(Much) LBO Models and Capital Structure How important is a companys - - PowerPoint PPT Presentation

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Nov 25, 2022 251 likes •360 views

Existing Debt in Leveraged Buyouts: Why It Doesnt Matter (Much) LBO Models and Capital Structure How important is a companys existing capital structure , i.e. its Debt and Equity, before it is acquired in a leveraged buyout?

SLIDE 1

Existing Debt in Leveraged Buyouts: Why It Doesn’t Matter (Much)

SLIDE 2

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?”

SLIDE 3

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…

SLIDE 4

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
f Equity to do the deal!

SLIDE 5

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!

SLIDE 6

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

SLIDE 7

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!

SLIDE 8

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

SLIDE 9

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

SLIDE 10

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