Chapter 4 -Leveraged buyouts

Maturity

"tenor" or "term" of a debt obligation refers to the length of time the instrument remains outstanding until the full principal amount must be repaid, shorter tenor is less risky than longer tenor

LBO financing sources rank

Bank Debt, High Yield Bonds, Mezzanine Debt

Bank Debt Term Sheet Order

Borrower, Facilities, Amount, Maturity, Coupon, LIBOR Floor Assumed Ratings, Security, Ranking, Guarantees, Amortization, Commitment Fee, Mandatory Repayments, Optional Repayments, Affirmative Covenants, Negative Covenants, Financial Covenants, Events of Default

High Yield Bond Term Sheet Order

Issuer, Issue, Amount, Maturity, Coupon, Assumed Ratings, Security, Ranking, Guarantees, Optional Redemption, Equity Clawback, Covenants, Change of control

Blind pools

LP subscribe to their capital commitment without specific knowledge of the investments that the sponsor plans to make

Mezzanine Debt

Refers to layer of capital that lies between traditional debt and equity, highly negotiated instrument between issuer and investors that is tailored to meet the financing needs of the specific transaction and required investor returns

Primary Exit/Monetization Strategies

Sale of Business, IPO, Dividend Recapitalization, Below Par Debt Repurchase

20%+

Sponsors typically target superior returns relative to alternative investments for their LPs, with this percentage historically serving as widely held rule of thumb

Characteristics of a strong LBO candidate

Strong cash flow generation, leading and defensible market positions, growth opportunity, efficiency enhancement opportunities, low capex requirements, strong asset base, proven management team

Bridge Loan

a bridge loan facility "bridge" is interim, committed financing provided to the borrower to "bridge" to the issuance of permanent capital, most often high yield bonds, bridge usually takes the form of an unsecured term loan, which is only funded if the take-out securities cannot be issued and sold by the closing of the LBO bridge financing provides comfort that the purchase consideration will be funded even in the event that market conditions for the take-out securities deteriorate between signing and closing of the transaction

Target Management

a strong management team can create tangible value by driving favorable financing terms and pricing, as well as providing sponsors with comfort to stretch on valuation, management typically holds a meaningful equity interest in the post-LBO company through "rolling" its existing equity or investing in the business alongside the sponsor at closing

Leveraged Buyout (LBO)

acquisition of a company, division, business, or collection of assets ("target") using debt to finance a large portion of the purchase price

Management Buyout (MBO)

an LBO originated and led by a target's existing management is referred to as this, basic premise behind MBO is that the management team believes it can create more value running the company on its own than under current ownership

Qualified Institutional Buyers (QIBs)

as part of Rule 144A, the SEC created this category of financially sophisticated investors known as this, high yield bonds are sold to QIBs through a private placement

Collateralized debt obligation (CDO)

asset-backed securities backed by interests in pools of assets, usually some type of debt obligation. When the interests in the pool are loans, the vehicle is called a CLO, when the interests in the pool are bonds, the vehicle is called a collateralized bond obligation (CBO)

Bank and Institutional Lenders

capital providers for the bank debt in an LBO financing structure

Limited partnership

capital raised from third-party investors and the sponsor partners and investment professionals is organized into funds structured like this

Bank Debt

comprised of either RCFs or ABLs, typically bears interest at a given benchmark rate, usually LIBOR or the Base Rate plus an applicable margin "spread" based on the creditworthiness of the borrower

IRR

defined as discount rate that must be applied to the sponsor's cash outflows and inflows during the investment horizon in order to produce a net present value (NPV) or zero

Dividend Recapitalization

dividend recap provides the sponsor with a viable option for monetizing a sizeable portion of its investment prior to exit, the target raises proceeds through issuance of additional debt to pay shareholders a dividend

Lean Manufacturing

efficiency enhancement that is a production practice and philosophy dedicated to eliminating waste

Six Sigma

efficiency enhancement that is focused on improving output quality by identifying and eliminating defects and variability

Maintenance Capex

expenditures deemed necessary to continue operating the businesses, capital required to sustain existing assets (typically PP&E) at thereby current output levels

