Big background resources
Private Equity
  • Increased leverage 
  • Might offer lower cost of capital (since cheaper than equity) with less equity dilution
  • Interest paid on Mezzanine debt is tax deductible where dividends are not
  • Senior creditors benefit from the cushion of the junior debt 
  • Debt under mezzanine arrangements is often payable after certain years (PIK interest), delaying obligation to buyer

Here, Par value is 100 so you lost 20 cents on the dollar (100-80). 
That twenty cents is divided by five since you still have five years left on the investment (20/5=4). 
So the current yield on the note is 14% (10+4=14).

You will find below some characteristics of a good LBO candidate:

  • Strong competitive advantages and market position
  • High barriers to entry
  • Steady and predictable cash flow
  • Defensible / strong market positions
  • Strong management team
  • Minimal future capital requirements
  • Potential for operationnal restructuring
  • Large amount of tangible assets for loan collateral
  • Clear exit route
  • Better understand companies from an operational prospective
  • Become actual investors (should be shown as a passion)

Secondary LBO

A financial sponsor can often sell a portfolio company to another financial sponsor in a leveraged buyout transaction known as a secondary buyout. This name derives from the fact that the LBO is being sold to the next buyer in another, separate LBO.

One possible rationale for this type of exit can be that the financial sponsor and current management team believe a larger financial sponsor can add value to the portfolio company as it moves into the next stage of its development. Alternatively, a financial sponsor may decide to sell the company to another financial sponsor if it has reached its minimum investment time period and has already created a high rate of return on its initial investment. Other potential benefits of selling to another PE firm include increased flexibility in the structure of the sale (where, for example, the seller could potentially maintain a partial ownership stake and enable the company to continue conducting its business with the intent of growth in the long term).

However, a financial sponsor is almost always a sophisticated buyer, and thus will try to purchase the asset at a minimal valuation, typically at a much lower price than would a strategic buyer. In addition, the attainable sale price could be highly dependent upon debt market conditions.

 

IPO

The primary benefit of an IPO exit for a portfolio company is the potential for a high valuation, provided that there is investor demand for equity in the company and stable, favorable public market conditions. That being said, an IPO involves high transaction costs. Additionally, if the financial sponsor is looking to fully exit the portfolio company, potential public investors might view a full exit as a lack of confidence in the future prospects of the business. Furthermore, the terms of the IPO may prohibit the financial sponsor from exiting some or all of its position for a period of time (called a “lock-up” period). Other potential problems with an IPO exit include the risk of the quality of the overall public equity market environment, and the likelihood of a discounted price for the IPO. (An IPO generally is priced at a discount to the expected trading price of the stock once the IPO is completed—typically about 15%-20% of the equity’s expected market value. This discount is designed to help drum up demand for the new issuance, but it results in value left on the table by the issuer of the IPO, which directly impacts the achievable value for the PE firm’s equity holders.)

 

Trade sale

A financial sponsor may realize gains in a portfolio company investment via a sale to a strategic acquirer. This allows for an immediate liquidity event for the financial sponsor. Strategic buyers typically intend to hold the acquisition over the long-term and thereby gain a greater competitive advantage and market share in its respective industry. A strategic buyer is usually a non-PE firm, and the acquisition is in the buyer’s strategic interest (whether it’s for market growth, trade secrets, new products, synergies, or other business improvements). Therefore the trade sale will usually command the highest sale price. For these reasons, the sale to a strategic buyer is generally the preferred exit option for an LBO investor.

1. Build operating model

Build the operating model for the target company. The most important financial aggregates will be the ones which will allow you to calculate a detailed cash flow before debt service (payments of debt principal and interests). The LBO transaction implies a completely new capital structure (more debt and more diverse tranches of debt). You will want to know if the company can support the new cap structure!

 

2. Valuation

Once you have the key financials, you need to know how the company is worth. Here it’s a usual valuation exercise: comps (precedent transactions and trading comps) and DCF.

 

3. Sources and uses

When you know how much the company is worth, you need to know how much the financial sponsor will pay for it in total: don’t forget transaction costs – it’s not free to raise debt and you will have to pay advisors (legal, financial etc..).

This step requires to think about the structure of the transaction: how much debt can you put in the transaction? What type of debt? And ultimately, what is the equity check (what the PE shop will have to put on the table)?
You will be able to answer these questions by looking at recent transactions in the same sector, by judging the appetite of banks in financing the asset etc…

 

4. New capital structure, new set of forecasts

When you have your new capital structure, you can then modify the operating model of the company: new interests to be paid, new type of debt to be repaid.
The forecasts will start from what is called “pro-forma” financial (pro-forma for the transaction).

