How much debt paydown is necessary by Year 5 in an LBO?

I am assuming 80%+ for the typical business. What if you're investing in a slightly younger company that has solid growth potential? I am modeling in only 5x entry leverage, but cash flow yield is not strong enough to support 80% debt paydown due to growth capex requirements. Only able to paydown 45% debt by Year 5. Would raising debt be difficult for such a company? I am assuming most lenders want their money back by Year 5, in which case would it be possible to do a refi just before exit?

Could experienced PE professionals give insights into what typical debt paydown requirements are?

 

The sponsor's incentive is to never pay down any debt.

Most will only amortize the required 1% per year (typical TLB). They also try to avoid ECF sweeps by doing acquisitions, spending on capex, or taking dividends.

Sponsors will typically lie to banks and lenders about pay down projections.

From my perspective, there is nothing wrong with never paying down debt, or even increasing the debt burden using dividends, as long as the company continues to grow into the new cap structure.

Finally, most lenders do not want their money back via prepays. We would rather leave it outstanding forever. Getting prepaid creates cash drag until you find somewhere new to deploy it. Keep in mind, banks don't lend to sponsors anymore - it's all hedge funds, CLOs, and high yield MFs. We have return hurdles and like to stay fully invested, generally.

Array
 
ackap:

What about covenants? Don't they mandate paydown?

I guess the covenant you are referring to is a leverage maintenance covenant? Like required stepdowns in the leverage ratio?

If so, you dont need to reduce debt to lower your leverage. You can grow EBITDA instead. This is what I meant by "growing into the cap structure."

or maybe you meant ECF sweep covenant? In which case, see what I wrote originally. You can just avoid them by spending capex, acquiring shit, or paying dividends.

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HarvardOrBust:
Cries:

The sponsor's incentive is to never pay down any debt.

I wouldnt say never since it's all dependent on optimal capital allocation and sometimes it makes sense to pay down debt over reinvesting in the business

The optimal capital structure today is 100% debt / 0% equity.

The closer you can get to that, the better. Therefore, nobody is paying down debt unless they have to. They are taking dividends instead, if they have nothing else to do with the money

Array
 

You don't always want to pay down debt. Most of the time, the optimal capital structure for a company/project includes some form of debt to make the potential equity IRR attractive. Therefore your question assumes that the initial debt level is higher than the optimal debt level - that may not always be the case.

Before you answer this question, I think you need to specify the type of project/company. For example, I work in infrastructure where project timelines can be more than 30 years. For technology firms, you'd probably be at the opposite end of the spectrum.

Double Doubler
 
Best Response

Going to use some made up numbers: $100M EBITDA, $500M debt and $300M equity at entry. Starting covenant wouldn't be below 6x if you're starting at 5x leverage. A reasonably aggressive stepdown might be to 3.5x by the end of five years. Under your case, even if EBITDA is flat at $100M and you pay down 45% of the debt, you're fine (as you'd have $275M, or 2.75x EBITDA).

But if you're spending growth capex, you're hopefully growing the business. Assuming flow-through to the bottom line, you'd be able to deal with covenant stepdowns through EBITDA growth, not just debt paydown.

Life, liberty and the pursuit of Starwood Points
 

From a DCM underwriting perspective (ie perspective of the banks who have to sell this to the market), the amount of deleverage will depend on the nature of the business and how hot the debt market is running.

For a first lien term loan B deal in the last 2 months on B2/B credit, I'd be wanting to see something like deleverage your 5.0x starting point to 2.0x or less by maturity in year 6-7.

As @Cries says, you can delever by raising EBITDA rather than by paying down debt. However, lenders will still want to see some degree of pay down. @petergibbons suggested 45% pay down (ie 55% remaining when the debt is due for refi) is a good number to market the deal on. You may be able to get away with less for a business that's got a strong competitive position in an industry that has a good long term outlook.

Those who can, do. Those who can't, post threads about how to do it on WSO.
 
SSits:

From a DCM underwriting perspective (ie perspective of the banks who have to sell this to the market), the amount of deleverage will depend on the nature of the business and how hot the debt market is running.

For a first lien term loan B deal in the last 2 months on B2/B credit, I'd be wanting to see something like deleverage your 5.0x starting point to 2.0x or less by maturity in year 6-7.

As @Cries says, you can delever by raising EBITDA rather than by paying down debt. However, lenders will still want to see some degree of pay down. @petergibbons suggested 45% pay down (ie 55% remaining when the debt is due for refi) is a good number to market the deal on. You may be able to get away with less for a business that's got a strong competitive position in an industry that has a good long term outlook.

Non-sequitur comment for educational purposes only:

Banks stress this stuff a lot during the underwriting process, but we don't really think about it because we know the sponsor is always lying. Plus, less paydowns is always better if the company is flatlining or growing due to return hurdles.

Another useful metric is Net debt/FCF. On an absolute basis, in any market, I'm looking for an 8x or less for your average HY cap structure. This is a good proxy for pay down capacity, and is much more back-of-the-envelope, but accomplishes the same thing.

FCF = Ebitda - capex. Don't bother including interest, because higher rates are always better. But traditional pay down statistics punish companies who pay you a higher coupon.

Sorry if I muddied the water with this comment. i understand that you are looking for the answer, but the point I'm trying to make is that you are probably wasting your energy modeling this stuff out in practice. False precision or something like that.

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