The Right amount of Leverage for Leveraged Buyouts

Posted on: June 10th, 2024

the-right-amount-of-leverage-for-a-leveraged-buyout

Leveraged buyouts are change of ownership transaction structures based upon layers of both debt and equity capital. The amount of equity and debt required for a leveraged buyout varies from deal to deal and is non-formulaic. The factors that determine the level of debt and equity required to close a leveraged buyout deal include company type, the price being paid, the Company’s cash flow stability and the buyer’s post-closing game plan. In general, the larger the company and the stronger the historical cash flow, the higher the debt amount. The smaller the company and the less stable the historical cash flow, the lower the debt amount. The buyer is often tempted to skimp on the amount of equity and to borrow more debt to close the deal. Sometimes this is sensible but often it is a miscalculation that leads to higher levels of capital structure liquidity risk.

The right amount of leverage for a leverage buyout depends on a number of variables and is usually a function of balancing the buyer’s desire for less equity with the lender’s desire for more equity resulting from their view of credit risk, industry risk and scale up capital plan. Lenders prefer balanced credit risk in leveraged buyout deals. This means deals with a strong layer of equity capital, as testament to the buyer’s commitment to the deal. Without buyer skin in the game, the lender has all downside risk should the company get in trouble. The lender’s view of industry risk speaks to the sensitivity of the company given economic changes in its industry. If the company is in a market perceived as riskier than average, the lender will not have comfort unless the buyer invests a significant amount of equity. Scale up capital plan means how much funding the business will need to achieve its growth objective. Buyers often underappreciate the capital intensity of their growth plans which results in tight liquidity should things take longer or cost more to implement.

Lenders are usually laser focused on the liquidity profile of the leverage buyout company due to their concern about downside risk. If the company underperforms and still has big investment plans, a thinly equity capitalized deal will not work. While there are ways for buyers to put in a lower amount of equity, they should be careful about overriding the legitimate concerns of lenders who control the amount of debt provided to their leveraged buyout.

In the acquisition financing arena, capital availability is destiny as companies require reliable access to capital to grow over the long term. Unforeseen capital needs usually arise when acquirers least expect it. This can cause some concern for the acquisition financing provider, especially when covenants tighten up and that working capital availability is utilized faster than expected.

Mezzanine debt borrowing is usually a straightforward activity that many companies use for funding of transitional growth. Mezzanine debt lenders are highly transparent about their due diligence approach and their post-closing loan management making it easy for companies to engage with.

Elections have consequences and positive ones at that for the acquisition financing middle market. While much media attention is paid to the direction of the yield curve and the Fed’s likely rate cuts, scant attention is paid to the more important drivers of the acquisition financing market – business psychology and regulatory climate.