LBOs - Why repay debt instead of keeping cash flow?
The M&I guide says that "using the company’s cash flows to repay debt principal and pay interest also produces a better return than keeping the cash flow." Is the intuition that the interest rate on the debt is always higher than the interest income you would get by keeping the cash? Would the exception to this be if reinvesting that cash back into the business and growing its enterprise value would generate an IRR that's higher than the interest rate on the debt principal? Not sure if this is the right way to think about it, so any help is appreciated here.
One (but not the only) explanation is to think about your own credit card balance. The interest payments can become a burden when you are doing nothing to repay debt. And yes you are correct that interest income is generally very minimal. Other reasons include reputation with creditors in terms of being a sponsor that actually pays down debt like they are expected to, as well as increasing refinancing risk (the risk of being unable to refinance the debt that is leftover at exit). Lastly, you would need to consider if you could be in default of any covenants by letting leverage sit / pile on. Particularly risky is the case that you experience a period of EBITDA contraction, making leverage ratio shoot up.
Thanks so much for the explanation - that makes a lot of sense
If you never pay down debt, it's tough to get more value when you sell.
Will highlight a couple reasons. Keep in mind a company has mandatory amortization (debt repayment scheduled amounts) so this is only concerning the decision of whether to debt sweep (optional repayment) or not. Also obviously you'd have to maintain the appropriate leverage/coverage ratios per maintenance covenants, but I assume a company doesn't run that close to the margins anyways so it shouldn't be a huge factor in making the debt sweep or not decision. It's a question of which application of cash retrieves highest returns to equity.
1) Delevering the company to increase equity portion: arguably for this reason alone you wouldn't need to pay down the debt immediately and could just get rid of it at exit year. 2) Reducing interest payments: this is the big part. Cash interest income is usually very low 2% whereas interest on prepayable debt could run >5%. Junior debt might even run >10% but you really can't do much here unless you want to pay the call premium/make-whole or try refinancing to cheaper debt. That said, you might want to refi to get rid of incurrence-heavy covenants on junior debt although there's not really a case for that nowadays because of cove-lite environment. Hence you use cash to repay debt as early as possible since you save more on debt interest than gain on cash interest income. 3) Growth capex vs. using the cash to pay off debt (and reduce interest income immediately): here you'd consider the return on capital for that capex historically. Keep in mind you should always do maint. capex but growth/acq. capex is a bit more up to mgmt jurisdiction. One quick measure has been % of historical growth capex vs. revenue (or incremental revenue YoY). You could try thinking about the technical definition of ROIC (earnings / total book capitalization) but I figure it's a bit too complicated to quickly extract.
Appreciate the thoughtful comment. (2) and (3) make sense for me, but in the case of (1), wouldn't repaying $100 debt vs. keeping $100 in cash have the same effect on exit equity proceeds since equity value = EV - debt + cash?
Precisely. That's why that bullet point ends with the sentence: arguably for this reason alone you wouldn't need to pay down the debt immediately and could just get rid of it at exit year.
If you're Apollo you just keep the cash.
If you're Apollo, you keep the cash and dividend some more. Gotta keep em hooked with the coupon.
Amen
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