Does pre LBO debt matter when screening for potential LBO candidates

Leverage is usually considered from a EBITDA and FCF perspective (ie measure of ability to deleverage) rather than D/E.

When I look at equity's share of purchase price funding, it's more as a sign of how much the PE firm stands to lose, hence had incentives to do a good deal. Also, equity share is partly a function of how much debt the business can bear, which takes you back to my first point.

Pre-LBO debt matters if there is a ton of it, there are heavy call protections, and you can't refinance it in the current market. I don't think there's a set percentage or number for acceptable pre-LBO debt levels -- this depends on the company and the market. For example, you can't LBO First Data today with with $21bn of debt, but you can LBO Air Medical and boost leverage from 5x to 7x (which KKR just did).

Aside from the potential breakage fees (which should rarely, if ever, be enough to turn away from a deal), pre-LBO debt is irrelevant when screening for potential targets - remember, you as a PE firm are buying the net assets of a company (i.e., the equity, which is equal to assets less liabilities including any debt) - if there is a lot of pre-LBO debt which can't be refinanced (rarely true) or you don't want to refinance it (you rarely have a choice due to CoC provisions), the purchase price will be smaller (since the proportion of liabilities to assets will be higher). If you buy a company on a cash free/debt free basis (most common), the purchase price will be higher (since the proportion of liabilities to assets will be lower). Either way, theoretically, you should end up with the same post-LBO "enterprise value" and amount of leverage in both cases (unless the pre-LBO debt can't be refinanced for some odd reason and covenants prohibit you from adding more leverage... but I have never seen such as scenario).

It's much more useful to look at the required purchase price of the net assets and how much equity vs. debt you can use to finance that (if there is existing debt that can't be refinanced for some odd reason, you won't have to "pay" for that anyway - it just rolls over).

Does that make sense?

I would say it does a bit in terms of making adjustments for expenses in relation to the debt. Then again, it is EBITDA focused so it doesn't matter that much. However, there may be some fees to retire and create new debt. Pretty much what everyone else has touched on already.

I would say the pre-LBO cap structure is irrelevant, as is the D/E ratio. Its probably silly to think that the pre-LBO cap structure is a statistically significant driver of post-LBO EBITDA & FCF generation.

There are certainly some fringe benefits that ILikeDistressed outlined, but to think it is a material driver is completely flawed.

The point that was made about having too much leverage making buyouts difficult also has merit. If the call premiums on pre-existing debt is too high, then it simply becomes more expensive to buy a company. This wont be reflected by a D/E ratio, however. You will have to read individual indentures to tease this info out.

The amount of leverage a company has historically taken on can be a sign of other things.

For example, if a firm has been significantly over-equitized further investigation could show that it's a business that has large swings in cash flow due to the nature of the business, so they keep it deleveraged with a cash pile to deal with that (completed contract project based businesses, for example).

Didn't we just talk about this a couple weeks ago?

Thanks for the comment guys. Big help! I will look more thoroughly through older posts next time before posting.

I have to admit I do agree with most of your points that pre-LBO debt should not matter in most cases. That is why I thought it was a bit puzzling that I was reading many comments and posts online where most of them stated that "a desirable characteristic of a LBO target is low or no initial debt".

If you do know any good books or academical papers which address this please let me know since I have not found any rock solid sources so far. Can´t really use this forum as a source at such a high academic level :P

Cheers

Take a look at Levered Financial Markets by Maxwell and Shenkman. A lot of that book is about process, terms etc and not directly on the points you're looking for, but it should help get you up to speed on the industry and jargon and it does, to some extent, touch on the stuff you're looking at.

Here's some more resources on the market for LBO debt: https://www.lcdcomps.com/lcd/f/primers.html http://www.mayerbrown.com/High-Yield-Bonds---An-Insiders-Guide-3rd-Edit…

Also, this may be handy for deciphering jargon: https://www.lw.com/bookofjargon-apps/boj-us-corporate-and-bank-finance