 

5. Credit statistics

Once you have your new set of forecasts, it is very important to know if it works! By “it works”, we mean “can the company support the heavy amount of debt?”. Credit statistics are some of the most important measures in a LBO, you will calculate ratio such as leverage or interest cover ratio in order to see 1) if the company can repay the debt and 2) if the company can repay the debt quickly. If the company can’t support the capital structure you set up, you have to modify it (lower the debt, use other debt instruments – loan, PIK note, high yield bonds etc…).

 

6. Returns

When you have your sustainable capital structure, you need to calculate the returns for the financial sponsor. 2 key measure of return: 1) Cash on cash (“CoC” multiple) – you invested £100 and you get back £200 when you liquidate your investment, you made a 2.0x CoC – and 2) Internal rate of return (“IRR”) which a value of return in percentage and taking into account the factor time.

Bear in mind that expected returns vary in function of the type of financial investor. A pension fund will expect a 10%-14% IRR while a Venture Capital firm will expect at least 30%-40%.

How do you generate returns?

  • Free Cash Flow generation and debt paydown
  • Tax shield
  • Operationnal improvement (EBITDAgrowth and margins improvement)
  • Mutiple expansion

How to improve returns?

  • Lower purchase price
  • Increase exit multiple
  • Increase the leverage used
  • Improve margins
  • Improve key aggregate (EBITDA)

The leverage is the amount of debt in a company.

When you decide to assess the leverage capacity of a company, you want to know the maximum leverage of the company.

When you want to assess a maximum leverage you need to make sure that the company can repay 1) interest expense and 2) the principal.

To do so, it is important to look at cash flow before debt service, its evolution and sensitivity to different parameters (sales growth, costs evolution etc…). This cash flow will have to be sufficient to 1) pay interest, 2) pay principal and 3) gives some headroom to allow the company to grow or face bad situations.

You can back-calculate the maximum leverage by taking the amount you can afford to give up to the debt holder.

To assess maximum leverage, you need to also look at the market: are companies in this sector very levered? Are banks landing money to this type of companies?

To assess leverage for a target, the financial sponsor need to be sure that the company can repay the debt quickly and gives space for equity value creation! If you have too much debt, equity value might get to 0 if things go badly!

For this one, it really fluctuates depending on the market. To answer the question “how is the debt market currently doing?”, you need to have a look at current government bonds, do you have countries in distressed? Do banks land money at the moment for levered transactions (LBOs), is the debt market closed or open?

Unfortunately, we can’t give you a straight answer as it will probably change! Have a look on mergermarket or in the press and you may find some answers!

Commercial due diligence process

Competitive landscapte and market position

What is your competitive advantage?

  • Product offering Technology
  • Premium brand
  • Distribution capabilities
  • Geographic presence
  • Disruptive business model

What are the barriers to entry into the business?
What are the costs of switching to a competitor’s product?
Where does the company fit in the industry value chain?
How has the industry changed over the last 5 years?
How do you expect that to change over the next 5 years?
Who are your main competitors?
From whom have you been gaining/losing market share?
What firm is the biggest threat to your company?
What is the biggest share gain opportunity?
What is the market landscape (fragmented market etc.)? How saturated is the market?

 

Industry growth/ addressable market

  • Growth of the market (historical and forecast)? Is the industry mature?
  • Total addressable market? Any segment of the industry growing faster than others?
  • Key macroeconomic drivers of the business. Trends?
  • Have there been any significant changes to the industry landscape (e.g. disruptive new entrants, consolidation, vertical/horizontal integration, demand/supply imbalance, etc.)?
  • What are the regulatory concerns and how can it adversely affect the business?

 

Customer base/ suppliers

  • # of customers? Sales generated by the top 30 customers?
  • Length of a customer relationship? What is a typical renewal rate?
  • Key decision makers for the customers? Buying dynamics? Length sales process?
  • # of suppliers? Supplier bargaining power?
  • Can price increases from the suppliers passed through to the customers? 

 

Capital requirements of the business

  • Is the business capital intensive? What percentage of capital expenditures is growth capital vs. maintenance Capex?
  • Fixed vs. variable costs?
  • Minimum cash requirement?

 

Financial due diligence process

  • Quality of earnings
  • Debt and debt-like items
  • Normal working level of capital
  • Tax structure

 

Legal due diligence process

  • Corporate filings
  • Property, plant and equipment
  • Lawsuits/ litigation/ patents
  • Environmental

Usually bank debt is cheaper than high yield debt. It will be cheaper because less risky than high yield debt (“junk bonds”). Bank debt will be more senior so in case of liquidation, banks will receive the money first. In addition, bank debt will be more likely to be secure against the company assets.

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