The Leveraged Buy-Out (LBO) mechanism is particularly popular with investment funds and is generally regarded as the preferred financial arrangement for a company takeover. This buyout method must be carefully prepared to avoid any nasty surprises, both for the buyer and the vendor. If you want to know how to set up an LBO, what kinds of LBO exist, who can undertake an LBO, and what the advantages and drawbacks of a Leveraged Buy-Out are, read on, as Agicap explains all the principles in this article.
What is an LBO (Leveraged Buy-Out)
A Leveraged Buy-Out, generally referred to as LBO, is a financial transaction in which a company is taken over by combining equity and debt. In the context of an LBO, a company can be acquired by means of borrowing an often high amount of liquid assets (bonds or loans) to cover the acquisition cost. The buyout is therefore financed by debt.
One of the main arguments in favour of such a transaction is that it only requires a small personal investment by the buyer (an individual, an investment fund or sometimes, the staff) to take control of a company. In this arrangement:
● The assets of the acquired company are often used as collateral to secure loans, along with the assets of the acquiring company.
● The acquisition is largely financed with a bank loan at a cost below the expected rate of return from the target.
In a leveraged buy-out (LBO), the ratio is usually 90% of debt vs. 10% of equity. Although an acquisition by means of a loan can be complex and take time, it can benefit both the buyer and the vendor if it is done correctly.
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How an LBO works
The purpose of an LBO is to acquire a total or majority interest in a target company while substantially limiting the initial investment by the buyers. So, a buyer may acquire a business valued at 100 with a personal investment of only 40 or 50.
To arrange a Leveraged Buy-Out, the buyer or group of buyers creates a holding company whose capital corresponds to the money they can invest or to their own investment plus input from financial partners. There are three main aims for setting up a holding company:
● Buy out the target company;
● Borrow funds to finance the buy-out;
● Repay the loan out of profits subsequently generated by the company.
1. The Loan
Thanks to the loan taken out by the holding company, plus its capital, the buyers can acquire 100% of the target company: the buyout is complete.
The company making the acquisition by means of an LBO, which is generally a private equity firm, uses its assets as financial leverage. The assets and cash flows of the company bought out (called target company or vendor) are also used as security and to pay the financing cost.
2. Repayment
The main difficulty then lies in repaying the loan. It is therefore vital to ensure in advance that the target will generate more profit than the cost of the loan. This is called positive leverage.
To be able to repay its loan, the holding company carries out regular cash transactions (out of the target's profits and cash flow). The holding company gradually starts its de-leveraging, a process which generally takes several years.
3. Holding company-target company merger
The transaction will be a success once the holding company has fully repaid the loan and bought back the shares of minority shareholders: the holding company can then merge with the target to form a single entity.
There are three main reasons for carrying out an LBO:
● To privatise a public company;
● To spin off a part of an existing company;
● To transfer a private property, as in the case of a change of ownership of a small business.
Challenges of an LBO
You will face different challenges depending on your position in an LBO:
As the director of the target company
● An LBO allows you to avoid mergers
● You must prepare a very precise business plan so as to achieve the expected leverage effects
● You face an often sizeable challenge with significant potential for enrichment
As an employee
● Management must meet the profitability demands of the new owners
● The possibility of joining the "pool" of investors
● Writing a new chapter in the company's history
As seller
● You are not necessarily forced to sell your business to your competitors (by turning to institutional investors for example)
● You can pass on the business to managers already working in your company
● An LBO can often be a lengthy and tedious process (even though deals are becoming increasingly easier).
Different Types of LBO
It is important to examine the scenarios that drive LBOs to understand their possible effects. Here, we look at four examples: the repackaging plan, the split-up, the portfolio plan, and the saviour plan.
LMBO or MBO
In the case of an LMBO (Leveraged Management Buyout), the company's current management team buys out the company. An LMBO generally takes place when a production unit is no longer a priority for an industrial group for example. Instead of offering the business to external investors, management offers to sell it to its employees (managers and/or employees) to secure its future. The employees may be joined in the deal by external investors and set up the holding company together. This transaction is financed by debt, with the aim of making sufficient profit to repay the loan and the interest.
