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 middle market finance, mezzanine debt lenders have their own unique communication style. Due to their position in the market and their hybrid debt-equity sensibility, their perspective straddles both the debt and equity world. While mezzanine debt lenders issue loans, they think more expansively about value like the way equity investors do. Their capital is used to accelerate growth resulting in increased levels of cashflow sufficient to repay the initial loan amount.

As a foolish consistency is the hobgoblin of little minds, so too are many of the acquisition financing myths that people hold. These acquisition financing myths are borne of cliches that arise in the wall street vocabulary and enter the archetypal story telling of acquirors. For some reason, very smart and serious business people adopt these myths without much assessment of the underlying logic.

The acquisition financing middle market tends to be viewed by borrowers as a vast sea of capital marked by minor differences in pricing and funding amount. Depending on the deal to be done, one needs either more or less acquisition financing to fill in the gap beyond the bank loan. In this context, capital is viewed functionally and indiscriminately as the sum of the terms and conditions within the loan agreement. While this is absolutely the case transactionally, the deal usually represents a much bigger event to the buyer than just a closing.