LBO deal: why use high yield debt? how are debt tranche splits arrived at?
a)
after reading this -> "Why would a PE firm prefer High-Yield Debt instead? If the PE firm intends to refinance the debt at some point or they don’t believe their returns are too sensitive to interest payments, they might use High-Yield Debt. They might also use High-Yield Debt if they don’t have plans for a major expansion effort or acquisitions, or if they don’t plan to sell off the company’s assets"
assuming deal confidence why assume higher interest expenses in first place?
b) how are deal tranche splits between bank, high yield usually formed? what is the decision process look like? how about splits also including other types of debt.
thanks.
a) A PE firm would use debt for many reasons. Probably the most prominent reason why a PE firm would use to debt is to be able to buy something that they wouldn't typically be able to buy with just their existing capital base. An easy comparison is like a person trying to buy a home. A person will usually have to put down a downpayment as well as take on a mortgage to finance their purchase of a home. An average person wouldn't be able to buy a house without the ability to pay for it over time(the mortgage). The same goes for a PE firm, they sometimes can't currently afford the asset they want to purchase and choose to take on debt. They believe that the yield from the investment will be greater than their interest payments. Another reason is that debt is tax deductible meaning it will effectively lower the amount of taxes the PE firm will have to pay on any gains. In addition, if the PE firm has strong "deal confidence" as you put it, they can use that debt to effectively leverage their portfolio and acquire superior returns relative to not using leverage.
b)So i'm not quite sure what you are asking, but I guess I'll explain what tranches are. There are several forms of debt and to name a few there is: secured debt, unsecured debt, mezzanine debt etc. Secured debt is the "safest" form of debt because they are backed by an asset. What that means is that if the company needs to be liquidated, the secured debt gets first claim to the company's assets. By having first dibs on the company's assets makes that debt issuance less risky and therefore that tranche receives a lower yield. The next after secured debt, is unsecured debt who get "2nd dibs" on the company's assets. This makes this debt more "risky" than the secured debt and therefore gets a higher yield. It's a little more complicated than that, but the tranches continue further down with the riskier debt requiring higher yield.
Hope this helps
At a certain amount of leverage, traditional debt markets are no longer available to companies. This is essentially always the case with companies being LBOed, which is why sponsors work with Lev Fin teams to raise leveraged loans and high yield notes to finance the transactions.
For the sponsor's returns, consider that an extra turn of leverage FAR counteracts the incremental interest expense in 99.9% of cases. Sponsors want to push for the maximum debt quantum they can possibly receive, regardless of cost (though of course they are still focused on cost and always make sure their banks are keenly aware that they need the perfect combination of lax covenants, low cost, and maximum leverage...)
As for tranches, it's a similar answer to above. Obviously they want to max out at the cheaper, more senior levels of debt, but bank appetite limits the amount they can raise, so they turn to the more yield-hungry hy market. You will sometimes see situations where the company's Term Loan is significantly oversubscribed by investors, allowing companies to downsize their hy tranche and upsize the TLB
Also to add to an answer to question b), sometimes the sponsor might prefer senior secured bonds (HY) over senior secured bank debt (Loans) given that bonds do not have financial maintenance covenants (though cove-lite loans accomplishes the same thing, but its not always available depending how hot/cool the market is). HY also has high breakage costs (given NC provisions) in the event if you want to refi or sale the company.
The splits are generally quoted by cap markets desks at the banks. Generally (and this is highly dependent on the company and its cash flow profile) loans go up to 3-3.5x and all in leverage caps at 5-6x. I'm not as close to the lev fin market as I used to be, but this should still be in the ballpark.
THANKS! I meant, what is the typical % of debt in a deal - what % high yield and what % bank loan?
I think BatMasterson answered this as 45%-55% but it was not a direct hit so asking for confirmation "loans go up to 3-3.5x and all in leverage caps at 5-6x"
Again, it depends on the deal. Stereotypical LBO should expect 60-70% debt if done by a private equity group (not including family offices and other private investment groups in this). For simplification purposes 2/3 senior and 1/3 sub/mezz, though you could see that shift in either direction.
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