Company owners often opt for an LMBO if they take retirement or if a majority shareholder wants out of the business. MBOs have several advantages, the first one being the continuity of the business. When the management team does not change, the owner can expect a smoother transition, with the company continuing to generate profits.
LMBI or MBI
An LMBI (Leveraged Management Buy-In) or MBI is based on the same principles as an LMBO, except that the company is taken over by external investors. They then replace the management team, the board of directors and the other members of staff with their own representatives. A management buy-in particularly takes place when a company is undervalued or not performing well.
An LMBI does not come with the same stability as an LMBO as sometimes, entire teams are replaced with new ones. An LMBI may be a good exit strategy for owners wanting to retire or who are out of their depth.
OBO (Owner Buy Out)
An OBO (Owner Buy Out) is a good option for company owners who wish to convert their professional wealth into personal wealth (i.e. into cash). An owner sells their company to themselves, thereby allowing them to receive capital that they can invest in personal accounts (in life insurance for example).
Thanks to this carefully invested money, they then receive additional income during retirement while simplifying the transfer of their estate to their family.
In the case of an OBO, the business is transferred in two stages:
● A partial contribution of the shares in the company to be sold to the holding company, with the company's founder acquiring a stake in the holding company in return. This stake means the assets continue to be considered as business assets for tax purposes (exemption). In parallel, the holding company takes out a loan to buy the majority of the founder's shares. The loan is repaid out of dividends from the company gradually being bought out;
● After a certain period of time, the founder sells their stake in the holding company. The last shares sold are higher in value than those sold in the first step because, in the meantime, the company has gained in value.
With an OBO, the seller gradually transfers their company while continuing to manage it. The buyer obtains facilities to buy the shares sold to the holding company, since they acquire a stake in its capital. Sometimes, the newly created holding company is sold on to a third party: this is called a "two-stage deal". The target of an OBO is ultimately valued by a financial investor supporting it.
Note that: The arrangement of an OBO must be thoroughly analysed from a legal, fiscal and wealth management perspective.
LBU (Leveraged Build-Up)
By means of an LBU (Leveraged Build-Up), the investor is generally seeking to reinforce their position in a given business sector by acquiring a new company.
In this specific context, the LBU is a bet on the future: the company raises even more debt to acquire companies in the same sector in order to consolidate its strategic positions. The investor takes a risk by engaging in this kind of deal as there is no guarantee that the value of shares will rise.
The buyer ultimately hopes to develop industrial synergies. Concentrating several entities operating in the same sector can improve the company's weight in that business sector and thus its ability to negotiate with suppliers. Productivity can also be improved, particularly in certain departments such as human resources.
BIMBO
The last LBO option is a method known as "BIMBO" (Buy-In Management Buy-Out). Here, the team of buyers consists of both target company managers and external directors. In this respect, a BIMBO is a type of LBO combining the features of an LMBO and an LMBI.
In practice, in a BIMBO, a new external management team joins the internal management team already in place to bring in new innovations and organisational methods with a view to facilitating the running of the business. The external managers acquire the company, but they keep the managers who were already in the company. This strategy offers the advantages of both a buyout and a takeover.
Duties and responsibilities are generally transferred efficiently and seamlessly, since some members of the new management team are already familiar with the company. This combination of management buy-in and management buy-out positions directors in an area in which they will be efficient, such as the development of a new product or service, finance, accounting or operations.
The new management team will bring fresh impetus and new ideas whereas the "historical" managers will guarantee business continuity especially while the deal is going through. And this new hybrid management team will focus on decisions concerning the strategy needed to maximise profits and repay the loans taken out (see below).
Statistics show that MBI deals tend to fail more often than MBOs. This is why BIMBOs are increasingly frequent.
Main Players
As they are complex deals, LBOs require multiple players, each one having a specific role. The main players in an LBO are: financial sponsors, investment banks, banks, institutional lenders and the target company's management team.
