WSP Red Book: LBOs

What is a leveraged buyout (LBO)?

An LBO is an acquisition made by a financial sponsor that creates a holding company to take on a bunch of debt to acquire a target company with as little equity as reasonably possible.

Once they take ownership, they look to lean-out the business’ operations to squeeze any value out of it through cost cutting, restructurings, or divesting assets. This creates incremental cash flows that can help pay down their debt.

The goal is to amplify their returns on a 5-7 year horizon and then sell the business with more equity to either another company/PE firm or take the company public through an IPO.

Explain the basic concept of an LBO to me using a real-life example.

One metaphor to explain an LBO is "house flipping," using mostly borrowed money. Imagine you found a house on the market selling for a low price, in which you see an opportunity to sell it later for a higher price at a profit. You end up purchasing the house, but much of the purchase price was financed by a mortgage lender, with a small down payment that came out of your pocket. In return for the lender financing the home, you have a contractual obligation to repay the full loan amount plus interest.

But instead of purchasing the house to live there, the house was bought as a property investment with the plan to put the house back on the market in five years. Therefore, each room is rented out to tenants to generate monthly cash flow. The mortgage principal will gradually be paid off and the periodic interest payments are paid down using the rental income from the tenants. Home renovations are completed with the remaining amount and any existing property damages are fixed – again, using the rental income.

After around five years, the house is sold for a price higher than the initial purchase due to the improvements made to the house and because the house is located in an area where home values have been increasing. The remaining mortgage balance will have to be paid in full, but you pocket a greater percentage of the proceeds from the sale of the house because you consistently paid down the principal.

What is the intuition underlying the usage of debt in an LBO?

Debt amplifies returns. By using debt in a deal, you can put up less of your own capital. So, if the deal goes well, you can capture a greater return than you could have if you used your own funds for the entire initial investment.

Additionally, it is cheaper to use debt than equity because of the position in the capital structure and the tax shield. So, using more debt than equity helps the company itself actually reach return thresholds easier.

What is the typical capital structure prevalent in LBO transactions?

Back in the day, it was common to see D/E in the 80/20 area, but today you are more likely to see closer to 60/40, though it depends heavily on the financing environment.

The different debt tranches include leveraged loans (revolver, term loans), senior notes, subordinated notes, high-yield bonds, and mezzanine financing. The majority of the debt raised will be senior, secured loans by banks and institutional investors before riskier types of debt are used. In terms of equity, the contribution from the financial sponsor represents the largest source of LBO equity. Sometimes, the existing management team will rollover a portion of their equity to participate in the potential upside alongside the sponsor, which usually makes up 3-20%$ of the equity component.

What are the main levers in an LBO that drive returns?

• FCF generation/EBITDA growth

  • comes from operational improvements, new growth strategies, accretive add-ons

  • Increases value at the same multiple, or can increase intermittent payouts to investors

• Multiple expansion

  • can come from better sentiment, growth prospects, scale, etc

• Debt paydown

  • Value of PE firm’s equity grows

What attributes make a business an ideal LBO candidate?

• Stable, preferably high cash flows

  • recurring revenue from long-term contracts, high value products and services

• Fragmented market, but a wide moat

• clean balance sheet

• Low risk of technological disruption

• High margins/favorable unit economics

  • sign of moat, low CapEx, low working capital requirements

• Strong, committed management team

  • proven track record, they have to executte the strategic plan

• Low multiple entry price (undervalued hopefully due to external factors or easily fixable problems.)

• Good value-add opportunities

  • selling non-core assets, cutting costs, better S&M

What types of industries attract more deal flow from financial buyers?

• Non-cyclical and low growth

  • more stability

  • Target’s need to turn to inorganic growth anyways

• Subscription/contractual based

  • recurring, stable revenue

  • B2B SaaS

• High R&D requirements

  • Incumbents want to acquire new tech, not go through the cumbersome process of innovating it

• Potential synergies

  • What industries or business types can combine to realize revenue or cost synergies

• Structural industry trends

  • can ride the wave, don’t have to pour a ton of money into being the groundbreaker

What would be the ideal type of products/services of a potential LBO target?

• Mission-critical: it is essential to the ultimate consumer and cannot be removed or easily replaced

• Recurring/Contract Based: enterprise software fits this mold and creates predictable revenue

• High switching costs: hard for end consumers to move away from the products

• High tech: better moat, more pricing power, less competition. This makes cash flows more stable and less risky.

