Quick LBO Question

(Lack of) synergies.

^^^ Exactly. A strategic can pay more and extract synergies to create value whereas an LBO shop needs to buy as cheap as possible to optimize the return, pure buy low -> sell high ideology...

Makes perfect sense. Thanks!

So are all the returns to the different suppliers of capital (financial sponsors, mezzanine funds, financial institutions, banks, etc) generated through the exit?

Is the exit always in the form of an IPO?

Also, what are the ways to determine the exit multiple?

Thanks for the help

Nope. The senior debt calculates it's return off of interest and amortization of debt and repayment at maturity. Mezzanine accrues if it's PIK and then repayment. Typically you can be exited in the debt pieces by either a refinancing or and exit but its not materially different from the lenders perspective which way he gets taken out of the capital structure.

As for the exits, there are multiple, IPO being the least likely for MM firms: IPO Secondary sale to another LBO fund Sale to a strategic buyer

There are two main ways to target a multiple for exit. Assume the same entry multiple but in the cases of the booming era LBOs done at excessive multiples, you test them out until you achieve a 25% IRR on a base case. Maybe higher, maybe lower than entry but you get an idea of what needs to be done and how realistic it is to sell for a multiple like that.

MezzKet, thanks.

So the capital structure of the deal is mostly driven by the required IRR to the equity holders, access to funds, and the exit multiple?

Also, when looking at the sources and uses of funds, do you try and refinance all of the existing debt or only a portion of it?

Lastly, how common is roll-over equity by existing management in the capital structure and how large of a stake do they usually make up?

Thanks again.

These days with debt so scare, LBOs are going back to their roots and actually creating true value rather than using leverage to target returns. In the booming times, leverage wasn't used for returns as much as it was used for the ability to buy massive companies at multiples in excess of 10x, a sponsors way to compete with strategics (cheap credit).... Your capital structure is capped by the terms of the current market so if you do an LBO these days, you have to determine how you can grow EBITDA in order to achieve that 25% target... The more debt the bigger the risk that a slight downturn in the business will force it under and you loose your equity, so it benefits the return but bites hard in return...

IF the terms of the debt are attractive, more attractive than what the market is offering, you may try to roll it over and convince the lenders not to exercise the change of control put and amend the credit agreement... This usually happens on on senior debt though and really has to be attractive. Most of the time you go in refinancing the debt in a standard LBO, especially in a secondary LBO. The reason you do this is because the rolled over senior debt probably will mature half way through the 5 year targeted holding period and refinancing it may be difficult because lenders don't like injecting money halfway into an LBO with the risk of being refinanced shortly thereafter....

Lastly, management ALWAYS rolls-over interest in the equity. Typically you like to see them roll-over 100% of after tax proceeds into the equity. You need this to align their interest in the business. Its not unlikely to see management earn 5x on their investment with warrants and such... if management goes through a second or third LBO it will be difficult to convince them to roll 100% so you'll felx down as they clearly know what their doing and you don't want to loose them on a small negotiating point..

Sof_2, are you doing any IB training program at the moment (like WSP, TTS, DealMaven, WST)? Just curious to know....

So the refinancing of existing debt is purely a financial decision (terms of debt in place versus what the market is currently offering) and not necessarily a strategic decision regarding seniority in the post-LBO capital structure?

As you mentioned with debt being so scarce, do you believe the LBO market will see more EBOs and all-equity deals going forward in the short term? Especially with so many firms trading at multi-year lows. How will this affect valuations? I am assuming that acquisition prices and multiples will go down because of the higher risk of more committed equity and the loss of debt generated tax-shields.

Also, do you think that seller's notes might become more frequent in order help the buyout funds finance deals? Like the seller loaning the buyer 20%-25% of the purchase price?

What other developments do you see in the buyout industry going forward in the short term?

I really appreciate your insight. This is really helpful.

lui, nope. I'm not.

