Why does existing debt not matter in an LBO?
Hi guys,
I was looking for an answer to the question why existing debt does not matter in a leverage buyout. I already checked the existing threads, but could not find an answer that helped me.
Sorry if I got his wrong:
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I always thought when buying the target the base price is the Equity Value (the fully diluted outstanding shares of the company x share price) + if there is debt, it will be A) either assumed as it is (then it does not increase the purchase price) or B) is refinanced (so additional funds are needed to replace the debt with new one and narrows the purchase price to EV)
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What I do not understand yet, if the existing debt needs to be refinanced and thus increases the effective purchase price, why would the PE firm not care about this? In my understanding, this would ultimately limit the amount of debt, the sponsor can use in the deal, because we need to refinance the existing debt first, which increases the equity portion the sponsor needs to add and lowers the flexibility to add more debt later?
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For example: Total debt capacity the firm can hold: 5x EBITDA; thereof 3x needs to be used for refinacing of existing debt and 2x left, which can then be used to finance the "equity value" portion of the purchase price
Maybe I misunderstand the meaning of refinancing the existing debt in this context, because I also read different ways in how it can be done: 1) Debt is refinanced/repaid by the sponsor and basically deleted, 2) Debt is refinanced (so basically replaced with new debt), but effectively kept in a new form = Same as assumed?
Maybe somebody can help me out here.
Thanks in advance.
Best,
M.
The existing debt plays a factor in the purchase price of the company and only the dollar amount outstanding as that feeds into the purchase price. A company will only agree to be sold as long as debtholders are paid off and equity holders receive a desirable return (unless in a distressed situation). So in that essence the sponsor does care about the value of the debt as it can affect purchase price. However it does not affect the future cash flows of the business or the exit as that debt is in essence terminated and replaced with new debt.
I might be reading into your question wrong; but I think what you're referring to is that you wouldn't care about the financing terms of the existing debt since you are just paying that off and replacing with the new debt and thus those terms are terminated. The interest rates and covenants of existing debts will not carry onto the future. You would, however, care about the financing terms of your new debts and revolver terms as the new interest expenses and restrictions can affect cash flows and therefore your return upon exit.
Never say never though. I'm too young to have ever seen this but could be a situation where it's in the best interest for a sponsor to not pay off the existing debts in full, which would make the existing debts' terms relevant to the future cash flows. A more seasoned professional can comment on that.
Hi, the purchase price should remain the same regardless the post transaction capital structure, I think you maybe mixing up the concept of sources and uses. Purchase price is one of the items of uses, whereas the sponsor equity/assumed debt/new debt is one of the items of sources.
If the debt raised from refinancing was greater than the existing debt of the company, the sponsor equity required would be less. However, the sponsor is still contributing the same amount of capital to acquire the company, i.e. repaying the debt and paying for the seller proceeds.
Regarding your example, the sponsor can raise more debt based on the 2x which will allow the sponsor to contribute less equity upfront. Again, the sponsor is still paying the same amount of capital, but they pay it with less equity.
In response to your question whether the existing debt matters, I think it depends on the terms of the existing debts, some debt has change of control clause, if the buyers was not aware, they will have to repay all the debt upon closing and could put the company at financial risk.
I might have understood your question incorrectly, so please take it with a pinch of salt.
I responded to a similar question here: https://www.wallstreetoasis.com/forums/rollover-of-existing-debt
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