Growth Capex

expenditures that are discretionary, is used to purchase new assets, thereby expanding the existing asset base

Second Lien Term Loan

floating rate loan that is secured by a second priority security interest in the assets of the borrower, ranks just to the first priority security interest in the assets of the borrower benefiting a revolver, TLA, and TLB

Debt percentage

in a traditional LBO, debt has typically comprised 60-70% of the financing structure

Equity percentage

in a traditional LBO, equity comprises 30-40% of the financing structure

IPO

in this exit, the sponsor sells a portion of its shares in the target to the public, post-IPO the sponsor typically retains the largest single equity stake in the target with the understanding that a full exit will come through future follow-on equity offerings or an eventual sale of the company

Tuck-In Acquisition

in this type of acquisition with a large entity absorbing a smaller one, the acquiring company already has all the operational aspects needed for a successful business, including distribution systems, inventory and a technology structure. It absorbs the smaller company into that platform, and the acquired company doesn't retain its individual structure

Term Sheet

key terms for the debt securities comprising an LBO financing structure are typically summarized in a one-page format

Institutional Lender Base

largely comprised of hedge funds, pension funds, mutual funds, insurance companies, and structured vehicles such as collateralized debt obligation funds

Intralinks

leading FinTech platform for secure document sharing and collaboration, detailed information on the target is typically stored in an online data room on platforms provided by companies like this

Below Par Debt Purchase

many PE firms have the flexibility to purchase the bank debt and high yield securities of their portfolio companies in the pursuit of acceptable risk-adjusted returns, strategy is particularly attractive when debt can be bought at distressed levels, as market conditions improved and the financial performance of these rebounded, the debt instruments increased in price commensurately

Internal Rate of Return (IRR)

measures the total return on sponsor's equity investment, including any additional equity contributions made, or dividends received, during the investment horizon

Institutional Term Loans (Term Loan B or TLB)

more prevalent than TLAs in LBO financings, these are non-amortizing loans with longer maturities and higher coupons, TLBs generally amortize at a nominal rate (e.g. 1% per annum) with a bullet payment as maturity

High Yield Bonds

non-investment grade securities that obligate the issuer to make interest payments to bondholders at regularly defined intervals and repay principal at a stated maturity date, usually 7-10 years after issuance, as opposed to term-loans, high yield bonds are non-amortizing with the entire principal due as a bullet payment at maturity, high yield bonds feature a higher coupon than bank debt to compensate investors for the greater risk, pay interest at a fixed rate

Limited partnership

partnership that is typically established as a finite-life investment vehicle with a specific total capital commitment, in which the general parter (GP, i.e., the sponsor) manages the fund on a day-to-day basis and the limited partners (LPs) serve as passive investors

High Yield Bond Covenants

principal covenants found in high yield bond indentures, incurrence covenant as opposed to maintenance covenants, prevent the issuer from taking specific actions only in the event it is not pro forma compliance with a "ratio test" or does not have certain "baskets"

Covenant

provisions in credit agreements and indentures intended to protect debt investors against the deterioration of the borrower/issuer's credit quality

Bond Investors

purchasers of the high yield bonds issued as part of the LBO financing structure

Call Protection

refers to certain restrictions on voluntary prepayments (of bank debt) or redemptions (of bonds) during a defined time period within a given debt instrument's term, these restrictions may prohibit voluntary prepayments or redemptions outright or require payment of a substantial fee "call premium" in connection with any voluntary prepayment or redemption

Coupon

refers to the annual interest rate "pricing" paid on a debt obligation's princiapl amount outstanding, can be based on either a floating rate (typical for bank debt) or a fixed rate (typical for bonds)

Security

refers to the pledge of, or lien on, collateral that is granted by the borrower to the holders of a given debt instrument

Seniority

refers to the priority status of a creditor's claims against the borrower/issuer relative to those of other creditors

Structural Subordination

refers to the priority status of debt instruments at different legal entities within a company

Contractual subordiation

refers to the priority status of debt instruments at the same legal entity, established through subordination provisions, which stipulate the claims of senior creditors must be satisfied in full before those of junior creditors

