Question on LBO Financing

You can borrow againist the cash flows of the target company.

prospective_monkey:

Hi guys,

I got a question regarding LBO Financing.

Consider:

(1) A PE firm collects cash in one of its funds, say fund A that has now money for more than one acquisition. (2) The firm finds an attractive target T and wants to buy it.

Now what I don’t get is…what comes first? How can you buy the company with the equity tranche from fund and debt tranche from HYB/ loans, when you don’t own the company yet and can’t load it with that debt?

Does the PE firm create a fund A1 that (1) issues bonds/ takes loans secured by pretty much nothing else than the plan to buy the target T and then (2) uses that money with the equity tranche to buy the target and merge it with the balance sheet of fund A1, in order to have the debt on the companies balance sheet? In that case fund A would own (besides its remaining cash for further transactions) the equity of the combined entity fund A1/target.

Is this correct?

I hope I have explained my question so that you guys may understand it.

Thanks a lot!

The Management Company of Funds A creates a Holding Company H. H is capitalized by equity from fund A and borrows to banks. The sole purpose of H is to acquire and hold T and it pays back the debt from the cash flows it will upstream from T.

This is confusing to me....

but I think you are confusing who "owns the equity" and how the fund allocates funds for add on acquisitions.

Usually the General Partner (GP) = the PE fund buys a firm with the funds it collects from the LPs (limited partners) = pension funds, endowments, wealthy indiv, etc

The fund then makes an initial investment in Company A (less than the GP has collected from LPs) usually with a set $ set aside for add-on acquisitons ("tuck-ins") if it is a roll-up.

As far as what comes first...usually as the diligence process moves along, as a PE firm you will have a few lenders that are familiar with the initial investment and will (hopefully) be amenable to this specifc tuck-in acquisition. You would bring them into the process so that they could put up a proposal about how much (additional) debt - if any - they are willing to lend in order to help PE fund acquire this tuck in.

If they aren't very hapy about the acquisition for whatever reason and have rights that stop PE Firm from using another lender, the PE firm would have to use all equity to purchase the target (bad situation for the PE frim). The sellers/shareholders of the Target company typically don't care too much how much debt you are putting onto the company unless they will be staying on as employees and feel the debt burden will be too high. Typically, banks aer more conservative nowadays anyways, so the amount of debt raised will well below the debt capacity of target T.

...not sure if that answers you question?

Relinquis has it down...legal entity structure for PE firms, especially large ones, can be extremely complicated and include various SPV's and VIE's. The count of separate entities can easily be over 100. I would encourage skimming through the S-1's of the largest PE groups to learn more, but here's one example, straight from an S-1 (I don't think it directly answers your question but helps give you an idea of the fund structure):

S-1:

We conduct the management of our private equity and capital markets funds primarily through a partnership structure, in which limited partnerships organized by us accept commitments and/or funds for investment from investors. Funds are generally organized as limited partnerships with respect to private equity funds and other U.S. domiciled vehicles and limited partnership and limited liability (and other similar) companies with respect to non-U.S. domiciled vehicles.

S-1:

In addition to having an investment advisor, each fund that is a limited partnership, or “partnership” fund, also has a general partner that makes all policy and investment decisions relating to the conduct of the fund’s business. The general partner is responsible for all decisions concerning the making, monitoring and disposing of investments, but such responsibilities are typically delegated to the fund’s investment advisor pursuant to an investment advisory (or similar) agreement.

Keep in mind too that the PE firm doesn't actually have any of the investors' committed capital until they're ready to invest with it, hence "dry powder," or uncalled investor capital commitments.

Relinquis: Thanks, that was the answer I was looking for.

Muskrateer: Thanks very helpful!

Patrick: Thank you for clearing up the structure between GPs and LPs.

Nabooru: Thanks for some practical insights.