Why should sponsor care about previous leverage of target company?
Hi guys,
I've been thinking about the following issue today:
Say you have a company with $100m EBITDA, and you want to LBO it at EV = 10x EBITDA = $1bn.
Let's also assume that your (you = the sponsor) maximum Debt/EBITDA ratio is 6x, so you finance the LBO with $600m in debt and $400m in own cash.
My question is: do you as a sponsor care about whether the target company has been previously more or less levered?
My intuition is that you should not care, since you pay with 6x EBITDA in debt anyway, and you also pay the entire EV which implies that all the existing debt gets bought out anyway.
But I keep reading from different sources that ideal LBO candidates should have low debt levels, and to be honest I can't yet see why...
Any insights would be highly appreciated!
Your intuition is right (at least in theory) - you're wiping the capital stack clean so however it was capitalized previously shouldn't matter after you put in place your new cap stack.
In reality though, there are a lot of other factors to take into account. Consider these examples - if a company has too big of a debt load and is about to go BK, it's probably not the best time to LBO it. Also, the leverage multiple of a company sets a sort of floor on what you can pay for it (assuming the lender doesn't want to take a write down). Finally there's also a perception/comfort issue - all else equal, you're going to have an easier time finding lenders to finance the LBO of a company that has a clean BS than one that is currently struggling with debt.
OK interesting, so it has to do with lender and sponsor confidence in some way.
But could you maybe elaborate a bit more on "the leverage multiple of a company sets a sort of floor on what you can pay for it (assuming the lender doesn't want to take a write down)" ?
Sorry I'm sort of new to the LBO field and don't quite understand what you meant by that xD
I think CHItizen is referring to the amount of debt of the target company that you are required to pay down if you acquire it. A higher leverage multiple = more debt to pay down if you acquire it, and assuming that you are paying down the debt in its full value where the lenders are not taking a write down, the company will have a higher minimum value (price floor) compared to a scenario where it has lesser debt.
I think, boiling down your basic concern that targets should be lower leveraged; they should be based on the fact that you want to be generating higher IRR by levering them up (i.e. if you contribute less equity, the better for your IRR). If you use your equity contributions to pay down already outstanding debt, then you're not really gaining anything, right?
E.g. - if you borrow $6 and add $4 of your own money ($10 equity transaction value; ex interest, etc, can't do math atm) to buy a stock, then sell it for $20, you earned $10 for your $4 of equity contribution (2.5x return).
However, if this transaction required you pay down the target's debt (assuming you'd want to delever the entity with the transaction), it'd require you to use a certain amount of your equity to take out bondholders - and usually at a premium given the CoC provision in most bonds... even IG.
So long story short, financial buyers aren't in the business of transferring value to bondholders.
Few other considerations why existing leverage matters: - If it is too high, then it is probable that company has been saving too much on essentials (e.g. maintenance of premises, staff, bonuses, research - depending on industry) so consider bringing those up to normalised levels - this will impact your intrinsic valuation - If leverage is high it might contain some form of HY/PIK instruments with high break costs - those will require additional funding and therefore reduce your returns, Sometimes these break costs can be as crazy as 5% of EV
Adding on to this - one of the value propositions of PE is that management have less flexibility to mess around. If the company is highly levered you're going to force discretionary spending (both over-ambitious capital projects and excessive corp expense) to a minimum. So if you take a company that has that so over spending mentality and lever it up it can be beneficial from an EV perspective.
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