Levering as much debt in an LBO?

sffinance321's picture
Rank: Baboon | banana points 167

If you could lever up let's say hypothetically 99% in the capital structure of a potential target in an LBO, would you do it? Why and why not?

My guess is that yes, in concept the more debt you take on over your own equity, the higher returns PE funds will find, but there is a risk that comes into play when you are over-levered unless the company is highly self-sustaining and generating a large amount of CF year over year. Is this the right answer?

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Comments (7)

Jan 4, 2019

This is obviously a theoretical question, but my practical answer is that a company that maintained adequate enough operating efficiencies in order to ensure that there would be essentially no downside risk that would trigger a blowup would not be a target for an LBO from a qualitative or quantitative standpoint.

But theoretically, a company with a very healthy debt coverage ratio that was acquired with 99% leverage would obviously yield a ridiculous IRR and upon exit you would be crowned as the heir apparent of Henry Kravis.

    • 2
Jan 4, 2019

1) Most companies do not have sufficient, reliable cash flows to support interest payments that would accompany 99% debt in the capital structure. This is why, practically speaking, no lender would provide this level of debt, and even if they would, I suspect it increases the risk profile beyond the appetite of even the most aggressive PE firms.

2) Completely ignoring the above, % return is not the only factor a PE firm wants to maximize. Put simply, would you rather earn 100% on $1, or 50% on $10? Sure, my marginal returns go down, but the extra $9 is still a good investment because I'm getting a $4 (44% marginal) return.

Jan 5, 2019

here is how you look at the #s:

  1. what is the acquisition EV/EBITDA multiple? let's assume 10x
  2. what is the funded LBO debt leverage? let's assume a ridiculous level of 9x, so your equity is 1x
  3. what is the FCF conversion of the business - FCF/EBITDA? ignoring the complications of interest expense, tax, etc. let's assume you find a business that has a sustainable 100% FCF conversion. so if hold period is 5 years, you can pay down 5x of debt upon exit
  4. EBITDA growth, multiple expansion, etc. even assuming no EBITDA growth or multiple expansion upon exit, you are selling the business at 10x, with debt paid down to 4x and hence equity of 6x. that's 6x MOM

that's why FCF generative businesses (with highly predictable and sustainable FCF) are highly sought after LBO candidate. you don't need to strive for EBITDA growth or timing the cycle well to drive returns, as illustrated above.

lastly, whilst IRR is important, it's not as meaningful as MOM - MOM of 1.01x over a week could represent very high IRR but essentially meaningless in terms of cash returns.

    • 1
Jan 5, 2019

What's MOM?

Jan 6, 2019

Money-over-Money = Cash-on-Cash = MOIC

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Jan 6, 2019

Dude read King of Capital. It's about Schwarzman and Peterson starting Blackstone but they give a fair amount (a few chapters at least) on the backstories of KKR and other buyout shops. They all used to frequently do 95%+ on their deals. So yes, you would do that. The only reason people don't is because banks won't let them.

Jan 6, 2019