To make things easier:
● L: Leverage, i.e. debt
● B: Buy
● O: Out, the buyer comes from the outside
● I: In, the buyer comes from the target company
● M: Management (acquisition by management)
Management Teams / Directors
Company directors or managers are central in a Leveraged Buy-Out. They are the ones who present the business and the merits of the target company to buyers and lenders. They deal both with potential investors and the lead underwriter (vision, financial and marketing documents, etc.). A solid management team boosts the value of the LBO target as it can generate good pricing and financing conditions.
Depending on their wishes and aims, existing management teams often acquire a significant stake in the post-LBO company, thereby aligning their interests with those of the buyer.
Financial Investors
Buyer or buyers means the financial investors in an LBO. Most often, the investor transfers the capital raised to funds established in the form of partnerships. The fund may be a conventional private equity fund, but also a performance fund, a division of an investment bank or a venture capital fund.
The partnership usually takes the form of an investment vehicle in which the general partners manage the day-to-day business and the limited partners (the buyer or buyers) play a passive role, providing capital when the general partners so require for specific investments.
Banks
Banks mainly focus on the target company and the credit profile, paying particular attention to cash flow.
The banks' model consists in ensuring that the target company has the capacity to pay all the interest. They particularly focus on guarantees or covenants to ensure they are protected in the event of any incidents.
In most cases, the stakeholders in an LBO turn to investment banks which play two specific roles:
● They provide advice about mergers and acquisitions; and
● They provide funding.
Investment banks give advice on both the buy and sell side, by drawing on their network and expertise. On the buy side, investment banks source deals and provide expertise, contacts or even in-house solutions. On the sell side, investment banks handle the entire sale process, by finding future buyers for example.
Banks particularly suggest the most appropriate financing structure and define the terms with which the buyer must comply. After approval by the credit committee, the investment bank can make the funding commitment which comprises: a commitment letter, an engagement letter and a fee letter:
● The commitment letter gives the commitment to provide the loan;
● The engagement letter indicates the sponsor's decision to use the investment bank to underwrite the bonds on behalf of the issuer;
● The fee letter sets out the different fees that the sponsor will pay to the investment bank, including the costs of bridge financing.
Banks and Institutional Lenders
Institutional lenders provide financing in the form of partial amortisation loans. Their role consists of providing the amount necessary to go ahead with the deal after "credit analyses". Institutional lenders may be pension funds, insurance companies or hedge funds.
Advisors and Intermediaries: M&A Advisors
M&A (mergers and acquisitions) advisors are the last important players in an LBO. They can carry considerable weight in the process since they provide real know-how and can considerably influence the terms of the deal. These players include:
● M&A Advisors: they primarily aim to value the company to be bought out. Generally well established in their regions, they are also responsible for presenting and proposing the deal to the various players (in the information memorandum). Finally, they act as advisors at the time of the valuation and during negotiations, for both vendors and buyers.
● Specialised Lawyers: some law firms specialise in drafting documents relating to the sale (loan agreements, pledges, etc.). As an LBO involves a lot of sensitive legal documents, they provide vital support.
● Auditors: their role consists in checking the information disclosed. For example, auditors will cross-check financial documents provided by the vendor to confirm that the company is correctly valued. For a large-scale LBO (valued at billions of Euros), they also give an opinion on commercial aspects of the company, on the quality of the directors, the information and management systems in place, the company's positioning, market trends, and environmental, legal and tax risks, etc. This is what is known as "due diligence".
LBO Leverage
There are four kinds of leverage in an LBO: financial, fiscal, legal and social.
Financial Leverage
Financial leverage refers to the capacity of the holding company to repay the debt. Only the target company repays the loan. Being a financial deal, an LBO should lead to gains in the medium or long term. The company's profitability should ultimately increase thanks to the debt raised. The bigger the difference between the target's internal rate of return and the holding company's borrowing rate, the higher the financial leverage will be.
So that the target can meet the costs of the deal, it must satisfy two criteria:
● Have a sufficient rate of return to generate dividend payments to the holding company;
● Have a return on investment (ROI) in the target that exceeds the interest rate charged by the bank.
Fiscal Leverage
An LBO is often carried out as part of a mergers and acquisitions (M&A) strategy. Sometimes, LBOs are also used to acquire competitors and enter new markets to allow a company to diversify its portfolio. But business people and private equity firms very often opt for an LBO due to the tax aspects.