  • Look for companies with high R&D, patents/IP, and industry reputation

• Locational competition: these fragmented businesses (like Chris, but also lawncare and stuff) have less competition and function largely on customer relationships

What is the relationship between debt and purchase price?

A higher purchase price means that the buyer will likely need to take on more debt in order to finance the deal, but this also means that firms can buy companies at a price they never would be able to with their cash alone.

Also, by not using all their cash, they can seek out additional investment opportunities to create other return streams and diversify

What is the relationship between debt and purchase price?

The debt-to-equity mix in private equity deals has hovered around 60% debt/40% equity as M&A activity stabilized since the 2008 financial crisis. However, leverage varies significantly across industries, besides being specific to the target company's fundamental qualities. Debt/EBITDA has hovered in the 5.0x to 7.0x range and is pressured upward as overall valuations increase. When LBOs emerged as a type of M&A transaction in the 1980s, debt represented as much as 90% of the capital structure. But this has come down because of the risks inherent to high debt burdens.

Ultimately, it is going to be based on the cost of debt and whether the cash flows of the target can reasonably meet those obligations.

Why might a private equity firm not raise leverage to the maximum leverage, even if it had the option to do so?

Inherently, leverage comes with risks.

• More default risk from incremental debt load

• Negative perception from the company’s perspective, they’d rather be viewed as a value-add partner

• In the case of a bankruptcy, there is large reputational risk and fund risk for the PE sponsor

• Planned dividend recap, especially if the firm has a view that rates will go down, so they want the optionality to lever up more in the future

What determines a company's debt capacity?

In most cases, a leveraged finance group at an investment bank and the capital markets team will guide a private equity firm looking to raise debt financing.

1. Industry risk like growth rate, barriers to entry, cyclicality, tech disruption and regulatory risks

2. Narrow in on the company’s position within said industry

3. Look at historical performance to create a forecast model that focuses largely on downside scenarios and predictable cash flows that would indicate capacity for debt

4. Based on scenario analysis from the forecast model, the company's appropriate debt capacity will be determined. This leverage multiple (Total Debt/EBITDA) represents the maximum leverage multiple the debt can be raised up to with a sufficient "cushion" that enables it to meet all of its debt obligations even if it were to underperform. This ratio will vary based on the industry and lending environment

In the context of an LBO, what is the “tax shield”?

The tax shield refers to the fact that the interest expense on all of the debt that the firm is taking out is tax deductible, so it isn’t actually as expensive as the headline rate would suggest when looking at financing.

Since senior debt is cheaper, why don't financial sponsors fund the entire debt portion of the capital structure with senior debt?

They cannot. Once the company reaches a certain amount of leverage, creditors will begin to demand incremental compensation for the incremental risk they are taking, which means you need to pay them a higher interest rate. Senior debt also imposes the strictest covenants, which could act to dissuade a debtor.

Also, part of the reason that senior debt gets to have a lower interest rate is because the creditors sit higher in the capital stack, insulated from losses by lower tranches. If there were no lower tranches, then there is nothing insulating them, and so they would demand a higher rate.

How do financial sponsors exit their investments?

They have three main ways of realizing value from one of their investments:

1. Sell to another sponsor or acquirer

   1. cleanest way, wipe their hands of risk, creates a one-time taxable event

2. IPO

   1. have to hold the stake for longer, which can hurt IRR and also introduces public market risk from the stock price moving on them

3. Dividend recap

   1. issue more debt during the holding period and use it to pay a special dividend to the equity holders, which can help boost IRR

What is the one caveat of an IPO exit?

The PE firm itself cannot just sell all its shares right away in the IPO. So, they have additional stock market risk and IRR risk from a longer holding period in a public company.

**there are lockups and also the sentiment around big insider sales like that

What is a secondary buyout?

A secondary buyout is when a PE firm LBOs a target that was already under the ownership of another PE firm. They may believe that they have additional value to add, but most evidence shows that secondary buyouts have a lower return profile than traditional buyouts because much of the streamlining will already have been done.

What is a dividend recapitalization?

When a sponsor borrows more debt onto a firm so that they can use the cash to pay out a special dividend. This can boost IRR incrementally since the investors get to receive payouts sooner. The cash they receive on their position also helps them de-risk.

