This is a conceptual question - I understand on a basic level the benefits of using debt in an LBO (reduces the upfront cost of acquiring, making it easier to earn a high return / frees up the fund to diversify investments), but I'm having trouble thinking about this from a cost of capital perspective.
For example, if I told you that the company you want to takeover has some new $20M capital expenditure, would you rather fund it with debt or equity? How about with a PIK loan?
I would think that you would use whatever form of capital is cheapest. Wondering if somebody else can embellish this explanation, because I have no idea what somebody would say if they prompted "What do you mean by that?"
You have the right idea. You would aim to finance capex with debt if possible as it is a cheaper source. A PE firm may target 20%-25% return on its capital, whilst the cost of senior debt may be in a range of c. 3%-4.5% plus the base rate.
In terms of choosing between normal debt and a PIK loan, capex is often financed through “standard”/senior debt rather than PIK as PIK notes are generally subordinated and therefore can often require 10%-15% PIK rates.
The senior cost of debt mentioned above is for the Australian market. It may be slightly lower in the US market.
Thanks. So basically, barring factors like the accessibility of more senior forms of debt / constraints created by covenants, I want to finance with the cheapest form of capital so I don't dig in to my own return. (I.e. Senior debt investors in the U.S. are expecting LIBOR + 200-400bps, whereas most PE firms are targeting 20%+)
PIK alternatively seems like a last resort source of financing.
Just one follow-up thought here...
If one were simply asked, "Why use leverage in an LBO?" I'd imagine you'd explain it like the following....thoughts?
-> First and foremost, leverage reduces the upfront cost of acquiring another company, which makes it easier for a PE firm to earn a high return (assuming the deal performs well). For example, if you bought an asset for $100, earned $10 on it for a year, and sold it for $100, your IRR would be 10%. Whereas if you bought that asset for $50, earned $10 on it for a year, and sold it for $50, your IRR would be 20%.
-> And more generally, debt is a cheaper source of financing than equity. Barring certain conditions, limitations or implications of raising money in one form or another, first and foremost companies should seek to raise money from the cheapest source possible
-> A secondary benefit of leverage is that the fund has more capital available to buy other companies
Prepfordays234,
While I think you understand the concept of why one should use leverage in an LBO, your description is not quite as clear to me. Leverage does not technically reduce the upfront cost of acquiring a company. In fact, leverage can slightly increase the upfront costs due to fees charged by lenders in order to loan the money. The key is not that the cost of the asset has changed, just the required equity in order to finance the transaction.
So why is this a good thing? The technical answer is that the debt cost of capital is less than the equity cost of capital. The business answer is that a PE fund is measured on ratio of capital returned to LPs over capital called from LPs (or Return on Invested Capital). The example you provided in which a cash generating asset is bought with $100 of equity versus $50 of equity is a good demonstration of this. Theoretically, more expensive assets have higher cash generation potential. Leverage lets a PE fund acquire assets with higher cash generation using the same amount of equity.
The PE fund is also measured on IRR, which is really just the timing element of the above Return on Invested Capital metric. Because leverage enhances ROIC, it will also enhance IRR all else equal.
As to your secondary explanation that leverage enables a fund to buy other companies, I'd argue that this is actually embedded in the first explanation. Also, based on my experience, leverage is more likely to influence the size of a PE firms acquisitions rather than the number of (platform) acquisitions. This is certainly not true in all cases though.
That makes sense - a better way for me to phrase my first point would be in terms of the equity check required ("reduces the upfront equity required to acquire a company, making it easier to earn a high MOIC")
Maybe I'm over thinking, but I'm still struggling on debt being cheaper than equity fuels the return....Objectively I get that debt investors would be expecting a far lower return than the PE firm, and we would want to minimize interest payments, but I think my thought process is skipping a step.
Perhaps think of it this way. Say you're buying a company for $10 million with 50% equity and 50% debt. Suddenly the seller tells you that he wants $11 million for the company rather than $10 million. How do you finance the extra $1 million required? If you finance it with additional senior debt, the return on your $5.0 million of equity will be higher than if you brought in a new investor who contributed $1.0 million of additional equity. Essentially, the dilution from issuing additional equity hurts your returns more than issuing additional debt.
This isn't a technical explanation but hopefully frames the situation in a way that is easier to understand.
The real reason debt is better is because debt allows you to do MORE acquisitions/capes/etc. Sure, it has a lower cost of capital, but here’s the real beauty of using debt:
If you’re fund has $100m of capital and you find a $100m acquisition generating $10m of EBITDA and pay cash, you’re done. Hopefully you make your 10% return on that and call it a day.
If you decide to finance that same acquisition with 50% debt you still have half your capital left. If you find an identical opportunity, you’re able to put the rest of your capital to work and now you’re generating $20m EBITDA on your same capital.
With debt: 20% return on your capital (less interest). No debt: 10% return on your capital
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