why do you pay off debt in lbo in exit?
In an lbo model, when the PE firm sells the portfolio company, why do you assume that the PE firm pays off the remaining debt. Wouldn't the acquirer of the company be responsible for paying off the debt?
For example, when calculating EV, you start with equity value and add debt because you assume the acquirer will have to pay off the debt. Why is this not true in a LBO model?
Do you really think a buyers would pay the same price for a company regardless of whether or not it has debt?
Wrong.
why does it matter who pays off the debt? equity has a certain value?
Let's imagine you run your own PE firm. Leverage yourself to the hilt. Acquire companies. Pay out dividends and bonuses from cash. Exit firm without paying off the LBO portion of the debt. Leave investors with the bill.
When people look into the IPO at first glance what will they see? They will first look at the pre acquisition financials (if available) or they will compare the post IPO debt figures to comparables.
If it was a private company and debt before acquisition was low they wouldn't be a prime LBO candidate without some attribute that is disruptive or highly profitable. If that is the case why would the owners sell to a PE firm? Far more profitable for less of a headache from the point of view of the target firm to secure a round of funding instead (and there is no shortage of funds willing to put money in stupid ideas tbh). This is one reason for hostile takeovers and activism/defense.
If it was a public company pre-acquisition when I look at your post-acquisition debt and compare it to the pre-acquisition debt am I really going to want to invest if/when I see post-acquisition debt is higher? Remember the PE company is going to ask for a share price premium on the IPO date relative to the acquisition date because they are trying to make money. The promise of improvements in the efficiency or operations of the company is not enough to justify a relative premium on their own because we have no financial basis for it unless the business was scaled up to a large degree (then why not pay down debt before the IPO, you must be making a lot of money?). So if you can't justify the relative premium based on business improvements investors will expect a financial one. (Unless, you have a company which has some attribute which is disruptive or highly profitable...which is one reason IPO's can be lucrative for outside investors. In that case some people don't look at your fundamentals as much as the opportunity you represent.)
So back to the top of my post. If we leave investors with the bill, what now? We now endanger our ability to raise new funds, acquire new lines of credit, and we have increased our short term volatility by undermining investor confidence. Unless we were lucky and our firm is recognized by the market as being disruptive (read: profitable) there is no benefit for us not to pay down the portion of our debt from the LBO. (does not happen often, these are the GOOG, MSFT of the world, note: not LBO's just random stocks which have had tremendous price appreciation) You might get away with not paying down the pre-LBO debt but I am on a phone and this post has gone on long enough, it isn't generally profitable or everyone would do it. You usually pay some of the pre-LBO debt down as well because the firm was an acquisition target for a reason which brings us back to the idea of funding vs selling the firm.
okay, but if you assume that PE firms pay off the remaining debt, then why do we use exit enterprise value when looking at the selling price? Shouldn't we use exit equity value since debt is being repaid down internally and not by the acquirer?
Just look this over.
http://macabacus.com/valuation/lbo
Your problem is getting tripped up by fine details without understanding the basic concept completely. Just slow down and follow the model and it will make more sense.
These are the specific pages you'll need to understand. * http://macabacus.com/valuation/lbo/capital-structure * http://macabacus.com/valuation/lbo/creating-value
You don't assume that the exiting PE firm pays off the remaining debt. Whatever unamortized principal balance of term loans that exists, together with any rolled over bonds, is debt that is refinanced by the buyer when there is a change of control with the new buyer (who puts a new capital structure in place).
Most LBO debt has a change of control clause, so when the company changes control (is sold), they are repaid.
Depending on how early it is, they will get bonus fees along with repayment. It makes sense if you think about it, because the debt investors committed their capital for a certain period of time, and now they're going to have to find somewhere else to deploy it.
I see, this explanation makes the most sense, thanks
I think he's misunderstanding this on a more fundamental level. It's not the equityholders that have to pay off the debt per se, the debt is a senior claim on the company's assets. When you sell the company, equity is simply the residual value after compensating debt holders. So the PE firm doesn't in fact "pay off" the remaining debt. The acquirer buys the whole company and probably refinances the debt.
Intern4ever is correct but don't think the question was why debt is refinanced.
And btw, it is almost always better to pay out dividends and minimize amortisation during the holding period.
dont rly undrstand.
lets say i am a PE firm and i sell my company for 100mill, and 70 mill is debt When I sell it for 100m, don't I receive the full 100 mill assuming that there is no obligation that states I have to repay debt when I sell it?
The transaction value is 100 but the cash the PE firm would receive would be 30, regardless if the debt is paid down upon closing or assumed by the acquirer.
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