How might operating a highly levered company differ from operating a company with minimal or no debt?

When operating a highly levered company, you cannot make mistakes. You have to be much more conservative and calculated with your decisions, because one misstep could get you behind debt payments and maturities that can swallow you. Also, you have limited capacity for reinvestment since you want to put as much cash flow as possible towards the debt.

How can a private equity firm increase the probability of achieving multiple expansion during the sale process?

Building a higher quality business via entering new markets through geographic expansion, product development, or strategic add-ons could help a PE firm fetch higher exit valuations – and increase the odds of exiting at a higher multiple than entry. Also, exit multiples can expand due to improvements in market conditions, investor sentiment in the relevant sector, and transaction dynamics (e.g., selling to a strategic).

Why is multiple expansion viewed as a less than ideal lever for value creation?

Because it is much more external, and you would rather bet on your own merits to deliver value rather than speculate on what the market as a whole is going to do or think.

The deal environment in the future is unpredictable, as well.

Can you name a scenario when multiple contraction is common?

For large-sized companies undergoing LBOs, it's normal to see minor multiple contractions. The reason is that as the company grows larger, the number of potential bidders that could afford to purchase the company grows smaller (i.e., a reduced pool of prospective buyers with sufficient capital). Since there's less competition, this usually leads to a lower purchase price.

This company could undergo an IPO, but this would depend on the situation, and a minor contraction in the exit multiple would not impair returns to the fund, especially since the expanded size of the company implies there was revenue and EBITDA growth, as well as debt paydown.

What are some risks you would look out for when assessing potential investment opportunities?

• Industry cyclicality reduces stability

• Customer concentration

• Customer/Employee churn

  • requires constant new acquisitions

• Temporarily inflated valuations

  • Don’t buy at the top of an industry

• Past institutional ownership

  • Less incremental value-add opportunities

• Retiring key management

  • introduces replacement risk

If you had to pick, would you rather invest in a company that sells B2C or B2B?

B2B. Typically these revenue are contracted, recurring, larger, relationship-driven, and necessary no matter what the economic conditions are. Also, higher switching costs usually, and they are less sensitive to price changes.

Imagine that you're performing diligence on the CIM of a potential LBO investment. Which questions would you attempt to answer?

Is there a strong management team in place and do they intend to stay on during the LBO?

What value does the company's products/services provide to their customers?

Which factors make the company’s revenue recurring? Are there any long-term customer contracts?

Where does the team see new opportunities for growth or operational improvements?

What has been driving recent revenue growth (e.g., pricing increases, volume growth, upselling)?

How is the threat of competition? Does this company have a defensible "moat" to protect its profits?

What specific levers does the private equity firm have to pull for value creation? Is the industry that the company operates within cyclical?

How concentrated are the company's revenue and end markets served?

Is there a viable exit strategy? Will there be enough buyer interest when the firm looks to exit?

What is a management buyout (MBO)?

An MBO is an LBO where prior management retains a significant amount of the post-LBO equity. Maybe due to recent underperformance or investor scrutiny, the management team believes they can better drive operational improvements, plus there’s no scrutiny of public filings.

They will roll over existing equity and put in new cash, while other financial sponsors or investors may also be in on the deal. The debt portion is akin to the debt of an LBO.

What is rollover equity and why do private equity firms perceive it as a positive sign?

Rollover equity is when the existing ownership retains their equity in the business through the process of an LBO. This is generally viewed as a positive sign because it shows that the management team is committed, optimistic, and incentivized to help create value. Also, it reduces the amount of equity or leverage that the PE firm has to contribute to fund the deal.

When might a PE firm prefer to use term loans rather than subordinated notes in an LBO?

A PE firm might prefer to use term loans if they are okay taking stricter covenants in exchange for a lower interest rate. Typically, this would be a trade-off they would be willing to make because it gives the sponsor more cash flow to pay down debt with, which is especially relevant because term loans are typically structured with the ability to make optional early repayments.

In addition, if the company is expecting to be active in terms of M&A activity (e.g., add-ons, divestitures), the restrictive incurrence covenants associated with subordinated notes should be considered.

Would a private equity firm prefer high growth or stability in revenue?

