How does the highly levered nature of leveraged buyouts boost profitability for the private equity firms?
What are all the different benefits of leverage that is commonly used by private equity firms? And what determines the exact amount of leverage?
Leverage boosts returns because debt ischeaper than equity.
The amount of leverage is determined by a company's cash flows. Too much leverage means and the cash flows of the business are insufficiently large to cover the interest payments on the debt, leading to financial distress. Not enough leverage means you're potentially leaving money on the table (if maximum leverage is your goal in this over-simplified scenario).
Leverage boosts returns but actually reduces the profitability of the company purchased.
An example using round, perhaps unrealistic numbers to illustrate:
You have $100MM to spend. Company A is selling for $100MM and it produces $10MM in profit every year. You can take all of your money, buy Company A, and get $10MM every year, earning 10% on your investment.
Or, you can go to a lender and ask for a loan. The lender is willing to give you $50MM at a rate of 8% interest. So you borrow $50MM and now you only need to chip in $50MM of your own cash to buy Company A. Company A now has to pay interest expense of 8% on the loan, or $4MM/yr. Its profits fall from $10MM to $6MM. But your investment was only $50MM, earning $6MM/yr = 12% returns. Because you borrowed some money, you still have $50MM available to go make another investment. You can buy Company B, which is identical to Company A. Doing the exact same thing you earn another $6MM on your second investment. At the end of the day, by using leverage, you boosted the returns on your $100MM investment from $10MM/yr to $12MM/yr.
And this is a conservative case as you buy at 10% unlevered IRR (10m 'profit' on 100m EV) and pay 8% for the debt. More common is 15% unlvered IRR and 3%for the debt --> debt turns good deals into great deals
See also this short movie on the credit crunch that explains it well:
I think there's no one fixed rule to dictate an 'exact' amount of leverage. My understanding is that the debt level is predicated on the following factors:
1) Range of LTV % that your PE firm usually is comfortable with (eg. could be in the zone of 50-60%)
2) Arrangement the PE firm has with its lenders for acquisition financing, and this differs from banks to banks. Sometimes, the investment may be acquisition financed by the PE firm's own balance sheet.
3) Company specific factors, such as the existing debt amount that target company already has (doesnt make sense to load a >70% LTV if debt levels are high to begin with), or how FCF generating the target company is going to be.
4) How much money are we looking at from Management rollovers, syndicate investors
LBOs will generally be financed with cash flow loans, so lenders will be primarily looking at leverage in terms of multiples of EBITDA, which serves as a proxy for cash flow. LTV is typically a real estate term, but commercial lenders will also look at the debt/capitalization metric, which is similar to LTV.
The PE firm and the lender will determine how much leverage they're comfortable with, but typically the PE firm will want more leverage and the lender's risk appetite will be the limiting factor.
The PE firm will typically ask for bids from its preferred banks or non-bank lenders. They'll choose based on how much debt is offered, the interest rate offered, and other contract terms. The PE firm will write the equity check, the lender will write the debt check. In the case of a megafund with multiple fund strategies, the private equity fund could partner with its own private credit fund. If the PE company is using its own funds to pay for 100% of the deal, then it's not really a "leveraged" buyout.
This is true, and I do not understand why, so I'd love to hear from someone on the PE side. These are enterprise value deals, so whatever debt the target company has gets refinanced and wiped out at the time of the transaction. The buyer essentially gets a blank slate for a new capital structure. But I hear over and over again that clean balance sheets make good LBO targets, so there's something I'm missing.
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