Looking to acquire an SME, question about LBO model cases and level of risk in classic PE

Hi,

I am in the process of searching for a small company to acquire, and have been struggling to find a target due to the various targets inability to service debt if business declines somewhat. This has led me to pull out of several discussions and I am starting to wonder about my approach.

I am questioning whether I am being too pessimistic/careful when evaluating investment cases (LBO model). Basically, my downside case is always based on declining revenues and slightly worsening margins, leaving the company 10 times out of 10 seemingly unable to service debt to any meaningful degree.

How do you usually think about debt service/leverage/ability to acquire a company in MM PE with regards to safety in a downside case?
Does the company have to be able to service the debt even when facing headwinds, or is this too much to ask for a target?

The targets I look at usually are just about able to service the debt in the base and upside cases, while the downside cases look completely disastrous, leaving me with the decision whether to risk it or not.

Thanks.

Comments (18)

Apr 11, 2019

A downside side that has declining revenues and worsening margins is usually pretty par for the course for a downside case. But why are you placing so much emphasis on the downside case? If the banks thought the downside case was more likely than the average downside case, they wouldn't lever it up as much, meaning the company would be less likely to default and so on and so on.

Biggest two questions with a downside scenario are 1) how likely is it; and 2) if this does happen how can I cut my losses with as little damage as possible? Usually that means renegotiating with the banks, which they are usually willing to do if they think the business will recover. So not servicing debt does not equal equity being completely wiped out.

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Apr 11, 2019

Thanks for the reply.

I am being extra cautious with the downside as this is personal/family business money, and this is a significant bet compared to our assets. So our equity ticket is pretty set in stone, and the amount of possible debt determines the size of the businesses we can look at from an EV perspective. So a failed investment is pretty disastrous for our HoldCo. Therefore I might be a bit too conservative, and looking to have a safe investment even in a downside case, even if this might not be realistic.

I feel the banks and lending processes at our level are not too sophisticated, and I am able to finance a deal pretty easily, without the banker/loan officer going too much into detail with the business. This comes with the downside of not having a sensible sounding board to review our assumptions.

The renegotiating part is a fair point though, something I will consider when looking at these scenarios. Thanks!

Apr 18, 2019

Using significant leverage to buy a business makes a lot more sense when you have a portfolio to diversify with. If one failed investment can tank your fund (or family), its probably not a smart decision.

Apr 11, 2019

If you are that downside oriented, which is not a bad thing, you should be looking at businesses with strong downside protection. Ie recession resistant, hight asset base, captive customer base, recurring revenue contracts, high visibility to backlog etc

Alternatively you could invest via a more senior mezz type security. Did a deal once where we were high in the cap stack but had penny warrants that gave us equity type returns.

Apr 12, 2019

Thanks for this.
I have currently been looking at distribution companies, which at this size are everything but the things mentioned. Thin margins, low asset base etc. This has been mostly out of familiarity with the business model/industry, but it might be time to reconsider this approach.

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Apr 11, 2019
  1. How will you react in a downturn, how did others in this industry react? If you have one paper mill that requires 300 people to operate it, then the way you survive a downturn is to lose a bunch of money. If you have a shop with 50 machines and 50 operators, you just scale down one at a time and scale back same way. Every industry or company is different.
  2. Choose your lender well. PNC and 5/3 have earned AWFUL reputations for how they treat borrowers. I've seen 5/3 flat-out lie twice while they smiled and sold off the note to a predatory hedge fund.
  3. I assume you are modeling the DSCR? That's the key covenant.
  4. Find lenders who will do this without a PG or cross collateral. Lenders are very loose on structure these days so you'll find one. Might cost you more - but will cost you less.
  5. Ringfence your liabilities better to protect other assets. Think how a real estate investor holds every property in a separate LLC.
  6. Seller financing.
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Apr 12, 2019

Thanks for this, really solid points.

I will have to put more focus on points 4-6. The lenders I have been in contact with so far are requesting cross collateral, or that I put the debt on the HoldCo level, where they basically have access to all other assets if things go south. Will be difficult but I will try to focus on getting the debt ringfenced without cross collaterals etc.

Thank you

Apr 15, 2019

How do sellers usually respond to a proposal with seller financing? Are they willing to take a smaller payout upfront? With a smaller cash out and position remaining in the company, the seller would still be exposed to risk. I would assume seller would want to see some kind of dividend or interests of some sort in addition to the principle pay back. In that sense, seller financing is similar to debt financing. What kind of debt securities would seller financing be most similar to in terms of return, terms, and seniority?