Generally, they would prefer stability. While high growth revenue can be a great thing, it also typically comes with higher risk, and a PE firm needs to manage its downside so that it can still make debt repayments.

Stability provides them that cushion and relative guarantee that allows them to make strategic decisions.

Why might a higher average selling price (ASP) or average order value (AOV) not always be better?

It may not always be better because it could coincide with lower volume propping up their revenues. A more concentrated customer base presents risks if a competitor came in to try to take them away with some sort of differentiated offer since only a few leaving can be very costly. Higher ticket items can also make it hard to expand to additional customers.

Can a highly capital-intensive industry be appealing to PE investors?

Asset-light industries can often be attractive because they require less capital to be deployed to generate sales growth. However, a highly capital-intensive industry could create a high barrier to entry that deters entrants, confers stability, and increases the collective pricing power over customers.

Since a capital-intensive industry implies higher amounts of PP&E, this can become beneficial when raising debt financing. As a result of having more fixed assets that can be pledged as collateral, the company can receive better lending terms as the borrowing base has increased.

When might customer concentration be considered being at a manageable level?

An exception to the customer concentration risk will be if there are irrevocable contracts in place (i.e., long term customer agreements). This contractual obligation between the company and the customer being served makes the concentration risk more tolerable but could still lead to a discount on the purchase price.

Explain the strategic rationale behind add-on acquisitions and how it creates value

Add-on acquisitions create the opportunity for synergies to be realized, which can provide an inorganic way to quickly boost cash flows that can be used to repay debt principal.

Another side benefit of the roll-up strategy is that it allows platform companies to compete with strategic buyers in auction-based sale processes since synergies can be realized.

How can value be created during a consolidation play?

• Increased pricing power: customers pay more for stronger brands and complementary product/service offerings

• More bargaining power: larger customers have more power over suppliers, allowing them to extend payables and make bulk, discounted purchases

• Lower CAC: Improved software, more infra integrations, etc lead to increased scale and higher efficiency

• Improved cost structure: Benefit from economies of scale and cost savings (things like combining divisions or offices and reducing overhead expenses.)

What does “multiple arbitrage” in a roll-up acquisition scenario imply?

Multiple arbitrage is achieved when a firm acquirers a firm trading at a lower multiple, making it accretive. So, once their cash flows are integrated with the acquirer, they will automatically trade at the acquirer’s multiple without having to make any actual improvements to the business.

A private equity firm has tripled its initial investment in five years, estimate the IRR?

~25%

Common IRR Aproximations

2.0x Initial Investment in 3 Years  ~25% IRR

2.0x Initial Investment in 5 Years  ~15% IRR

2.5x Initial Investment in 3 Years  ~35% IRR

2.5x Initial Investment in 5 Years  ~20% IRR

3.0x Initial Investment in 3 Years  ~45% IRR

3.0x Initial Investment in 5 Years  ~25% IRR

How many years would it take to double a $100,000 investment at a 9% annual return?

Using the rule of 72, it would take roughly 8 years.

**Rule of 115 can estimate time to triple an investment

If an LBO target had no existing debt on its closing balance sheet, would this increase the returns to the financial buyer?

Most private deals are done on a cash-free, debt-free basis already, so pre-LBO capital structure doesn’t matter much at the end of the day since equity going in and cash flows during the holding period (dividends, fees, exit proceeds) are what drive returns.

**If mgmt. is inexperienced running a company with debt that might impact the risk a bit due to the lower margin of error.

Where do financial sponsors typically get their capital?

It depends on where in the capital structure the capital sits.

For term loans, they may look to banks or insurance companies for sourcing.

For subordinated debt, they may look to private credit firms or pensions.

For mezzanine debt, they may look to hedge funds or opportunistic credit investors.

For equity, they will be putting a lot of this up themselves, but additional equity may come from management or other partners on the deal.

Other sources of capital include sovereign wealth funds, endowments, and HNW individuals.

In the private markets, what does "dry powder" mean?

Dry powder is cash sitting on the sidelines that can be used opportunistically to make new investments when they become attractive.

If dry powder is high, it means that it is hard to find opportunities, which means that bidding processes will be competitive.

What is proprietary deal sourcing and how does it compare to intermediated deals?

