Leverage relevance for LBO target

good for which party? how risk averse is the investor? how much debt is already being put in the company? way too many assumptions to give a good answer here

Good for the sponsor. Basically why do sponsors prefer to invest in companies with relatively low leverage.

as long as the IRRs and everything else makes sense, I don't see why PRE-LBO leverage would matter. For example, if post-acquisition, sponsors want the capital structure to be 70%-D and 30%-E, and PRE-acquisition the leverage is the same (70-D; 30E), then all the sponsors have to do is refinance the whole 70%. If PRE-acquisition, the leverage is 20-D and 80-E, they would have to refinance the 20 and add an extra 50 in Debt. When people say one of the criteria of doing an LBO is for the target to have low debt, it doesnt make any sense - what matters is the post-acqusition capital structure and the ability of the sponsor to raise the required debt. end of

Int Exp : If I am buying a 6x levered company in a super cyclical industry, likely LBO debt will price wider than existing debt. Existing debt likely trading at already impemissible levels from a pro forma int. exp. standpoint.

Covenants of a highly levered co.: the cov's on existing sr. sec. debt in a levered co likely impermissible / not as attractive as unlevered co.

there's a myriad of other sht, underinvesting in R&D / CAPEX due to higher leverage and covenants but let's leave it here for now.

Existing capital structure is largely irrelevant to a sponsor looking to do an LBO. The only reason a sponsor would be concerned with current capital structure is if there are consequences associated with change of control that would cause additional transaction related expenses.

For example, bonds generally have a non-call period and even when they can be called, there is a call-premium involved. So if LBOTargetCo recently issued $500M of bonds, there could be pretty hefty breakage costs. So lets say there's a bond that is 10NC5 (10 year bond, non-callable for the first 5). It was issued 1 year ago, $500 million principal, 10% coupon.

Essentially you'd have to repay principal plus call-premium plus PV of unpaid coupon... if there are several years until the call period.

So if you were to LBO this company you'd have to pay the following:

The principal due in 9 years=$500M Call premium: $25M (typically, since its a 10NC5, first call is 5 years from issuance, at that point the issue is callable at par+50%+coupon, so in this case its callable at 105. This generally declines ratably to par by the time you hit maturity (so it would be callable at 105, 103.75, 102.5, 101.25, 100 for years 6, 7, 8, 9, 10), All coupon payments from now until the first call date (4 years from now, so 4x10%x500M=200M

So in order to retire this debt early the company will have to pay the PV of: $525+200M=$725M, or PV($225M) above the principal outstanding. In these cases, which aren't all that uncommon, either it will be a deal breaker and it would have never even got far along in the process to have evolved from an idea to an actual deal or the sponsor/bankers/company will have a fairly strong degree of confidence that they can skirt alot of these issues by reaching an agreement with bond holders.

Sorry if I got his wrong:

- I always thought when buying the target the base price is the Equity value (the outstanding shares of the company) + if there is debt, it will be either assumed (then it does not increase the purchase price) or refinanced (so additional funds are needed to replace the debt with new one)

- What I do not understand yet, if the existing debt needs to be refinanced and thus increases the effective purchase price, why would the PE firm not care about this? In my understanding, this would ultimately limit the amount of debt, the sponsor can use in the deal, because we need to refinance the existing debt first, which increases the equity portion the sponsor needs to add and lowers the flexibility to add more debt later?

- For example: Total debt capacity of 5x EBITDA; thereof 3x used for refinacing of existing debt and 2x left, which can then be used to finance the "equity value" portion

Ignore all answers above

Low leverage at target companies means existing shareholders can cash a lot of money (value of their shares is high) and they can retire. Most of them are not aware, not accustomed or unwilling to work with high levels of debt, so as a PE you have an arbitrage opportunity here basically.