Cap Structure in LBO
To those familiar with Capital Structure in LBOs and financial engineering; would it be correct to say that the capital structure PE firms use in an LBO would be the capital structure that leads to the lowest WACC?
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no, it’s the lowest equity check usually with the lowest leverage possible to still make exit feasible
I’d agree with lowest equity check and whatever’s the cheapest financing they can get. Just because they want X structure doesn’t mean that regulated banks can and are willing to provide that.
With the rise of credit arms of PE funds this may be less of a concern for sponsors moving forward but who knows what if any regulation of shadow banking will emerge post covid
I would answer probably but not always. It’s the lowest wacc you can feasibly get i.e. lowest equity in + cheapest debt you can find.
But there can be nuances. Eg maybe you include some convertible pref structure that increase wacc (hurts common equity which mgmt May hold) but protects the pe firm’s downside a bit. You might overequitize if it’s a high quality asset and 100m extra equity can be put in at 18% irr vs 19% irr if you just max debt (growth drives return in fast growers not leverage), so what’s better deploying more of the fund + lower risk or the point of irr? So maybe just putting more equity can actually be a rational choice in that case if it lets you deploy your fund with fewer deals (search and transaction costs are high in illiquid markets)
Thanks for posting this - can you explain how convertible pref increases WACC? Not sure I understand
Thanks for the response, how does that protect the downside? Wouldn't those preferred shares still be paid out before we see what is left for our equity?
No, this is only in situations where there is significant information asymmetry. A large pref will increase perception of agency cost and info asymmetry wrt the valuation of the common. That's one major reason you see auto conversion at IPOs so the banks can present a straight forward balance sheet to the mkt.
For all of these you have to relax the capm assumptions (info asymmetry, agency, transaction cost etc). In a capm world every example here can be refuted.
Sorry I'm having trouble following, what is agency cost and auto conversion?
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