Introduction
A leveraged buyout (LBO) is a financial transaction in which a company is acquired using a significant amount of debt to finance the acquisition. Private equity firms are a driving force behind LBOs, as they provide the capital needed to acquire the target company. In this article, we will take a deep dive into the different types of financing used in LBOs, including senior-secured debt, second-lien debt, high-yield debt, and mezzanine capital.
Senior-Secured Debt
Senior-secured debt is the most senior type of debt in an LBO transaction, meaning that it has the first claim on the assets of the target company. This type of debt is typically provided by traditional lending institutions such as banks and insurance companies. In a typical LBO transaction, senior-secured debt makes up the majority of the financing, often accounting for 60-80% of the total capital structure.
Second-Lien Debt
Second-lien debt is the next most senior type of debt in an LBO transaction, sitting behind senior-secured debt in the capital structure. This type of debt is typically provided by institutional investors such as hedge funds and private credit funds. Second-lien debt is generally used to fill the gap between senior-secured debt and equity in the capital structure, accounting for 10-20% of the total financing.
High-Yield Debt
High-yield debt, also known as junk bonds, is a less senior type of debt in an LBO transaction. This type of debt is typically provided by institutional investors such as mutual funds and pension funds. High-yield debt is generally used to fill the gap between second-lien debt and equity in the capital structure, accounting for 5-10% of the total financing.
Mezzanine Capital
Mezzanine capital is the most junior type of financing in an LBO transaction, sitting at the bottom of the capital structure after common equity. Mezzanine capital is similar to both subordinated and unsecured debt but is closer in nature to equity. Mezzanine capital is typically provided by institutional investors such as mezzanine funds and private credit funds. In an LBO transaction, mezzanine capital is used to fill the gap between high-yield debt and equity in the capital structure, accounting for 5-10% of the total financing.
Common Equity
Common equity represents the most junior tranche of the capital structure in an LBO transaction. It is provided by the private equity firm and its investors. In an LBO transaction, common equity is generally used to fill the gap between mezzanine capital and the total financing required. It typically accounts for 10-20% of the total financing.
In conclusion, LBOs are complex financial transactions that are typically financed by a mix of debt and equity. The specific mix of financing will vary depending on the target company and the private equity firm’s investment thesis. However, in general, senior-secured debt makes up the majority of the financing, followed by second-lien debt, high-yield debt, mezzanine capital and finally common equity.
Types of Financing in LBOs
When it comes to leveraged buyouts (LBOs), there are several types of financing that private equity firms can use to fund the acquisition of a target company. These include:
Senior-Secured Debt
This type of debt is considered the most senior tranche of financing in an LBO, as it is secured by the assets of the target company. This means that in the event of default, the lender has first priority in receiving payment from the sale of the assets. Senior-secured debt is often used to finance the majority of the purchase price in an LBO, as it is considered the lowest-risk form of financing.
Second-Lien Debt
Second-lien debt is considered a less senior tranche of financing compared to senior-secured debt, as it is also secured by the assets of the target company but is subordinate to the senior-secured debt in terms of priority of repayment. This means that in the event of default, the lender of second-lien debt would be paid after the senior-secured debt lender. Second-lien debt is often used to provide additional financing in an LBO, and is considered to be higher-risk than senior-secured debt.
High-Yield Debt
High-yield debt, also known as junk bonds, is considered an even less senior tranche of financing compared to second-lien debt. It is unsecured, meaning it is not backed by any assets of the target company, and is considered to be the highest-risk form of financing in an LBO. Despite the high risk, high-yield debt can be attractive to private equity firms as it often comes with a higher yield than other forms of financing.
Mezzanine Capital
Mezzanine capital is similar to subordinated debt in terms of its relative seniority in the capital structure, but it is closer to equity in nature. Mezzanine capital is often structured as a combination of debt and equity, with the lender receiving a return in the form of interest and the potential for equity participation in the target company. One of the key benefits of mezzanine capital is that it can provide a private equity firm with a source of financing that is not as expensive as traditional debt.
Each type of financing has its own unique characteristics and can be used in different ways in LBO transactions. For example, senior-secured debt is often used to finance the majority of the purchase price, while mezzanine capital can be used to provide additional financing at a lower cost. It’s important for private equity firms to carefully consider the mix of financing they use in an LBO, as the relative seniority and risk profile of each type of financing can have a significant impact on the target company’s capital structure and financial health.
Role of Common Equity in LBOs
In addition to debt, private equity firms also use common equity as a source of financing in LBOs. Common equity represents the most junior tranche of the capital structure, as it is the last to be repaid in the event of default. Despite its relatively junior status, common equity can be an important source of financing for private equity firms as it allows them to align their interests with those of the target company’s shareholders.
For example, private equity firms often use common equity to finance a portion of the purchase price in an LBO, in exchange for an ownership stake in the company.
In a leveraged buyout (LBO), private equity firms typically use a combination of debt and equity to finance the acquisition of a target company. One of the types of financing used in LBOs is common equity, which represents the most junior tranche of the capital structure.
Example: The Carlyle Group’s LBO of Sedgwick Claims Management Services
In 2017, global private equity firm The Carlyle Group used common equity to finance a portion of its acquisition of Sedgwick Claims Management Services, a leading provider of technology-enabled risk and benefits solutions. The Carlyle Group used a combination of debt and equity to finance the $6.7 billion deal, with the common equity component coming from the private equity firm’s own funds and co-investors.
Example: KKR’s LBO of Envision Healthcare
In 2018, global private equity firm KKR used common equity to finance a portion of its acquisition of Envision Healthcare, a leading provider of physician-led medical services. KKR used a combination of debt and equity to finance the $9.9 billion deal, with the common equity component coming from the private equity firm’s own funds and co-investors.