Financial Sponsors

refers to traditional private equity (PE) firms, merchant banking divisions of investment banks, hedge funds, venture capital funds, and special purpose acquisition companies (SPACs), among other investment vehicles

Investment Banks

role in an LBO is a provider of financing and as a strategic M&A advisor, sponsors rely heavily on them to help develop and market an optimal financing structure

Cash Return

sponsors examine returns on the basis of a multiple of their cash investment "cash return", e.g. 300 million equity contribution leading to a 1 billion equity proceed is a 3.3x cash return, however there is no factor for the time value of money

20%+ annualized return

sponsors have historically sought this level of rate of return in an investment exit within five years

Low Capex Requirements

strong LBO candidate characteristic - all else being equal, low capex requirements enhance a company's cash flow generation capabilities

Leading and Defensible Market Positions

strong LBO candidate characteristic - leading and defensible market positions generally reflect entrenched customer relationships, brand name recognition, superior products and services, and a favorable cost structure, and scale advantages, among other attributes

Growth Opportunities

strong LBO candidate characteristic - sponsors seek companies with growth potential, both organically and through potential future bolt-on acquisitions

Strong Asset Base

strong LBO candidate characteristic - strong asset base pledged as collateral against a loan benefit lenders by increasing the likelihood of principal recovery in the event of bankruptcy (and liquidation)

Proven Management Team

strong LBO candidate characteristic - talented management is critical in an LBO scenario given the need to operate under a highly leveraged capital structure with ambitious performance targets

Strong Cash Flow Generation

strong LBO candidate characteristic - the ability to generate strong, predictable cash flow is critical for LBO candidates given the highly leveraged capital structure, debt investors require a business model that demonstrates the ability to support periodic interest payments and debt principal repayment over the life of loans and securities

Efficiency Enhancement Opportunities

strong LBO candidate characteristic - while an ideal LBO candidate should have a strong fundamental business model, sponsors seek opportunities to improve operational efficiencies and generate cost savings

Stapled financing (staple)

the investment bank running an auction process (or sometimes a partner bank) may offer a pre-packaged financing structure, typically for prospective financial buyers, in support of the target being sold

Lead Arrangers or Bookrunners

the primary investment banks responsible for marketing the bank debt, including the preparation of marketing materials and running the syndication

Investment Horizon

time from which the sponsors acquires the target until its exit

Sale of Business

traditionally, sponsors have sought to sell portfolio companies to strategic buyers because they pay a higher price due to synergies but the proliferation of private equity funds has led to more sales to financial buyers

Bolt-on Acquisition

type of acquisition where one company that is added by a private equity (PE) firm to one of its platform companies, in these cases, the acquired entity may continue to operate as an individual department or division under the umbrella of the larger company

Revolving Credit Facility

type of bank debt - line of credit extended by a bank or group of banks that permits the borrower to draw varying amounts up to a specific aggregate limit for a specified period of time, it is unique in that the amounts borrowed can be freely repaid and reborrowed during the term of the facility, subject to agreed-upon conditions set forth in a credit agreements

Term Loan

type of bank debt which is a loan with a specified maturity that requires principal repayment (amortization) according to a defined schedule, typically on a quarterly basis

Negative Covenants

type of covenants that limit the borrower's and its subsidiaries' ability to take certain actions (often subject to certain exceptions or "baskets")

Affirmative Covenants

type of covenants that require the borrower and its subsidiaries to perform certain actions

Financial Maintenance Covenants

type of covenants that require the borrower to maintain a certain credit profile through compliance with specific financial ratios or tests on a quarterly basis

Asset-Based Lending Facility (ABL Facility)

type of revolving credit facility that is available to current asset-intensive companies, ABL facilities are secured by a first priority lien on all current assets of the borrower and may include a second priority lien on all other assets

Roadshow

typically a 3-5 day process (depending on the size and scope of the transaction), where bankers from the lead underwriting institution (and generally an individual from the sponsor team) accompany the target's management on meetings with potential investors, typical roadshow includes stops in the larger financial centers such as New York, Boston, Los Angeles, and San Francisco

Amortizing Term Loan (Term Loan A or TLA)

typically require substantial principal repayment throughout the life of the loan, significant annual required amortization are perceived by lenders as less risky