Often the argument seems to be made that a good LBO candidate has low debt, since this allows adding leverage. How relevant is this though if the old debt is completely retired and a new debt package is arranged for the buyout? If anything wouldn't it be advantageous if the company is already used to operating at high debt levels? Why then would people consider a company less attractive for an LBO if the company already has high leverage?
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I suppose you could argue that a company is losing value from being underlevered, so as a financial sponsor you could pay a higher premium with a more efficient capital structure
In general though, lower debt = better LBO candidate sounds like a silly vault guide answer. Pre-existing capital structure is irrelevant for valuation purposes beyond the effect of any debt breakage/refinancing fees.
I asked this question a while back - got some good answers: http://www.wallstreetoasis.com/forums/leverage-relevance-for-lbo-target
If the old lenders were smart breakup fees and change of controls can be cost-prohibitive.
Existing capital structure is irrelevant. Only considerations vis-a-vis current capital structure is if there are any breakage cost implications and as it may inform the new capital structure (eg markets appetite for the credit, pricing, etc).
Anytime I hear existing leverage as a consideration when assessing an LBO candidate, I mark it as a wrong answer and lack of understanding of PE investing.
Perhaps it is from an equity perspective, but not from the perspective of the banks underwriting the debt and the syndication market.
We like to see LBO targets with leverage because we know that there are lenders familiar with the name and who will often be willing to roll into the new debt package. This reduces syndication risk and gives underwriting banks comfort there will be sufficient demand.
As an LBO debt underwriter, we get a little anxious when we're bringing a new LBO target name to the market where the market is not familiar with the name. In that case, it's not a seasoned story and we fear the syndication market may give us a "too hard" reaction due to lack of familiarity.
The loan syndication market also takes comfort that the target business can handle the new debt if there is a track record of rated debt and compliance with covenants under the old debt.
This is only one among a number of factors when looking at an LBO debt underwrite, but it does often come up.
How is existing capital structure irrelevant? Wouldn't an already highly leveraged company have a hard time raising a huge sum of debt in the capital markets, to finance the sponsor's purchase? In other words, isn't an LBO financed by incremental leverage, not total pro forma leverage?
This has always been my default answer, but I realize there are a few components that might make you think twice. 1. As someone noted before, if the company is underlevered, the equity valuation might be lower due to an inefficient cost of capital. Thus a premium you would pay could be less than what you might pay if the company were optimally capitalized. The same might go for a highly levered business. 2. If a company has never been levered, the capital markets might be wary about how much leverage you can put on the business considering it has never had leverage before. 3. Expensive breakage costs
I agree with Marcus that existing capital structure is irrelevant. The concerns that are mentioned above are all concerns of the sellers rather than those of the buyer. The price you are willing to pay does not change. You may be willing to pay a higher premium for publicly traded companies (as a % of the current trading price), but the absolute dollar value you are willing to pay will remain unchanged.
Obviously all this changes if you agree to pay a portion of the sellers' fees or otherwise assume the sellers' risks/liabilities, but that's a separate issue.
Although I agree w/CompBanker below, #2 is quite relevant in the MM. Tend to see more companies without debt, particularly if they were a family or closely-held business. Although the fear is overblown from the seller's perspective (i.e. worried if they roll 20% and it gets levered up highly), there are some legitimate performance concerns for companies that aren't used to maintaining covenants and closely monitoring financials.
Generally, the right financial buyer should be able to mitigate the issues though, far more than say the same group of owners that go through a recap.
I guess it really comes down to which perspective you're taking. As a MM PE investor, I've never seen this as a problem. Maybe the PE firms I've worked at have been more hands-on when it comes to managing cash flow, but I've never had lenders shy away or reduce their leverage package because a company does not have a history operating with debt. I've definitely had owners who are rolling substantial amounts of their proceeds influence the amount of leverage we put on a business, but that doesn't happen very often.
Couldn't you potentially conduct a dividend recap alongside an LBO in the case of an under-levered company, thereby increasing your IRRs? I am just thinking through this in my head and it seems like a significant advantage to LBO-ing a under-levered company. Is this correct or am I making a mistake some where?
I think there is an error in your logic. If you think about a purchase price, you are going to hypothetically maximize the amount of leverage you can apply towards the purchase price. If you have left room for a dividend distribution, that means you put up more equity than was necessary since Equity + Debt = Sources of Cash. In other words, you would be trading a lower amount of equity for higher amount of equity + repayment of some of that equity in the form of a dividend.
I have seen lenders shy away from companies with little to no existing debt. Obviously other issues at play, but I think existing debt can serve as validation from a herd-mentality standpoint, especially in the lack of staple financing.
I don't think I've ever seen lack of debt being a hindrance on the new capital structure. Some hypotheticals have been offered in this thread already that could make it possible, but unlikely. Another that I'd add is that low debt can be indicative of cyclical business, necessitating a more conservative capital structure, in which case you'd probably want to overequitize it anyways.
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