In this tutorial, you’ll learn why a company’s existing Debt and capital structure don’t make (much of) a difference in leveraged buyouts and LBO models, despite guides that claim the contrary.
You’ll also learn about a few exceptions where these items do make a small difference.
Existing Debt In Leveraged Buyouts: Why It Doesn’t Matter
At the 2021 SALT New York conference, which was held earlier this week, one of the panels on the main stage discussed the best macro shifts coming out of the pandemic and investing in value amid distress. The panel featured: Todd Lemkin, the chief investment officer of Canyon Partners; Peter Wallach, the managing director and Read More
Table of Contents:
6:33 Exception #1: Call Premiums
10:00 Exception #2: Lender Familiarity
11:50 Recap and Summary
For the most part, a company’s existing capital structure does NOT matter in leveraged buyout scenarios. That’s because in an LBO, the PE firm completely replaces the company’s existing Debt and Equity with new Debt and Equity.
Let’s say that a PE firm wants to acquire a company for 10x EV / EBITDA using 5x Debt / EBITDA.
Regardless of whether a company has 0 Debt or 4x Debt / EBITDA before the LBO, it will still have 5x Debt / EBITDA after the LBO.
The PE firm will also have to contribute the same amount of equity to the deal (5x EBITDA).
Existing Debt would affect things only if it somehow increased the Purchase Enterprise Value.
But that line of thinking is incorrect: If a company raises additional Debt, both its Cash and Debt balances increase, canceling each other out, and resulting in the same Enterprise Value.
So, unless you have incorrect beliefs about the concept of Enterprise Value or the pricing for leveraged buyouts, existing capital structure doesn’t matter.
However, there are a few small exceptions where it makes A BIT of a difference.
Exception #1: Call Premiums
Some Debt limits early repayments; for example, on a 10-year unsecured bond issuance, the company might not be able to repay Debt at all for the first two years.
Then, after that, the company might have to repay 105% of the outstanding principal if it does so in Years 3-4, 103% in Years 5-6, 101% in Years 7-8, and 100% in Years 9-10.
These “call premiums” make it more expensive to repay the Debt, which is almost always required in LBO scenarios, and increase the
effective Purchase Enterprise Value.
But they still don’t matter that much: In a 10x EV / EBITDA deal with 5x Debt / EBITDA, for example, a 110% call premium would increase the purchase multiple to 10.5x and reduce the IRR by about 2%.
And the call premium is usually much less than 110%.
Exception #2: Lender Familiarity
If the company has a track record of servicing its Debt, paying interest, and using loans responsibly, lenders may be more inclined
to invest in another Debt issuance from the company.
Or, if the company has a poor track record with all of those, lenders may be less likely to invest in a new Debt issuance.
These points don’t affect the purchase price or IRR, but they may make it easier or more difficult to get a deal done.
You could argue that a solid track record might result in a lower coupon rate on the Debt, but that’s quite a stretch, and it would be difficult to find real data to support that theory.
Even if that happened, a slightly lower interest rate would make almost no difference on the IRR or money-on-money multiple.