LBO - Repayment of Debt
Just a quick question about the value of repaying debt during an LBO; wanted to make sure my logic was correct. This is the way I'm thinking about it:
Conceptually, if you have a certain amount of cash (let's say x) on the balance sheet, it makes more sense to use that cash to pay down debt because if you pay down debt, your interest expenses will go down, which increases net income and therefore increases cash flows. With this additional cash, you can repay even more debt, which drives net debt down by even more. So your net debt is down by x + a little extra. If you were just to hold on to that cash, net debt would just go down by x. So your overall equity return is higher if you pay down debt rather than if you just held on to that cash.
Is this correct? Are there any other aspects I'm missing with regards to the value of debt repayment?
In theory yes, but you don't buy a company only to repay all its debt, you buy the company expecting that the returns from the company will cover the debt and it will also leave you with some extra cash. Also, 1 penny today is worth more than 1 penny tomorrow, so what an investor will do in an LBO scenario will be to put down the minimum amount of equity possible (cash) and use the rest of equity for other investments that may return more than what the debt and interest will cost.
Because, to begin with, most investor could put down 100% of money, but leverage is used as a means to not "tie" all their capital to a sole investment, and instead, to pursue additional profitable investments that - again - will produce additional CF to not only cover debt but also to leave them with some extra profits and higher returns after debt is fully paid.
so focusing on paying debt as fast as possible = lower NPV, compared to carrying the debt until maturity and use the extra cash for more profitable investments
So in that case, why pay down debt at all during the holding period? Considering the return on equity investments is (almost) always going to be higher than the cost of debt, wouldn’t you always prefer to have more cash on hand to invest in other things with? Ie, wouldn’t the highest NPV play be to not pay down any debt until the very end and just keep using any extra cash generated to make additional investments?
because of a combination of those 2:
1) the longer the debt duration, the more expensive it is (higher interest) + point 2
2) investors don't always find profitable alternative investments, so in that case, they will opt to repay debt (for reasons you pointed out) as that is the most profitable alternative
edit: to add another point, loan agreements also have covenants (i.e. restrictions on what you can and can't do during the debt's duration), so if the company is becoming profitable and you may want to pursue other acquisitions/riskier investments, then those covenants may prohibit or request additional interests for waiving the covenants (i.e. freeing you from the restriction), so if the NPV of those acquisitions/riskier investments is higher than the NPV of using that money in the limits of the loan agreement, then you may opt to pay the debt (paying the debt before maturity may bring a prepayment penality, but even here you decide between the NPV paying the debt before vs. doing something else meanwhile you wait the loan to mature).
Use the cash to pay dividends to the sponsor, tell the lenders to amend the credit agreement or take the keys, move on to the next investment.
That's broadly correct, yes. You also need to account interest income on cash sitting on BS (if you don't repay debt, forgone income if you don't) in your analysis but impact should be small overall.
Agree with the above comments that you're not wrong... but this is not what you would do. Cash is king and the business earns it for itself - not the lenders. Give them their pound of flesh per the agreement and distribute the rest (if allowed). If not allowed, negotiate better terms and allows allow for some level of distribution. Even if you are tied up with excess cash flow recapture covenants, only pay what you have to. Cash is king and you never know what will happen next quarter. The lender certainly isn't going to give those extra payments back if you find liquidity pinched.
So you typically don’t want to make optional debt repayments? I thought the whole point of the LBO investing style was to reduce debt over time thereby increasing equity, and thus driving your returns up overall compared to a pure equity investment.
No - why would you?
The whole point of the LBO investing style is to MAXIMIZE your returns to equity by using as LITTLE of it as possible. Let some other schmuck hold the bag if something goes wrong. Returns are high because equity base is low.
The real returns occur after you start taking a hatchet to the P&L to reduce expenses or increase prices (or both). Then the same company becomes more valuable in a short period of time and you can sell it (and retire the debt) or IPO it (and retire the debt). In either case, equity position accrues all those gains in value.
Just paying down debt does nothing to the value of the company.
This post is the exact reason why my group doesn’t hire from diversity programs
And you spending your free time trolling WSO to try and make sarcastic quips is exactly the reason why you’re still stuck in IB as an associate.
If you keep cash on balance sheet you don’t get to keep it once you sell the company, whoever buys the company does. I.e. Dell LBO. So you want to extract all the cash you can and keep a minimum load of cash.
This is not accurate for the majority of deals...
The big thing you are missing is the concept of internal rate of return, the fund's hurdle rates that trigger carry, the significance of borrowing at a low after-tax cost of debt, and the interplay between these.
A successful private equity firm receives substantially all of its compensation through carried interest. Carried interest means a share in the investment returns they deliver to limited partners. It looks something like 1) no carried interest up until a 9% fund return 2) 50% share in the fund returns between 9% - 13% then 3) 20% share in all returns thereafter.
