In a leveraged buyout (LBO), the company uses leverage, or debt, in order to acquire another company or one of its parts. In an LBO, private equity funds can use multiple types of debt or capital as leverage. The most common types of capital or debt used are a Revolver, Bank Debt, and High Yield Debt. Each of these can have advantages and disadvantages for the buyer and seller.
Revolver
A revolver is a type of debt that works when a senior banks debt, functions like a line of credit. When the company is in need of capital, they will draw the revolver to meet the credit limit and then repay the revolver with excess cash when it is available. Using a revolver is advantageous in that it provides companies flexibility with capital and allows them to not seek additional finances.
The drawbacks of a Revolver, however, are its associated costs. The first cost is the interest rate charged on the amount withdrawn from the revolver. This is generally structured to charge a premium that varies based on the credit of the borrowing company. The other cost is an undrawn commitment fee. This fee compensates the bank for the loan and is based on the difference between the revolver limit and the amount drawn.
Bank Debt
Bank Debt is another type of debt used in an LBO. Bank Debt is generally a lower interest rate security, but is associated with a strict payback plan. These debts are arranged over a five to ten year period and in that time the bank can restrict a company’s ability to make other acquisitions.
Although this structure is an effective way for a company to gain capital, some see the restrictions as a drawback. If a company is seeking to make further acquisitions without the strict financial schedule, then Bank Debt may not be the best type of capital.
High Yield Debt
The other popular type of debt used for capital in an LBO is High Yield Debt. This type of debt is unsecured and named for its high interest rate. The high interest rates are in place in order to compensate investors for the risk taken in the debt. These debts are popular because in a High Yield Debt investors are willing to provide more capital than banks. This type of debt also provides the company with a flexible payment plan.
This High Yield Debt has many advantages, however has a higher interest rate than that of a Bank Debt.
When deciding the type of capital that a company should use for an LBO, considering the benefits and drawbacks are important. The specific debt structure can impact the success of the investment and future investments for a given company.
For more information on leveraged buyouts, read our recent blog post.
FAQs
The most common types of capital or debt used are a Revolver, Bank Debt, and High Yield Debt. Each of these can have advantages and disadvantages for the buyer and seller. A revolver is a type of debt that works when a senior banks debt, functions like a line of credit.
What happens to debt in a leveraged buyout? ›
In an LBO, the existing owners of the company (the "target firm") typically sell a majority or all of their shares to the buyer, who then assumes the company's debt. The buyer then uses the company's assets and cash flow to pay off the debt taken on to finance the purchase.
What does the debt structure of the firm normally look like after a leveraged buyout? ›
LBO Overview
Generally speaking, the debt will constitute a majority of the purchase price—after the purchase of the company, the debt/equity ratio is typically around 2.0x or 3.0x (i.e., usually the total debt will be about 60-80% of the purchase price).
What are the three types of debt instruments? ›
Further, they fulfil the financial needs of the organisation or government that raised the capital. The different types of debt instruments are debentures, fixed deposits, bonds, certificates of deposits, etc.
What is the debt structure of an LBO? ›
An LBO is a transaction in which a PE firm acquires a target company using a large amount of debt, typically 60-80% of the purchase price. The debt is secured by the assets and cash flows of the target company, which is expected to generate enough earnings to repay the interest and principal over time.
Where does debt come from in LBO? ›
LBOs are often executed by private equity firms who raise the fund using various types of debt to get the deal completed. Capital for an LBO can come from banks, mezzanine financing, and bond issues.
Which of the following is a combination of debt and equity in LBO? ›
In an LBO, there is usually a ratio of 90% debt to 10% equity. LBOs have acquired a reputation as a ruthless and predatory business tactic, especially since the target company's assets can be used as leverage against it.
What are the different types of leveraged buyout? ›
There are four main leveraged buyout scenarios: the repackaging plan, the split-up, the portfolio plan, and the savior plan. The repackaging plan involves buying a public company through leveraged loans, making it private, repackaging it, then selling its shares through an initial public offering (IPO).
Who owns the debt in a leveraged buyout? ›
A leveraged buyout (LBO) is when one company buys another company using mostly borrowed money. The buyer puts up the company being bought as collateral for the loan, and the purchased company assumes the debt on the loan.
What is senior debt in LBO called? ›
Bank Debt. Bank debt is also referred to as senior debt, and it is the cheapest financing instrument used to acquire a target company in a leveraged buyout, accounting for 50%-80% of an LBO's capital structure. It has a lower interest rate than other financing instruments, making it the most preferred by investors.
In the world of leveraged buyouts (LBOs), mezzanine debt has become a popular financing option. This type of debt sits between senior debt and equity in the capital structure, providing a flexible and attractive option for companies looking to fund their acquisitions.
Why use debt in an LBO? ›
Simply put, the use of leverage (debt) enhances expected returns to the private equity firm. By putting in as little of their own money as possible, PE firms can achieve a large return on equity (ROE) and internal rate of return (IRR), assuming all goes according to plan.
How does having no existing debt on an LBO target's closing balance sheet impact the returns to the financial buyer? ›
How does having no existing debt on an LBO target ' s closing balance sheet impact the returns to the financial buyer? A ) It significantly increases the returns due to the absence of prior financial obligations that need to be cleared, allowing for a greater allocation of funds towards growth investments.
What are the two ways of financing a leveraged buyout? ›
There are two major types of leveraged buyout financing: Purchase financing, the funding that is used to make the business acquisition, and operational financing, which provides necessary working capital to integrate and grow the acquired company.
Who provides debt in LBO? ›
Bonds or Private Placements
Bonds and private notes can be a source of financing for an LBO. A bond is a debt instrument that a company can issue and sell to investors. Investors pay cash upfront for the face value of the bond and in return, get paid, an interest rate until the maturity date or expiration of the bond.
What are the key components of an LBO? ›
Key credit metrics in an LBO model include debt/EBITDA, interest coverage ratio, debt service coverage ratio, and fixed charge coverage ratio.
Who funds the debt in an LBO? ›
When a company is acquired through an LBO, the purchaser, usually a private equity firm, borrows most of the money to make the purchase. As the debt is paid down, the equity in the company grows. At the same time, the new company may also make improvements to its business, increasing the company's value.
What are listed debt instruments? ›
Just like shares are listed on the stock exchange, debt securities are also listed on a stock exchange.