• Proprietary deal: initiated through cold outreach or existing relationships. Negotiations are friendlier. PE firm usually wants to establish a relationship so that when an opportunity comes. Grueling, long process. Most target companies are already doing pretty good so why would they want to sell

• Intermediated deals: led by an investment bank with a large list of potential buyers. Increased competition leads to higher prices and the investment bank is incentivized to get the higher selling price too.

From a limited partner's perspective, what are the advantages/disadvantages of the private equity asset class?

Advantages:

• Steadier, often higher returns

• Less exposed to equity markets

• Low reinvestment risk

• Managers are more active in their portcos

Disadvantages

• Illiquid

• Less transparent

• If it goes bad, it goes really bad

Explain the “2 and 20” compensation structure in private equity.

PE firm charges LPs a 2% management fee on their AUM and then takes 20% of returns above a specific hurdle rate, usually.

What is a distribution waterfall schedule in private equity?

The schedule shows how disbursements will be paid based on claim priority.

Classic Structure:

1. Initial LP investment returned in full, as well as returns up to the hurdle rate

2. 20% of returns above that go to GPs due to catch-up clause

3. Remaining proceeds split 80-20 between LPs and GPs

In the distribution waterfall in private equity, what is the catch-up clause?

It states that once the LPs have received a specified return (usually their initial investment plus a hurdle rate), the GPs receive the majority (or all) of the profits until the return proportion outlined in the agreement is met so that the GPs' return will “catch-up” to the original agreed-upon split since the LPs were paid first.

What is a clawback provision?

A fund can start well in terms of investment returns (i.e., the first couple of exits), which benefits both the GPs and LPs, but then later, the back-end of the remaining portfolio companies could be less profitable, and this clause gives LPs the right to reclaim some of their capital back from the profits that the GPs took.

What is the difference between a recapitalization and an LBO?

LBOs are accounted for as an acquisition, meaning assets are written-up, and goodwill is recognized.

Recapitalizations are mechanically similar but are not accounted for as an acquisition – thus, the asset bases carryover and remain unchanged with no goodwill recognized. Since no goodwill is recognized, negative equity is often created because the offer price is often higher than the book value of equity.

What is a recapitalization in the context of PE?

A recapitalization changes a company's capital structure — usually by piling on new debt to fund a big payout to shareholders — without being treated as a true acquisition, because the same legal entity survives and existing owners keep a continuing stake. There's still an offer price since a buyer is paying (often above book value) to take control or buy people out; what's different is only the accounting. Because it's not a purchase, assets stay at their old carrying values and no goodwill is created. So unlike a real acquisition — where the premium over book gets absorbed by writing up assets and booking goodwill — here the debt piles on but the asset side can't be inflated to match. Equity gets squeezed and often goes negative.

Why do some portfolio companies pay sponsor consulting fees?

Many private equity firms, particularly those with in-house consultants, a team of operating partners, or have a separate division specifically offering consulting services, will arrange these types of advisory fees in their investment agreement.

So the PE firm will actually be helping fix the operations, and the fee helps boost their IRR.

What is the impact of the 2017 tax reform on the private equity industry?

1. The most significant change was that corporate tax rates were reduced from 35% to 21%. There were also reductions to S Corporations/LLCs, but the impact is a bit murkier and minor. 2. Companies face limits on how much interest expense can be deducted for tax purposes. While the formula is a little more complicated, companies can roughly deduct interest up to 30% of their EBITDA. This offsets the lower tax rate benefits for highly levered companies. 3. Companies can now accelerate depreciation for tax purposes even more than they could before, which lowers upfront tax bills. This lowers taxes further for capital intensive businesses. 4. Companies can no longer carryback NOLs, but they can carryforward indefinitely instead of just 20 years. Also, companies can use NOLs to offset only 80% of current period income (before tax reform, NOLs could offset 100% of current period income)

For private equity funds, the limited partnership is called a “blind pool.” What does this mean?

This means that investors pool their money in not knowing exactly what it will be invested into and having essentially no choice over.

In private equity, what is a capital call?

A capital call is when a PE firm has commitments from LPs, finds an investment opportunity, and then calls for the cash to actually be sent in from the LPs to take advantage of the opportunity.

This is also called a drawdown, and it allows them LP to use short-term, low-risk investments so that its cash is not just sitting idly by.

A penalty fee or immediate call of all capital might occur if the LP doesn’t meet their capital call obligation usually within a period of 7-12 days