Example: Blackstone’s LBO of Team Health
In 2016, global private equity firm Blackstone used common equity to finance a portion of its acquisition of Team Health, a leading provider of outsourced physician staffing solutions. Blackstone used a combination of debt and equity to finance the $6.1 billion deal, with the common equity component coming from the private equity firm’s own funds and co-investors.
These examples illustrate how private equity firms often use common equity to finance a portion of the purchase price in LBO transactions. By using common equity, private equity firms are able to increase the amount of debt they can take on, which in turn increases the leveraged return on their investment. However, it also increases the risk for the target company, as the higher level of debt can make it more difficult for the company to meet its financial obligations.
Sources:
https://www.carlyle.com/news-and-events/news/the-carlyle-group-to-acquire-sedgwick-claims-management-services
https://www.kkr.com/news/press-releases/kkr-to-acquire-envision-healthcare-in-a-9-9-billion-transaction
https://www.blackstone.com/media/press-releases/article/blackstone-to-acquire-teamhealth-for-6-1-billion
Mezzanine Capital in LBOs
Mezzanine capital, also known as “mezz,” is a type of financing that sits between senior debt and equity in a company’s capital structure. It is similar to subordinated and unsecured debt, but it is closer to equity in nature due to its higher risk and potential for higher returns.
Mezzanine capital is commonly used in leveraged buyout (LBO) transactions to help private equity firms raise the necessary capital to acquire a target company. In an LBO, the private equity firm uses a combination of debt and equity to purchase the target company, with the goal of generating high returns for its investors. Mezzanine capital can provide the private equity firm with additional funding while also offering the lender the potential for higher returns than traditional debt.
However, the use of mezzanine capital in LBOs also raises potential risks and controversies. One concern is that the high levels of debt used in LBOs can put significant strain on the target company’s financial health, potentially leading to bankruptcy or other negative consequences. Additionally, there can be conflicts of interest between the private equity firm and the mezzanine capital lender, as the private equity firm may prioritize its own returns over the health of the target company.
One example of a high-profile LBO involving mezzanine capital is the leveraged buyout of Toys “R” Us by private equity firms KKR, Bain Capital, and Vornado Realty Trust in 2005. The private equity firms used a combination of senior debt, second-lien debt, and mezzanine capital to finance the $6.6 billion purchase price. However, the heavy debt load taken on by the company as a result of the LBO ultimately led to its bankruptcy in 2017.
Another example is the buyout of energy company TXU by private equity firms KKR, TPG Capital, and Goldman Sachs in 2007. The $45 billion LBO was one of the largest in history at the time and relied heavily on mezzanine capital to finance the purchase price. The private equity firms’ decision to take on significant debt to finance the acquisition ultimately led to the company’s bankruptcy in 2014.
Despite the potential risks and controversies associated with the use of mezzanine capital in LBOs, it remains a popular financing option for private equity firms due to its potential for high returns. It is important for investors to carefully consider the potential risks and consequences before investing in a mezzanine capital offering.
Sources:
https://www.nytimes.com/2007/02/26/business/26txu.html
https://www.nytimes.com/2017/09/19/business/toys-r-us-bankruptcy.html
Positive Impact of LBOs
Leveraged buyouts (LBOs) have been used as a means of acquiring companies for decades, and in many cases, they have had a positive impact on the target companies. One of the key benefits of LBOs is that they can provide a significant amount of growth capital to the target company, allowing it to expand its operations and potentially increase its revenue and profits.
Examples of Positive Impact of LBOs
One example of a positive impact of LBOs is the acquisition of HCA Healthcare by a group of private equity firms in 2006. The $33 billion LBO provided HCA with significant growth capital, which it used to expand its operations, acquire other healthcare companies, and improve its existing facilities. As a result, HCA’s revenue and profits increased significantly, and the company was eventually taken public again in 2011 at a valuation of $31.6 billion, providing a significant return for the private equity firms and their investors.
Another example is the acquisition of Neiman Marcus by Ares Management and the Canada Pension Plan Investment Board in 2013. The $6 billion LBO provided Neiman Marcus with growth capital to invest in e-commerce and other initiatives, resulting in significant growth in revenue and profits and a successful IPO in 2020.
Negative Impact of LBOs
However, LBOs are not without their drawbacks. One of the main criticisms of LBOs is that they can have a negative impact on the target company’s employees and the economy as a whole.
Examples of Negative Impact of LBOs
One example of a negative impact of LBOs is the acquisition of Toys “R” Us by private equity firms in 2005. The $6.6 billion LBO loaded the company with debt, which it struggled to service, eventually filing for bankruptcy in 2017. As a result, the company had to close all of its stores, resulting in the loss of thousands of jobs.
Another example is the acquisition of Clear Channel Communications by private equity firms in 2008. The $26.7 billion LBO loaded the company with debt, causing the company to cut jobs, reduce employee benefits and sell off assets.
Ethical Concerns
In addition to the potential negative impact on employees and the economy, LBOs also raise ethical concerns. One of the main criticisms of LBOs is that they are often financed with a significant amount of debt, which can put a tremendous amount of pressure on the target company to generate enough cash flow to service that debt. This pressure can lead to cost-cutting measures, such as layoffs and reduced employee benefits, which can have a negative impact on the target company’s employees. See our report on Human Capital Industry Report: Understanding Employee Retention Rate and its Impact on Growth.
Conclusion
While LBOs can provide a significant amount of growth capital to the target company, they are not without their drawbacks. In addition to the potential negative impact on employees and the economy, LBOs also raise ethical concerns. As such, it is important for investors and other stakeholders to carefully consider the potential risks and benefits of LBOs before making a decision to invest in or participate in one.
