Financing for Leveraged Buyouts

Secured and unsecured debt, often used together, are the two types of debt utilized in LBOs. The former is sometimes called asset-based lending. It contains two more types, the senior debt, and the intermediate-term debt.

These two are often considered as one in smaller buyouts. On the other hand, larger deals have multiple layers of secured debt. Depend on the term of the debt and the types of assets used as security.

Unsecured Debt

The latter, unsecured debt, is also called subordinated debt or junior subordinated debt. It lacks the protection of secured debt but carries higher returns to offset this additional risk. Subordination refers to the fact that more senior creditors. It needs to have their obligations satisfied before payment can be made to the subordinated creditors and equity investment is added to the debt financing. The percentage of the total financing that the equity component constitutes varies, usually in the 20% to 40% range.

The Dealmaker

The sponsor or the dealmaker works with the investment banks or those who provide financing. These banks conduct due diligence on the proposed deal. They will present this deal to them once they are confident that they will meet the criteria. They may present for the various prospective lenders. Wherein it shows its analysis and the reasons why lenders should feel secure providing capital to finance the deal.

A similar roadshow-type process may be conducted to develop an interest in an offering of high-yield bonds. That may be part of the overall deal financing structure. These are usually preceded by a memorandum related to the bond offering. Before this becomes final, it will usually require SEC approval.

If the banks approve of the proposal, they will initially provide a commitment letter that includes the terms of the loans. In some cases, banks will hold some of the debt in their own portfolio. While seeking commitments from other sources of finances while syndicating the rest of the debt.

Debt Capitals and Leveraged Loans

Debt capital comes from revolving loans or amortizing term loans that bank lenders provide. These banks typically involve commercial banks, savings and loan associations, and finance companies.

Long Term Debt

Longer-term debt commitments typically come from institutional investors such as insurance companies, pension funds, and hedge funds. Note that term loans can be investment grade or non-investment grade.

The latter group is referred to as leveraged loans. Unlike a revolving loan facility, which can be paid down but also reborrowed, Term loans usually have a fixed amortization schedule and are to be paid over a set loan period. Once payments are made, they cannot be reborrowed.

Bond Issuance

Another partial source of the debt capital may be a bond issuance. Which would probably require the investment bank to provide a bridge loan to close the time gap between when all the funds are needed to close a deal. And when the bonds can be sold in the market.

As previously stated, under asset-based lending or secured debt. We have senior debt and intermediate-term debt. Asset-based lending is secured by relevant current assets if the business being acquired in the LBO. It has a high volume of assets like inventories or receivables.

Senior Debt

Lending with such facilities is a function of the allowable “borrowing base,” which may define which assets are eligible. For example, older receivables or out-of-date inventories might not be eligible. In addition, the lending percentage will usually be less than the borrowing base to allow some protection cushion for the lender.

The former type of secured debt consists of loans secured by liens on particular assets of the company. Physical assets like land, plants, and equipment are the collaterals or those that provide the downside risk protection required by lenders.

The term of this kind of debt can reach five years or more. It also has different forms depending on the target’s business’ nature as well as the types of collaterals they may provide.

Moreover, the senior debt may make up between 25% and 50% of the total financing of an LBO.

The interest rate tends to be in the range of prime plus 2% to 3%. It also often comes with maintenance covenants, which impose financial restrictions on the target over the life of the loan. Furthermore, bank debt is usually priced above some variable base market rate, such as LIBOR or prime rate.

Asset-Based Lendings

Asset-based lending, whether senior or intermediate-term, is ensured stable cash flows, flows as determined by examining the pattern of historical cash flows for the company. The more erratic the historical cash flows, the greater the perceived risk in the deal. Even in cases in which the average cash flows exceed the loan payments by a comfortable margin, the existence of high variability may worry a lender.

Another characteristic that is deemed desirable is stable and experienced management as seen by the length of time that the management is in place. This will assure lenders that they are more experienced, implying that there is a greater likelihood that management will stay on after the deal is completed.

Creditors often judge the ability of management to handle an LBO by the cash flows that were generated by the firms they managed in the past. That is why is their prior management experience was with firms with liquidity problems, lenders will be more cautious about participating in the buyout.

Another thing that lenders tend to look for is room for cost reductions. reductions. Assuming additional debt to finance an LBO usually imposes additional financial pressures on the target, these pressures may be alleviated somewhat if the target can significantly cut costs in some areas, such as fewer employees, reduced capital expenditures, elimination of redundant facilities, and tighter controls on operating expenses.

Lastly, they see to it that the LBO candidate owns noncore businesses that can be sold off to quickly pay down a significant part of the firm’s post-LBO debt. With this, the deal may be easier to finance. This characteristic is also sometimes considered by unsecured LBOs.