Learning about leveraged buy-outs
Let's take a look at the positives and negatives which are associated with this type of business financing.
First of all, what is a leveraged buyout? We use of leverage (or debt) to fund the purchase of a business. A company will “lever-up,” taking a very small portion of their own funds to purchase a business, while borrowing the remainder which could represent a great deal of money. Basically we are borrowing money in order to buy in a business otherwise we couldn't have afford
Here are the step by step guide on how LBO are implemented.
1. A company is purchased using an excessive amount of debt. 2. The holding company will hold and maintain the company for for a limited period of time. 3. there may be dividends made prior to selling - 4. during a period of 1 to 7 years hopefully it will sell for a massive return (IPO or an M&A exit) and reap the rewards of a great return.
How can LBOs help a business?
An LBO promotes debt disciplines for managers which forces cost cutting within the organization, because investors will want to improve how it looks on the accounting "books"
The company can gain access to capital
Assuming the PEG (private equity group) or purchasing entity (maybe you?) holds better management expertise than the selling company, then expertise can help turn the company around, producing greater profits when the company is later sold.
And what types of firms are generally the type of candidate that would fit an LBO? Mature and declining industries with low growth and steady cash flows who are in need of necessary cost discipline implementation. The key is that the steady cash flows helps to repay the loan made to purchase the business.
DEEP KNOWLEDGE
we need to learn about different types of debt you need to know in order to finance the acquistion, we will talk about each one more in depth in separate articles.
(definition you need to know - "lien" a right to keep possession of property belonging to another person until a debt owed by that person is discharged.) Senior Revolving Debt — Revolving debt is typically secured one of several ways. It means you can borrow and repay on a continual basis.
Senior revolving debt is often tied to a first lien on inventory, accounts receivable and other current assets.
It can also have a first or second lien on property, plant, equipment and other fixed assets. Third, senior revolving debt can even hold a lien on certain intangible assets.
Finally, liens or pledges are sometimes held against the the stock of the target company or perhaps some of its subsidiaries (less common).
Lenders will stop at nothing at working to securitize, in some way, the loan. Senior revolving debt is used frequently when companies are sourcing capital for financing an acquisition, working capital or letter of credit financing (sometimes known as a credit line). Most frequently senior revolving debt is referred to as commercial paper and is generally provided by institutional lenders, including commercial banks. Senior Term Debt — Fixed assets are most frequently used as a securitization instrument against any senior term debt. A first or second lien on current assets, intangibles or target company stock is also used. Typically provided by commercial banks and often combined with senior revolving debt, senior term debt is sometimes even subordinate to the senior revolving debt. Subordinate debt means Subordinated debt is any type of loan that's paid after all other corporate debts and loans are repaid, in the case of borrower default. Borrowers of subordinated debt are usually larger corporations or other business entities. Senior Subordinated or Mezz Debt — Mezzanine (mezz) debt is debt–both secured or unsecured–by junior liens on some of the assets secured by more senior debt. It too is also used as a source for acquisition financing. Because mezz loans are either highly subordinated or not secured against any assets at all, the debt is frequently high-yield and sometimes referred to as “junk.” Mezzanine debt is frequently placed by investment bankers, with many of the purchasers being institutional funds, including insurance companies, pension funds, investment funds and other larger financial institutions. It is the highest-risk form of debt, but it offers some of the highest returns -- a typical rate is in the range of 12% to 20% per year. A mezzanine lender is generally brought into a buyout to displace some of the capital that would usually be invested by an equity investor. Sale Leasebacks or Special Arrangements — In most instances a lender will arrange for the purchase of a specific performing asset owned by the business, including equipment, data or other necessary assets that may be critical to the business and its operations. The arrangements could include installment purchases of anything from office copiers, to data servers or the data itself.
The lender typically pays a large lump sum up-front for the assets (in many cases the critical assets) to the business and the business will lease-back these assets from the lender by installments.
The downside here is that sale leasebacks–while not ultimately as expensive as giving away equity–are the most expensive of those mentioned thus far. Due to the nature of the equipment obtained, the business will need to have a healthy cash flow to buy them back otherwise eventually the business operations itself will be affected.
Less common methods:
Seller’s Subordinated Notes or Warrants — Seller subordinated note or warranted can be either unsecured or secured in a first, second or even third position. In some instances, this type of debt instrument is convertible to common or preferred stock. Employee Stock Ownership — In some instances, we have seen various types of debt be layered in with an ESOP as a method for financing an acquisition. With the right structure, this helps to assuage some taxes and premiums can sometimes be paid by the acquirer for the purchase of the business. There are several ways to creatively structure such a transaction.
The options above are the most common methods for extending credit to those looking to perform acquisitions, perform a management buyout or to provide a liquidity bridge until the company decides to sell to the general market by broad auction sometime later. When any senior or subordinated lender–typically represented in an institutional setting–using leverage in a transaction, there are key considerations which are often part of gauging whether financing should be extended. Here are a few:
The value of the collateral in the event of liquidation
The viability of the financial projections and pro-forma financial statements of the borrower
Is there enough existing and future cash flow to service both senior and junior debt in the transaction?
Will any necessary asset liquidations (sell off) occur in time and at the right level to properly amortize the term debt or decrease a revolver commitment?
A look at the macro status of the industry and overall prospects of the company’s profitability going forward
What is the amount of junior debt in a transaction?
The amount of equity currently (or being brought to the table) in the deal.
Reminded that we need multiple experts when proceeding with any transaction that involves a high degree of risk. LBOs certainly fall in that realm.
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