This is because an LBO can subsequently lead to a reduction in the taxable income of a company. In this way, the future buyer enjoys tax benefits that were not previously available. These tax benefits are available:
● In the form of a deduction of interest for tax purposes at the holding company level;
● Via the parent-subsidiary tax regime: when a company holds more than 5% of the capital of another company (through the tax-free distribution of dividends between the target and the holding companies). This opportunity is known as "neutralisation of double taxation". On receiving dividends, the holding company is only taxed 5% (representing fees and expenses);
● Via the tax consolidation regime: this is possible when a company holds more than 95% of the capital of another company. With this mechanism, a single tax amount can be declared for the whole group, by adding up the profit or loss of each company. This is called "fast-track merger". The losses posted by certain companies cancel out the profits of others, thereby reducing the tax burden (tax-free dividend distribution, deduction of losses, etc.)
Note that: these three effects cannot be combined or be used concurrently.
Legal leverage
The third type of leverage in the context of an LBO is legal leverage. This consists of taking control of the target company without holding the majority of the shares. To control the target company, you only need 51% of the share capital of the holding company through which the LBO takes place (i.e. 26% of the target), whereas a direct acquisition would have required twice that amount.
The more buyers there are in an LBO, the smaller their equity interest will be. Therefore, by multiplying the number of intermediaries, the cost per buyer is reduced, unlike a direct acquisition of interest in the target company. Indirectly, there is therefore a reduction in the amount of capital needed to retain control of the company.
Social and Human Leverage
There is also one last type of leverage that is no doubt less obvious than the others: this is social leverage. This concept underlines the importance of the role played by the buyers in an LBO. To meet the considerable financial constraints involved in an LBO, the members of the management team must be experienced and motivated.
Through their actions and choices, they are the sole guarantors of the success or failure of the financial deal. This is why financial institutions and investors pay special attention to the assessment of the team of buyers in their analysis (motivation, skills and complementarity).
Whether they contribute funds or not, they commit to manage the target company efficiently, both during and after the transition. If they contribute capital, they have all the more incentive to act as owners and are more involved in the deal.
How to finance an LBO
Remember that: a leveraged buy-out is based on a bank loan. But unlike a conventional financing transaction, an LBO offers the possibility of using multiple sources of funding. A target company is therefore often acquired by contributing only 30 to 50% of the purchase price.
But the incurrence of debts necessarily means that repayments must be prioritized among investors (here we are not referring to equity investors). It is very important to bear in mind that the senior debt always takes priority over subordinated debts.
Below are the different forms of financing for an LBO.
Equity
In an LBO, the amount contributed as equity is usually between 30% and 50% (investment capital). The remaining 50% to 70% is financed by debt (via bank borrowings). Note that these percentages do not apply for all financial arrangements and they vary with each deal according to the prevailing market conditions at the time.
As the determination of the sale price may be a source of disagreement between the vendor and the buyer, the parties have several means that represent real complementary levers.
Senior Debt
The senior debt is a loan taken out by the holding company with one or more banks to buy the target company. The bank loan is the main source of funding, and will be repaid over five to nine years (depending on the terms). Two repayment clauses generally apply to senior debt:
● One amortised tranche, i.e. which can be repaid as dividends are received;
● One bullet tranche, which must be repaid at the end of the loan.
Via this mechanism, the holding company is not under too much pressure in terms of cash flow management to repay the debt. However, unfortunately, dividend payments may not be quite as high as expected. If this is the case, then the senior debt will serve as security via the company's assets. And the lender will acquire those assets if the company is unable to repay the debt.
Good to know: as this debt is highly secured, the interest rate is therefore relatively low.
"Second Tier" Financing
This "second tier" LBO financing is an intermediate product between the senior debt and the senior mezzanine debt. Sometimes called "subordinated debt", it differs both by its maturity and its repayment terms. You can therefore take out this debt over a period of seven to ten years, but you must repay it in one final instalment. This is called a "bullet" repayment.
In contractual terms, second tier lenders are subordinate to senior lenders in their rights to the proceeds from realising securities. As a result, the second tier debt will only be repaid if the senior loan has been repaid in full.