The big thing here is that the PE firm cannot borrow at a post-tax cost of debt that is higher than the hurdle rates for carried interest without harming carried interest itself. Think, why would a PE ever allow a creditor to get "carry level" returns or higher when the fund can snatch those returns by self financing and going without debt? So in order to be able to justify the use of leverage, you really need an interest rate that's low and reasonable. Like one poster mentioned, this steers funds away from the long-term higher yield debt products. If they needed that temporarily, they'll get rid of it quickly. That could be one answer, but the interest rates generally must be lucrative.
Now assuming you have appropriate debt products, leverage can be used to maximize returns. Typically people think of this as just to have low equity on the front-end and magnify returns on the back-end (just like margin trading). There is more value in debt than just that, however. Here's a "sorta simplified example". Let's say:
- Your fund has carry hurdles starting at 9% and 13%;
- Your debt products cost 7%;
- Your portfolio company is worth $1000 ($500 debt and $500 equity); and
- Your portfolio company unlevered (i.e., when ignoring the debt) cash flow is $120 per year (which implies a 12% WACC and 16% cost of equity with the 8% cost of debt)
Let's assume for simplicity no growth in the business. Enterprise value is starting and ending at $1000.
You might think why have the portco pay $35 of interest (7% of $500) each year? Over 5 years, that interest would equal $175 and a sizeable chunk of the current equity inside. If it pays off no debt, the equity release at exit would $500 and the same at entry. The answer is in the rates of return.
The PE firm will be getting the cost of equity (16%) as it's rate of return based on the cash flows. That will be blowing through the carry hurdles. Anything it does that chases something less than that, moreover, less than the 9% hurdle, is going to dilute the rate of return, which will dilute the carried interest, and PE compensation.
They will rifle the cash back to the fund as fast possible and make distributions to LPs to maintain that 16% equity return rather than chase creditor returns by avoiding interest.
Disclaimer: Its 2am on a Saturday morning. I grossly oversimplified basically everything a PE would be doing to the investment and how value would be changing. Nonetheless, hopefully, it illustrates that by not paying debts down you get a carry-maximizing return beyond all hurdle rates and by paying down low-yield debts you dilute that.
Exception to the rule that doesn't matter for our purposes: If your fund is **way** into carry, you can do silly stuff like trying to pick up pennies. That's because even a super diluted investment return could leave you well in the maximum hurdle rates and an 80/20 split if you've crushed it elsewhere. In that case, you might as well try to maximize cash on cash returns because you are going to keep 20% of everything. Just don't tell your LPs.
Edit: I ran my fugazi example through Excel real quick. I'm not rehashing this example, but it looks like both cases would actually hit my made up carried interest hurdles. You get my drift though. Paying down debt lowers the IRR. In this one case, hah, chasing the higher cash on cash returns will win out for the fund. Maybe I should say something very WSO right now like "Suck it LPs."
That all sounds very smart but you’ve got a few basics wrong so it doesn’t make any sense. This is not how carry and the hurdle works
In the interest of quality, feel free / I’d encourage folks to add more. I know it is a gross oversimplification, but I think the business acumen is there. I made the actual carried interest calculations at funds before the move into TS.
Simplistically, in nearly all scenarios cost of equity (think fund target returns) > cost of debt > interest earned on cash in the bank. Therefore you nearly always want to do a dividend to equity holders before paying down debt or keeping excess cash on balance sheet. In most deals, the CA restricts how much you can dividend out before paying down debt, unless you get an amendment or do a full blown dividend recap, and thus most times you would pay down debt if you had no need for the cash on balance sheet or don’t need it for future high-returning projects. It’s important to accurately forecast cash needs in future periods though before doing this or else you may run into cash problems if performance isn’t strong as expected or working capital increases a lot, and you have a cash interest payment coming due (in scenarios like this the deal team is not going to have a fun time…). This is overly simplistic but how I think about it.
To add onto the whole point of taking leverage in the first place...
It's always the debt you want to pay down that won't let you (higher interest debt with NC / makewhole / other protections), and the debt that you don't want to pay down (all the cheaper secured / senior debt) that wants you to (gotta negotiate hard to make sure you can recycle your proceeds from literally any payout instead of early prepayment)
What if a company has some less ideal debt that matures in 2024 or 25, but also credit with more favorable terms that matures in 2033?
In practice, almost no LBO actually pays down debt. They will pay the required 1% amort on a typical term b and cf sweeps if required but rare because they always find a reason to not do so (M&A, capex, investments etc). If anything, sponsors will do dividends. There are of course exceptions but this is generally how things almost always play out.
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