Exactly... it's really a deal by deal analysis... An LBO fund won't do any EBOs unless they are venture funds or make minority investments.. It takes to much to achieve 25% returns without leverage.. A fund would have to run in overdrive to achieve those returns. Their already struggling to clear 25% with the market's debt terms and 3.0x leverage. Second, the funds dont have enough cash to continue buying the same sized companies they historically have without leverage, the cash needed would drain the fund by 1/3rd in one deal. Valuations being so low will help with the returns especially since leverage is low ie higher exit multiples... It will help increase equity value toward the end... There are some fund attempting to fund their deals by lending mezzanine and supplying the equity in an attempt to close deals and still generate moderate reutrns...

Without the leverage, buyout funds will bid so low it will make it very difficult to bid against a strategic as they will attempt to bid as low as possible in order to deploy as little equity as possible... As for the valuation, clealry from a WACC perspective, you're using the highest cost, equity, and free cash flow is minimized as you don't extract tax shields from the debt, fees paid on debt for beginners.. This innately creates the lowest valuations from a theoretical perspective..

Seller / Vendor loans have always been used but are extremely sensitive these days and I've personally seen a few deals collapse due to the nature of the terms on these facilities. The best way to see them is as earnouts especially if a fund owns the target... The size won't reach 20% ever as that means that they can't cash out at close but instead roll-over the risk at the equity level for 10-15% PIK... It doesnt really pay out to roll over that much money so you may see a MAXIMUM of 10% seller notes in the structure with very aggressive...payout terms..

In general, the markets will remain the way they are until credit frees up and terms become more attractive.. There are too many adverse terms to do deals ie low leverage, high debt cost, low valuation multiples affecting both buyers and sellers... My opinion is you'll see more and more debt funds aggressively pushing into the senior space or subordinated debt accounting for more of the capital structure. I think you'll see alot of refinancing / attempts to restructure the capital structure as they need to weather the downturn and wait for market turnarounds in order to sell at reasonable multiples... I'm personally seeing alot of funds trying to do this as they realize the danger of overleveraging. Second, maturities are coming up and their original plan of refinancing, a sale, is unlikely as they wont sell in the current market as their returns will be crap... I've seen deals that have been hanging in the market constantly renegotiating the purchase multiples down as the market keeps shifting... Until there is some stability no one will move, I can say many funds are looking to exit investments and many debt funds are looking to deploy capital but its just a standoff and the market waiting for the other players to make the first moves...

are you looking into switching over to the buyside from sellside?

Just a note, its not as thrilling as it used to be... its just tons of cashflow monitoring for the forceable future... funds will conserve cash and make it last till at least the end of 2010 as it will be extremely difficult to fundraise...

its not higher... its lower... fcf is minimized as you don't take advantage of the tax implications..

I look at the FCF calculation which takes into account cash taxes (irs taxes) instead of book taxes (standard from a buyout perspective)... therefore cash taxes are minimized by depreciation & amortization... By default, this increases FCF as it generates these tax shields...

More D&A lower pre-income minimizing taxes. Lower taxes = higher FCF...

Also, the DCF calculation is done off of unlevered FCF (no interest taken into account) therefor the only difference can come from the taxes which make the difference... What you were talking about is FCF available for debt service which clearly is higher in an EBO as there is not interest charge...

Now why use IRS taxes instead of book? Well because we want to see actual cash paid the whole purpose of the cashflow statement.

Errr I meant "lower" on my first sentence. Thanks for clarifying. I had levered and unlevered FCF mixed up. You also mentioned something about the debt fees. I assume you're talking about origination fees. Were you implying that those fees would have increased FCF for the reason mentioned in my previous post?

Debt fees are commitment fees paid to lenders at closing in order to make their return more attractive... These fees are amortized on both the GAAP books and tax books...

This amortization allows pretax income to be minimized therefore reducing cash taxes... Lower cash taxes increase FCF... I'm not arguing that they dont get added back in because they do, the difference in the EBO and LBO FCF comes from the tax shields you can take in order to reduce cash taxes and extract more free cash flow... These tax implications are key in LBOs.