Hi all,
I was studying technical for the fall recruitment and had a question regarding the type of financing one would use for a LBO. I realize that it wouldn't be a LBO any more if one uses cash but the guide was asking why a PE firm would use leverage instead of cash in an LBO transaction. The answer was that using leverage will boost its return by reducing the amount of capital it has contributed upfront. However, I was a little bit confused because you are using the cash flow of the purchased company to pay off the principal and interest of the debt. Wouldn't it generate more return if you purchase the company with cash (a cheaper form of capital) and just take the generated cash flow by paying it as dividend instead of paying for the interest on the debt that you would use for an LBO and exit out with the same multiple? I understand you would have to use leverage for it to be a LBO but I was not quite sure why using leverage will boost your return throughout the investment horizon. Is the boost in return referring to the exit moment?
Thanks!
Yes, at exit. Say your portfolio company get a 1B equity value at exit, you would get higher return if at entry you committed 100m cash/own capital+ 400m debt (1B on 100m) vs. 500m cash/own capital (1B on 500m)
Does that mean that using cash for the transaction will have higher return over the investment horizon?
I think you're overcomplicating it for yourself. It's as simple as this (feeding off the previous example):
To calculate your return on your capital you subtract the purchase price (the portion made up by cash), or initial value, from the final value (1B in this case), then divide the result by the purchase price. To get it as a percentage you multiply the result by 100. In this example your initial total investment was 500m.
Scenario 1: 100m cash + 400m debt = 500m initial investment. 1B - 100m = 900m ... 900m/100m = 9 ... 9 * 100 = 900% return on your cash
Scenario 2: 500m cash = 500m initial investment. 1B - 500m = 500m ... 500m/500m = 1 ... 1 * 100 = 100% return on your cash
You can see how leverage in scenario 1 significantly boosts the return on your capital. Hope that helps.
PE Firm Goal: Maximize return while balancing risk, opportunity cost, partnering agreements, servicing/enhancing other investments. Thus judicious use of capital available for investments may include spreading those funds over multiple investments. As the above example pointed out 9x looks better than 1x. It also allows you to make -1x to 12x on several other investments hopefully bettering you chances of exceeding your hurdle rate...
or I could be blowing smoke...
Makes a lot of sense. So by using leverage, PE firm can spread the capital that they have into multiple investment opportunities. Thank you!
Some quick thoughts. Interest is tax deductible but does not reduce value so there are economic advantages to debt. Also, cash is a limited resource, while your thesis is correct you did not factor in risk. Let's say that there is an 80% chance of success in an investment, 20% gets wiped out . If you spread your bets over 5 companies you'll likely find your success metric - and then you raise fund #2. If you bet it all on one company you may find that 20% and then you're unemployed.
There are some PEGS that do invest cash and do follow your thesis. They do a lot of all cash deals and reduce their odds that way. I just talked to one a few weeks ago on the west coast.
Makes perfect sense. Thanks for the input!
During school I worked for a group that specialized in smaller multi family housing. We would put together deals that only needed one or two investors, on average.
One day, some rich kid that didn't know jack about investing got in touch with us and wanted to buy a 15-20 unit building in town. He said he'd do all cash. While an all cash offer gets things moving faster, we explained how he could invest in three different projects simultaneously at 30-35% equity in each since the CF from rent could cover debt service and expenses. The result is diversified risk, i.e. can afford to have one or two properties fail, and potential to make three times as much.
So OP, leverage lets you put in less money to get a higher % return i.e. put in 30 for something worth 100. Exit when it's worth 200, MoM is 6.7x. As opposed to put in 100 and have a MoM of 2x. The key is being able to service the debt with CF from operations, hence why LBO targets typically have predictable cash flow. Additionally, you want to pay down debt so you can participate more in the exit/pay less interest going forward.
One more thought, I've seen cash work to get deals closed quickly and then the PEG will leverage up the investment in the following months. It's a good strategy, cash is the strategic advantage to get the LOI signed but the final structure ends up looking like everyone else with debt.
Cash in a private company LBO (Originally Posted: 01/05/2014)
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Not entirely sure what part is confusing you, can you perhaps clarify further? When doing the adjustments for the acquisition, zero out the cash balance and make all of that cash additional proceeds to the seller. Then, start your LBO in year 1 with no cash on the balance sheet. Proceed to generate cash through operations in Y1 and use that cash to pay down debt.
Quite honestly, you don't care about the cash balance in the years leading up to the acquisition. All cash is being swept in the acquisition and the cash generated was under a different capital structure.
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So when you're modeling it, in the first year after the acquisition, you have to hit the cash flows for the normalized working capital balance. I'd start by seeing what kind of working capital balances similar businesses carry.
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