Existing Debt in Leveraged Buyouts: Why It Doesn’t Matter (Much)
LBO Models and Capital Structure “How important is a company’s existing capital structure , i.e. its Debt and Equity, before it is acquired in a leveraged buyout?” “Some guides say that ‘ideal LBO candidates’ should have minimal Debt . But why does that matter at all?”
Capital l Structure in Leveraged Buyouts • SHORT ANSWER: These guides are incorrect – the existing capital structure in a leveraged buyout does NOT matter! (Much) • Why: In an LBO, the private equity firm replaces the company’s entire capital structure with new Debt and Equity • Typical Argument Against This: “But if a firm doesn’t have much Debt yet, the PE firm can use more Debt to fund the deal!” • PROBLEM: Nope… think about how the valuation and Debt financing process works for a minute…
Capital l Structure in Leveraged Buyouts • Purchase Price: Almost always based on an EV / EBITDA multiple – let’s say a 10x EV / EBITDA in this simple example • Then: The PE firm will use an amount of Debt based on reasonable leverage and coverage ratios, such as a 5x Debt / EBITDA median • So: Regardless of whether the company has 0 Debt or 4x Debt / EBITDA initially, it will still have 5x Debt / EBITDA afterward • And: The PE firm will still have to contribute 5x EBITDA in the form of Equity to do the deal!
Capital l Structure in Leveraged Buyouts • So: Since the multiple is based on Enterprise Value, existing Debt would affect things only if it increased the company’s EV • But: Does that happen? No! Raising additional Debt makes no impact on EV since it increases both the company’s Cash and Debt • Therefore: Existing capital structure doesn’t matter, unless you believe that Debt increases a company’s Enterprise Value (wrong!) • But: Are there any exceptions? Could existing Debt make a difference? Yes, it could – time to go down the rabbit hole!
Rabbit Hole #1: Call ll Premiums • Some Debt: Restrictions on early repayment – common with 10-Year Unsecured Bonds • Example: For the first two years, the Debt cannot be repaid; if the company wants to repay it early after that, it must pay: • Years 3-4: 105% of principal • Years 5-6: 103% of principal • Years 7-8: 101% of principal • Years 9-10: 100% of principal • So: “Call Premiums” make it more expensive to repay the Debt early, increasing the company’s Purchase Enterprise Value in an LBO
Rabbit Hole #1: Call ll Premiums • But: How much do they matter ? Let’s say the company has 5x Debt / EBITDA already, and the Purchase EV / EBITDA is 10x • If all the Debt has a 110% call premium, then the Purchase EV / EBITDA increases to 10.5x • Our Simple Model: IRR decreases by ~2%... Who cares? • And: The call premium is usually much less than this • Anything Else? Yes, let’s go down Rabbit Hole #2!
Rabbit Hole #2: Lender Familiarity • People: Like what’s familiar – and investors are no different! • So: If a company already has Debt, that could help its case in a leveraged buyout because lenders might be more familiar with it • Real-Life Analogy: If you want to borrow money for a home, you need to show evidence of loan repayment history and not being idiotic with credit cards • Same Idea: If a company has borrowed responsibly, paid Interest, and repaid its Debt in the past, it’s more reliable
Rabbit Hole #2: Lender Familiarity • But: This point doesn’t affect the purchase price or the IRR – it just makes it easier to get the deal done • Maybe: You could argue that the company might get a lower coupon rate or better terms if lenders know it… but that’s a stretch • The Bottom Line: The company’s existing capital structure and existing Debt barely make a difference
Recap and Summary • Existing Capital Structure: Doesn’t matter – the PE firm replaces the company’s Equity and Debt with all -new Equity and Debt • Conflated Concepts: Yes, a company’s ability to service Debt matters a lot, but that’s separate from how much Debt it has right now • Exceptions: Call premiums can make a difference with some Debt, especially longer- term bonds, and “lender familiarity” matters • BUT: In the grand scheme of things, this is item #499 on the list of criteria for ideal LBO candidates – purchase price, cash flow stability, credit stats/ratios, etc. all matter far more
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