The Leveraged Buyout Part 2: Debt, Debt, Debt

Note: This article assumes you read the earlier article that describes and explains LBOs. If you have not read it and have no background on LBOs, check this out!

How are LBOs Financed?

In order to come up with enough money to successfully purchase a company without using large amounts of equity, private equity firms will take out the following types of debt:

Bank Debt

The major source of debt in an LBO is standard bank debt, which requires full amortization (payback) over a period typically in the 5–8 year range. Bank debt can either be structured using evenly distributed payments, or one payment at the end of the term (a bullet payment). All loans from the bank are collateralized as most banks are unwilling to extend the amount of credit required for an LBO, which is often 4 to 6 times the acquired companies EBITDA. The interest on this is typically a floating rate pegged to the Federal Funds Rate plus an additional predetermined amount (similar to a mortgage). Banks will often also include covenants to the debt they offer, which are conditions that reduce the risk associated with lending. These include restrictions on future acquisitions and cash flow sweeps, which require a certain amount of cash flow to be put towards paying down the debt. Typically 30–50% of the debt structure in an LBO comes from the bank. Those pursuing an LBO will often use as much bank debt as possible because it is the lowest costing source of credit.

(Note: my definition of large and small LBOs is not definitive at all, and just provides a ballpark of the magnitude of transactions I’m describing)

For Large LBOs (>5 billion):

Mezzanine Debt and (Junk) Bonds

Pictured above is a junk Bond, Daniel Craig.

For larger acquisitions, Bonds and Mezzanine Debt are often required to cover the gap between the necessary amount of money and that offered by the bank. Bonds and Mezzanine debt offer higher returns because they are unsecured and thus holds additional risk. Bonds are debt offered to investors with a fixed coupon that have a bullet payment; this means the principal + compounded interest is paid when the bond matures (check out investBETA’s article for more on bonds). Bonds issued for LBOs are often considered to be junk bonds because they are very risky; if the company issuing the bonds goes bankrupt, since the bondholders have low priority during liquidation they often will lose all their money. Mezzanine Debt is similar in nature to bonds, except it is convertible to either preferred stock or debt. Mezzanine debt will only be used if other sources of debt are not enough to cover the entire cost of the LBO, and if the acquiring company does not want to offer any more equity. This is because the cost of Mezzanine debt is very high.

For Smaller LBOs (<5 Billion):

Seller Leverage

Seller leverage occurs when the selling member does not take full payment for their company, pushing back payment in the form of a loan. Evidently this would only occur in a non-hostile takeover. In many cases, the previous owner would like to retire, and they want to find someone to run the business — they are looking to sell their company. This is an example of an ideal situation to through in a sellers note (a more eloquent way of saying seller leverage). This form of debt often makes up around 10% of a smaller LBO.

History of LBOs

Now that you have an understanding of how LBOs are financed, we can take a look back in time at the periods of LBO booms and busts. The first boom in LBOs occurred in the 1980s. It died down in the 90s, but returned in the early 2000s, and is currently making a resurgence. LBOs are most successful in certain conditions: firstly, there have to be good candidates for leveraged buyouts. Secondly, since the cost of an LBO is the interest accrued on debt, lower interest rates, often guided by the fed, reduce the cost of doing an LBO. Finally, there must be a market for high-risk debt, which are almost always required to finance an LBO. Note that in this section I am looking at the big LBOs that have occurred, and am not focusing as much on smaller LBOs, which for the most part have continuously occurred since the 1980s.

Back to The 80s:

Although LBOs have occurred since at least the middle of the 20th century they first boomed during the 1980s. As of 1987, one-quarter of the companies on Forbe’s top 400 non-public companies had been taken private via an LBO. The start of the LBO boom was marked by the acquisition of Gibson Greetings in 1982 — its incredible success started off a string of over two thousand LBOs by 1990. The reason why LBOs became possible in the 80s was the emergence of the junk bond market, which grew from 10 billion in 1979 to 189 billion in 1989. This provided the means to accrue the cash necessary to perform an LBO. The yield on these bonds averaged out to be 14.5 percent, with default rates hovering around 2.5 percent. Although the Federal Funds Rate did not drop substantially during the 1980s, since there were many prime targets for LBOs, they remained mostly profitable until the end of the 80s.

Eventually, overzealous investors started buying companies not well suited for LBOs. By the end of the 80s, many large bought out companies went bankrupt, and in 1989, the supply of junk bonds dried up. In 1991, default rates on the unsecured instruments behind LBOs had risen to 10.3%.

The 2000s: A Volatile Period for LBOs

From 1996–2000, telecommunication companies were the primary target of leveraged buyouts. In 2001, the tech bubble popped, leading to the default on many of the junk bonds used to finance those LBOs in 2002. High default rates always tighten credit markets, which caused a relative halt in LBOs. In 2003, however, things turned around considerably as the Federal Funds Rate had been slashed from upper single digits to a low of 1% in June of 2003. Investors, craving for higher yields, were suddenly much more willing to stomach more risk, and demand for junk bonds had returned. This was combined with the passing of The Sarbanes Oxley Legislation, which created new rules and regulations for publicly owned companies (red tape which increased costs), making the idea of going private much more attractive to public companies. This created a near-ideal environment for LBOs: money was extremely cheap, and companies were much less hostile towards the notion of going private. Between 2004 and 2005, many humongous LBOs occurred, including those of Dollarama, Toys-R-Us, Hertz, and Georgia Pacific.

All good things have to come to an end, however. In 2007, the collapse of the market for mortgage-related securities zapped the entire market for high yield debt. Yield spreads increased, meaning that although interest rates were, on a historical basis, still relatively low, the interest on high-risk securities was quite high. Many previously announced LBOs did not go ahead as planned, and once again LBO activity came to a near halt.

Today:

In the past decade, interest rates have been consistently at extremely low levels, making cash nearly free (largely due to a lack of inflationary pressure — if you’re interested in economics, you can check out this article). Although we are seeing fewer of the big flashy deals of the past, smaller LBOs remain common today. To learn from the past, it is important to monitor just how risky certain types of debt are, and to keep an eye on the stipulations banks put on debt. When interest rates are near zero, it puts a lot of pressure on banks, which pushes them to drop some of the conditions on debt I mentioned earlier. This could prompt default rates to rise, endangering their creditors, but also risking sending shockwaves through the economy.

Hopefully, this article helped you learn more about how leveraged buyouts are financed and offers some historical background on LBOs. If so, be sure to look over some key takeaways and at some next steps you can take to support us and further your learning!

Key Takeaways

1. LBOs are financed using different types of bank debt, junk bonds, seller leverage and mezzanine debt.
2. LBOs tend to be most successful when there are good LBO candidates, low-interest rates and a solid market for high-risk debt.
3. During the 1980s, the market for junk bonds expanded rapidly which opened up the possibility of LBOs. The early profitability of LBOs led to a major boom during the 80s.
4. Rapidly changing conditions in both interest rates and credit markets have led to vast swings in the size and profitability of LBOs in the 21st century.

Next Steps

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