One of the drawbacks of this debt lies in the high interest rate set by lenders. As it is less secure than the senior debt, the risk of default is generally higher.
Mezzanine Debt
To obtain additional financing to the bank loans and thus increase the financial leverage, a "junior" or "mezzanine" debt can be incurred. The term is between eight and ten years, but is often risky for lenders. Like second tier financing, mezzanine debt is subordinate to senior debt, so the company will only be able to pay it off after repayment of the senior debt. This financial leverage often takes the form of bonds with equity warrants or an issuance of convertible bonds.
Buyers In an LBO, the management teams are often stakeholders. Their role implies that the buyers are in charge of the operational running of the target company. Consequently, they are generally involved in the financial structuring as they have the possibility of contributing their own funds.
Note that: the buyers may be either teams already in place before the deal, or external directors and managers hired for the deal.
Mezzanine Financing and Family Businesses In recent years, mezzanine financing has been used increasingly by family businesses as it offers them facilities. In this case, the financing is in the form of subordinated debt (or junior debt). The average duration is five years and it offers the advantage of having a fixed rate over the entire term.
There are also variations, including a conversion right or a share in the profits. Thanks to this supplement, it is easier for the buyer to obtain a bank loan from lenders for the senior debt. For family businesses, mezzanine debt is therefore a sizeable asset in finalising the deal.
Note that: as mezzanine financing is riskier, it costs between 4% and 7% more than a bank loan on average.
Revolving Credit
A revolving credit is a form of senior bank debt that works like a credit card for businesses. In principle, it is used to help finance a company's working capital requirement. A company is said to "draw" on the revolving credit up to the limit when it needs cash. It agrees to subsequently repay the revolving credit once it has sufficient excess cash (without any repayment penalty).
A revolving credit gives companies a degree of flexibility in their funding needs, by granting them access to cash without having to find additional financing by means of a loan or shares. Two main costs are associated with renewable lines of credit:
● The interest rate applied to the amount of the revolving credit used;
● A commitment fee that pays the bank for agreeing to lend up to the limit of the revolving credit.
High Yield Bonds
High yield bonds are thus named due to their high interest rate. This interest rate compensates investors for the risk they take by holding such a debt.
This type of debt is often needed to increase the level of debt beyond what banks and the other main investors are prepared to provide. High yield bonds can, in principle, be refinanced when the borrower raises new debt at a lower cost. This subordinated debt comes with a bullet repayment (one final payment) and generally has a maturity of eight to ten years.
A company retains more financial and operational flexibility with high yield bonds, due to the existence of covenants. There are also early repayment options (after four to five years for high yield bonds). Like most subordinated debt, the interest rates on high yield bonds are higher than those of senior debt.
CapEx Line of Credit
A CapEx (short for Capital Expenditure) line of credit is rather like a revolving credit. This line of credit is designed to enable the company to finance certain investments during the LBO such as the resources it needs for its operations.
Exceptional Dividend Distributions
As a production tool in operation, the target company no doubt has cash flows. Depending on its financial health, the buyer is entitled to use this cash flow to finance the deal, without impacting the business. In other words, it must not use the portion of cash flow that serves to finance the operating cycle. It is therefore possible to fund part of an LBO using distributable reserves, i.e. exceptional dividends.
Vendor Credit
Vendor credit, also known as deferred payment, means that the vendor accepts a payment facility for the benefit of the buyer, consisting of deferred payment of all or part of the sale price. This credit is definite and is not subject to any condition or uncertainty. Therefore, the default risk is covered by a surety or a first-demand bank guarantee.
This method is particularly advantageous for the buyer as it allows it to involve the vendor in the buyout process. Because, if the deal fails, resulting in the company being unable to repay the loans taken out, the buyer will no longer be able to repay the loan granted by the vendor.
For the vendor, the deferred payment has the advantage of pushing the price up, since it grants the buyer a credit facility. The longer the term of the loan, the more risk the vendor bears. It is a means of influencing the purchase price, and the interest rate. Seasoned lenders usually want the vendor credit to be subordinated to senior debt.
