How to Leverage Leveraged Buyouts: A Deep Dive into Acquisition Financing

Leveraged buyouts have long been the subject of fascination and condemnation in the US Acquisition Financing market. They came of age in the 1980’s during the junk bond revolution, when virtually any type of business was leveraged with acquisition financing. The junk bond era succeeded in democratizing access to acquisition financing for all companies provided they were large enough.

Unfortunately, this led to the overuse of junk bonds for deals that should never have been done. The junk bond market then recovered and became increasingly stable, which paved the way for the emergence of the private credit markets of today. The junk bond market succeeded in getting investors to focus less on asset collateral and more on cash flow and debt service capacity. Whereas traditional bonds were always low risk and low return, junk bonds presented a higher risk adjusted return possibility to investors.

This created an institutional investor appetite for a wide range of private debt investments that offered less risk than equity but higher returns than low-risk debt. Leveraged buyout sponsors seized on this shift in institutional investor demand and applied this new category of acquisition financing to middle market companies, creating private credit industry over the last 35 years. Over the course of this growth, we have been involved in over $2 billion in financings and learned a thing or two about the best way to leverage acquisition financing to do a successful deal.

1. Acquisition Financing is best used in moderation. Sponsors are always tempted to put in less equity and do as much with other’s people money as they can. This puts the company in an illiquidity straitjacket and increases the risk of insolvency. If you leverage up at closing, you leave no extra capital to invest or to carry you through a down stretch.
2. Acquisition Financing is only as good as the maturity level and temperament of the people providing it. If the management of the lender is immature and emotional, you run the risk of your financing becoming very unfriendly quickly should the business underperform.
3. Acquisition financing can only be unlocked by a buyer with equity at risk, a strong background and a compelling growth story for the target business. Acquisitions are hard things to pull off and lenders screen for quality candidates with strong track records of prior achievement.
4. Focus on Financing Structure Value vs. Pricing – most buyers focus on interest rates and fees, not structure value which includes financing flexibility, covenanting approach, and access to follow on financing. Sometimes the better deal is more expensive on pricing, but it provides immensely more benefit in terms of capital availability and repayment flexibility.
5. Focus on the growth story as opposed to ability to finance. Before you do a leveraged buyout, you need a compelling reason for the target business to perform better under your ownership. Focus on answering the question – “Is it a deal worth doing” as opposed to “Can I raise the financing”.