior debt. The only pitfall of this debt is that subordinated debt has a high interest rate. As this debt is not as secured as the senior debt, the risk is usually higher for the lender; that’s why they charge a higher lending cost than the senior debt.
#6 – Mezzanine Debt:
This LBO financing through debt has the most risk for lenders and that’s why it costs a lot more than other types of debts. This debt stands after senior debt and unsecured debt. And the repayment method is a bit different than other debts. Here’s how it works. If you take a debt of 100 shares in the form of mezzanine debt and you need to pay 10% of interest every year, you will 5% in cash and 5% in kind. The latter part of interest is called PIK (paid in kind). In the first year, you will pay 5% in cash and the rest 5% will accrue in the next year along with the 10% of the next year’s principal amount. And this method will go on until the whole debt is being repaid. Mezzanine debt is given usually for the period of 10 years or less. So you as a private equity firm need to pay off the debt within 10 years. Mezzanine debt also includes warranties or options so that the lenders can participate in equity returns or sorts.
How to Finance an LBO with thin assets?
What to do when the company’s assets have been too thin? We will take an example to illustrate this.
- Let’s say that Company MNC has a pre-tax income of $1.25 million and the offer they get is a $5 million. So they go to the lenders and try to arrange some debt against their assets. The only problem they have is that they don’t have enough assets to use as collateral. Company MNC has around $2 million worth of assets including the equipment but still, there is a huge gap of $3 million.
- In this situation, the only option is to finance the LBO through cash flows. For that cash flows have to be huge. It should cover the senior debt, the subordinated debt, and the salary of the entrepreneur. If the cash flow is not that big, there’s no point for which you should go for the buyout.
- There’s another option available if the asset value is higher than the cash flows and the price. You can sell off the assets of the company (which can also be called equipment finance) and then with the rest you can run the company.
- LBO financing is great business by itself. If you can buy a great business, you would be able to make huge profits just by putting in some of your own money and by borrowing the rest of the money as debts.
- The only crucial thing you need to take care of is due diligence. You need to make sure that before you ever decide to purchase the company, you know everything about the company – the operations, the products/services, how the company is run, the senior management and how they make decisions, the cash flows coming in, pre-tax income every year, the capital structure, and the strategy of the business for future expansion.
- If you can do a thorough analysis and find it satisfactory, then only you should go for an LBO. Otherwise, it’s better to invest your money in some other investment opportunities.
LBO Financing Video
This has been a guide to what is LBO Financing. Here we discuss the top 6 strategies used by private equity firms to finance an LBO. We also look at the other options they have when the assets are thin. You can learn more about Investment Banking & Private equity from the following article –