Hybrid Financing
In addition to the financing methods with which M&A companies are very familiar, hybrid financing is also used increasingly in LBOs. Securitisation is a preferred method in the context of structuring a Leveraged Buy-Out. This technique involves converting illiquid assets into liquid securities.
In practical terms, the company raises capital by issuing securities, based on the projected cash flows from assets. And these security issues will allow the company to repay part of the debts incurred.
Another trend in LBO financing is the use of mortgage loan portfolios or rights linked to leasing transactions. This combination of techniques is particularly popular with buyers as it gives them greater leverage while limiting the inherent cost of the deal. Margins on securitisation (between 0.8% and 1%) or mortgage loans (between 1% and 1.2%) are much lower than those on a revolving credit at 2% or on senior debt.
Advantages of an LBO
If a company is in difficulty (whether financial or operational), the directors may be required to take decisions that can be irreversible, such as selling the company. However, selling a business that is not performing to the best of its ability can be a perilous mission. This is where the advantage of an LBO lies. Not only does it improve the company's position on the market, but this kind of financial set-up also provides protection from bankruptcy that would impact both shareholders and the staff. If the company still has some liquid assets and potential for growth, it should find a buyer ready to take up the challenge.
An LBO can therefore be advantageous for:
● The current management team: directors and managers are more involved and actively contribute to achieving development objectives;
● Employees: they may also take part in the financial deal, reflecting their attachment to their company;
● The vendor: the vendor can set the price while ensuring that he leaves the company with a solid plan in place. Leveraged buyout is an ideal exit strategy for business owners seeking to obtain maximum cash at the end of their career.
● The buyers: they negotiate the buyout by taking advantage of the leverage effects.
LBO and Tax Benefits
As we have seen, an LBO offers three main tax benefits: in the form of a deduction of interest on borrowings at the holding company level;
● Via the parent-subsidiary regime;
● Via the tax consolidation regime.
● When grouping several companies together under the tax consolidation regime, it is also advisable to use other methods such as:
● Providing intangible assets (trademarks, patents, etc.);
● Cash pooling;
● Participation in accounting and administration, and financial and legal management.
This type of arrangement offers the possibility of recovering VAT and organising a transfer of cash inflows to the holding company in order to deduct the tax deficits generated by interest on loans.
Lastly, there is a specific tax regime in the event of a leveraged management buyout (LMBO). To obtain these benefits, the voting rights attaching to the shares of the holding company must be held by at least 15 salaried employees or at least 30% of the staff if the company has fewer than 50 employees.
Limits of an LBO
As we have seen, a leveraged buyout has several advantages both from an operational and a tax perspective. Although it has been very popular over the past fifteen years, it is nonetheless vital to stress that this buyout method has certain limits.
1. Mandatory payment of dividends This is one of the main constraints of an LBO. Once bought out, the target company must transfer a substantial part of its cash flow in the form of dividends.
2. The necessary approval of banks It's quite simple: without the agreement of a bank, the leveraged buyout cannot go ahead. Lending banks will therefore examine the history and investment needs of all the stakeholders very thoroughly. And they approve or reject the financial set-up. However, banks can be more understanding as regards repayments, if the holding company occasionally faces a difficulty.
3. Repayment, the absolute financial priority Throughout the debt repayment period, the financial results will serve as cash flow. As a result, bonuses, training and investments will no doubt be sidelined.
4. Limited investments in the short term At the end of the repayment period, the holding company has, in principle, finished repaying the loan taken out to acquire the target company, and it therefore becomes the owner of the target. However, the target company may not have generated sufficient inflows to update its production facilities or invest in employee training. This is when the upgrading then begins.
5. A possible loss of competitiveness As its investment capacity is limited, the target company may suffer a relative loss of competitiveness. In this case, only business activities that are sufficiently profitable will be continued. The other entities may have to go through another buyout (whether leveraged or otherwise).