Apr 15, 2019

I've usually seen it in smaller transactions, typically add-ons. Like you pointed out, it's less attractive to sellers than straight cash upfront, so you'll only see a seller note where there's a little hair and either its a proprietary process with no other potential buyer or no one is willing to give more cash upfront.

Just from my own data set, most often at the very bottom of structure with anywhere from a nominal rate to 6-10%. Fully amortizes over 2-3 years. Sometimes see it with a lien on the assets associated with the transaction.

Another way to think about it is as a longer term escrow / holdback that has some economics associated with it in exchange for the longer lockup period.

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Apr 16, 2019

Great notes, could you perhaps expand a bit on your fifth point with respect to some broad strategies or approaches you'd take?

Most Helpful
Apr 16, 2019

My partner is the grand master of avoiding PGs (personal guarantees) and his theory is to break down the other side's needs. What do they actually want when things fall apart? They don't want to sue you personally, take your wife's jewelry and kick your kid out of their home. And very few judges would allow that. And the smart entrepreneurs can protect their assets so well that a PG doesn't really matter. So if they can't mug you in your living room, what will satisfy their needs? Let's break it down; they want to make sure you can deal with tough times - show them your record, they want to have your compliance - offer a document of support, they don't want to sue you for control or receivership - sign a prejudgement remedy, you can agree to every single step which might end in an orderly liquidation and what more could they want? They can hire an interim turnaround manager and end up no better off - minus his fees. Workout and credit officers want an easy life with less assholes then they are dealing with currently. A PG doesn't offer that but a package of compliance does. That's the theory, hard to put in practice. A strong auction process with multiple banks will net you one, especially these days.

Oh, another thought, why do banks give loans to PE groups without PG's? Why the hell should they get that deal and not a scrappy entrepreneur like you?

Ringfencing - study corporate legal structures and read some dull-ass text on what protections an LLC offers. Read the legal text, that's what the judges read. If it's in black text then you can rely on it. When you understand that you can start theorizing on structures and picturing where liabilities go or don't. Then read though asset purchase agreements (boring) and see where these key points are covered. That's it - you just covered the bases from legal text to document and you know how to treat liabilities. Enormous shit moves within lines of text. Then reverse engineer the LOI and think how you'll plant those seeds with comforting text, which they will approve with their signature.

My point on Real Estate investors is that they hold each property in a separate LLC so if someone slips and falls at one property they can't sue the others. Even large property holders like McDonalds or Walmart will do that. Also a PE group will hold all the assets in totally separate entities that allow no cross collateralization and that's what an entrepreneur should do.

Hope that helps.

    • 5
Apr 16, 2019
  1. Utilize seller note
  2. Do not over-lever the company and max out covenants from the onset
  3. Utilize mezzanine financing which typically have better covenant cushions are more flexible, especially if they have some equity deployed on top of the mezz tranche
  4. If you utilize low leverage you can always recap down the road if the Company continues to grow
  5. All of this is highly dependent on the industry, type of Company, and how much EBITDA there is
    • 1
Apr 16, 2019

If you want to make your "lender downside", which you'd share with the banks as your idea of what a downside looks like, then just solve for revenue and margin declines that get you to a 1.0x fixed charge coverage ratio (same thing as DSCR discussed above). They'll feel good that even in the downside you put forth, you're still making principal and interest payments. Seller financing is a good way to plug a shortfall in your sources of capital and align interests, but it'd need to be fully subordinated to the bank debt/senior paper.

Apr 16, 2019

My thoughts and comments are purely academic as this isn't my space, but my first thought is that if you have a more risk averse forecasting mentality (which isn't inherently a bad thing), then you may want to look into companies that typically have more downside protection when the broad economy faces headwinds. If you're looking at say a MM retail firm and their DSCR is floating at near 1 on an annualized basis because of off-season revenue declines, the issue is likely not with the targets you're analyzing, it's the industry itself.

Maybe look at firms that tend to have higher degrees of recurring revenue in order to be able to shake off some of the nerves of "well what if we start to see margin pressure start to crush this already highly levered company."

Edit: I see above that you're giving consideration to looking at higher asset base, wider margin targets which IMO is a smart move considering your need to shore up the investments returns for the HoldCo.

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Apr 17, 2019
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