6. A very small margin of error In an LBO, the same leverage that brings greater reward also comes with a bigger risk. The margin of error for the buyer is slight, and if it is not able to repay the debt, it will not obtain any return. Depending on the buyer's definition of risk and its risk tolerance, this situation can either be attractive or a source of anxiety. Cash flow must therefore be constantly monitored, and the variances measured and analysed: Agicap is an ideal solution for this type of situation:
7. The threat of bankruptcy The risks of a leveraged buyout are also high for the target. Interest rates on the debt incurred are often high and can bring down its credit rating. If it is not able to service the debt, then it will end up filing for bankruptcy. LBOs are particularly risky for companies operating in highly competitive or volatile markets.
8. A turbulent handover A change of management can often bring instability both inside the company and out. It is not uncommon to lose some customers during a company takeover, which is why the profile of the new management team is so important.
9. Inability to make repayments Lastly, the major risk of an LBO is that the subsidiary will not generate the profits expected at the time of the buyout. This will create difficulties, or even mean that instalments on the loans taken out by the holding company cannot be met.
Legal Constraints of an LBO
A leveraged buyout is based on company law and labour law so as to set up a suitable structure to generate profit. It is therefore important to think about a few legal rules and principles before embarking on such a buyout strategy.
1. Due diligence Due diligence gathers all the information obtained by the stakeholders about the target company. From analysing financial statements and forecasts, to the reasons for the sale, the market situation and potential for growth, nothing must be overlooked! Due diligence also includes the employment situation (unionisation, HR policy and management, etc), the tax situation and the business plan. On the basis of this key information, the future buyer will start approaching financial partners for the deal.
2. Liabilities guarantee When structuring an LBO, a liabilities guarantee limits the risks inherent in the target. Here, the stakeholders draft a contract certifying that the accounting data underlying the target company's valuation is exact. As protection, the buyer has the possibility of requesting a "liabilities guarantee" clause which provides it with a guarantee against risks of an increase in the liabilities.
3. Debt guarantee A debt guarantee requires the holding company to grant the lending banks security on the target company's shares.
Economic and Social Benefits of an LBO
LBOs often come under criticism due to the fact that the target company tends to reduce its costs once the buyout is completed. It does this with the aim of repaying the debts as soon as possible. However, this reduction in costs often comes with staff cutbacks or layoffs.
At the same time, some critics voice concern about misuse of LBOs. Sometimes a management team sets up a leveraged buyout and then sells the company back to the same team in order to make short-term personal gains. These "predators" sometimes even target other companies in difficulty by privatising them and then dismantling them. They can then sell off the assets and file for bankruptcy, while obtaining a high return.
However, in most cases, LBOs meet with great success and are beneficial for the target company.
Exit from an LBO
Any knowledgeable investor is aware that preparing exit strategies is just as important as actually making the investment. This is because the subsequent sale of the equity interests largely determines the return on an investment. In France, an LBO spans five years on average from its legal closing to the end of debt repayment. To then exit after a leveraged buyout, several internal and external factors must be considered such as:
● The specific characteristics of the target company;
● The market conditions;
● The macroeconomic environment.
Investment funds have different exit possibilities at the end of an LBO:
IPO
On top of showing that the buyout was a real success, an initial public offering (IPO) is the best option for the management team. The company has achieved growth and the bet paid off: the investor makes a good ROI. Naturally, certain conditions must be favourable to the company's valuation.
Note that: an IPO (initial public offering) comes with several new requirements (minimum size, disclosure of financial information, etc.).
Secondary, tertiary and quaternary LBOs
A secondary LBO consists of turning to other shareholders than the original ones, to carry out another LBO. If this is done a third time, we call it a tertiary LBO. And likewise for a fourth deal, called a quaternary LBO.
This solution is only possible if the company is sufficiently profitable or has good prospects of growth. As the first LBO will normally have put the finances on a better footing, the secondary LBO should offer the new investors even better conditions. The amount of the former senior debt is refinanced through this new LBO.
However, rates of return cannot increase infinitely and some investors think that multiple LBOs increase the risks.
Sale to an Industrial Entrepreneur
Selling to a corporate entity is a last exit option. The sale price is generally better as potential synergies are valued and integrated into the amount. As a strategic acquisition for the buying company, this buyout secures the company's future. The sale to another company is also the most gainful solution.
However, the management team is often opposed to this kind of deal as it loses control of the group and ultimately, its independence.
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