Sources of Capital: Buyout Funds

Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser et al

The base content of this section is adapted from "Note on Leveraged Buyouts," 2003, by Professors Colin Blaydon and Fred Wainwright, Tuck School of Business at Dartmouth; Jonathan Olsen; and Salvatore Gagliano. The authors gratefully acknowledge the support of the Tuck Center for Private Equity and Entrepreneurship. Copyright© Trustees of Dartmouth College. All rights reserved.

A leveraged buyout (LBO) is an acquisition of a company or division of another company financed with a substantial portion of borrowed funds. In the 1980s, LBO firms and their professionals were the focus of considerable attention, not all of it favorable. LBO activity accelerated throughout the 1980s, starting from a basis of four deals with an aggregate value of $1.7 billion in 1980 and reaching its peak in 1988, when 410 buyouts were completed with an aggregate value of $188 billion.

The perception was the deals were less risky. LBO targets were established companies with histories of profitability, defined market niches, and proven management teams. Significant leverage was generally available through mezzanine lenders who augmented traditional lenders. At the time this was primarily the hunting ground of mezzanine lenders. Management was often attracted because they had little equity in their companies and could obtain significant positions in the buyout. Until the industry demanded more equity in the deals, the management teams often faced the insurmountable task of repaying debt at the sacrifice of growth and internal investment. Thus it was difficult to adapt to market changes. With greater equity investments, management has the ability to balance the computing uses of cash.

In the years since 1988, downturns in the business cycle, the near-collapse of the junk bond market, and diminished structural advantages all contributed to dramatic changes in the LBO market. In addition, LBO fund raising has accelerated dramatically. From 1980 to 1988 LBO funds raised approximately $46 billion; from 1988 to 2000, LBO funds raised over $385 billion. As increasing amounts of capital competed for the same number of deals, it became increasingly difficult for LBO firms to acquire businesses at attractive prices. In addition, senior lenders have become increasingly wary of highly levered transactions, forcing LBO firms to contribute higher levels of equity. In 1988 the average equity contribution to leveraged buyouts was 9 to 17 percent. In 2000 the average equity contribution to leveraged buyouts was almost 38 percent, and for the first three quarters of 2001 average equity contributions were above 40 percent. From the data we have in 2004, the contributions have begun to trend downward and are in the 35 percent range.

These developments have made generating target returns (usually 25 to 30 percent) much more difficult for LBO firms. Where once they could rely on leverage to generate returns, LBO firms today are seeking to build value in acquired companies by improving profitability, pursuing growth including roll-up strategies (in which an acquired company serves as a platform for additional acquisitions of related businesses to achieve critical mass and generate economies of scale), and improving corporate governance to better align management incentives with those of shareholders. Fund returns are now a result of operational improvements (50 percent), leverage (20 percent), and multiple expansion (30 percent), whereas during the Internet bubble returns were driven by multiple expansion (55 percent), operational improvements (15 percent), and leverage (30 percent).

In the context of this handbook, you will find the terms buyout and leveraged buyout used with the same intended meaning. These firms provide a potential funding alternative that may allow shareholder liquidity and growth capital combined into one transaction.

History of the LBO

While it is unclear when the first leveraged buyout was carried out, it is generally agreed that early leveraged buyouts were carried out in the years following World War II. Prior to the 1980s, the leveraged buyout (previously known as a bootstrap acquisition) was for years little more than an obscure financing technique.

In the postwar years, the Great Depression was still relatively fresh in the minds of America's corporate leaders, who considered it wise to keep corporate debt ratios low. As a result, for the first three decades following World War II, very few American companies relied on debt as a significant source of funding. At the same time, American businesses became caught up in a wave of conglomerate building that began in the early 1960s. Executives filled boards of directors with subordinates and friendly outsiders and engaged in rampant empire building. The ranks of middle management swelled, and corporate profitability began to slide. It was in this environment that the modern LBO was born.

In the late 1970s and early 1980s, newly formed firms such as Kohlberg Kravis Roberts and Thomas H. Lee Company saw an opportunity to profit from inefficient and undervalued corporate assets. Many public companies were trading at a discount to net asset value, and many early leveraged buyouts were motivated by profits available from buying entire companies, breaking them up, and selling off the pieces. This bust-up approach was largely responsible for the eventual media backlash against the greed of so-called corporate raiders, illustrated by books such as The Rain on Macy's Parade by Jeffrey A. Trachtenberg (Times Business, 1996) and films such as Wall Street and Barbarians at the Gate , the latter based on the book by Bryan Burrough and John Helyar (Harper & Row, 1990).

As a new generation of managers began to take over American companies in the late 1970s, many were willing to consider debt financing as a viable alternative for financing operations. Soon LBO firms' constant pitching began to convince some managers of the merits of debt-financed buyouts of their businesses. From a manager's perspective, leveraged buyouts had a number of appealing characteristics:

  • Tax advantages associated with debt financing.
  • Freedom from the scrutiny of being a public company or a captive division of a larger parent.
  • The ability for founders to take advantage of a liquidity event without ceding operational influence or sacrificing continued day-to-day involvement.
  • The opportunity for managers to become owners of a significant percentage of a firm's equity

Theory of the Leveraged Buyout

While every leveraged buyout is unique with respect to its specific capital structure, the one common element of a leveraged buyout is the use of financial leverage to complete the acquisition of a target company. In an LBO, the private equity firm acquiring the target company will finance the acquisition with a combination of debt and equity, much like an individual buying a house with a mortgage. Just as a mortgage is secured by the value of the house being purchased, some portion of the debt incurred in an LBO is secured by the assets of the acquired business. Unlike a house, however, the bought-out business generates cash flows that are used to service the debt incurred in its buyout. In essence, the acquired company helps pay for itself (hence the term bootstrap acquisition ).

The use of significant amounts of debt to finance the acquisition of a company has a number of advantages, as well as risks. The most obvious risk associated with a leveraged buyout is that of financial distress. Unforeseen events such as recession, litigation, or changes in the regulatory environment can lead to difficulties meeting scheduled interest payments, technical default (the violation of the terms of a debt covenant), or outright liquidation. Weak management at the target company or misalignment of incentives between management and shareholders can also pose threats to the ultimate success of an LBO.

There are a number of advantages to the use of leverage in acquisitions. Large interest and principal payments can force management to improve performance and operating efficiency. This "discipline of debt" can force management to focus on certain initiatives such as divesting noncore businesses, downsizing, cost cutting, or investing in technological upgrades that might otherwise be postponed or rejected outright. In this manner, the use of debt serves not just as a financing technique, but also as a tool to force changes in managerial behavior.

Another characteristic of the leverage in LBO financing is that, as the debt ratio increases, the equity portion of the acquisition financing shrinks to a level at which a private equity firm can acquire a company by putting up anywhere from 20 to 40 percent of the total purchase price. Private equity firms typically invest alongside management, encouraging (if not requiring) top executives to commit a significant portion of their personal net worth to the deal. By requiring the target's management team to invest in the acquisition, the private equity firm guarantees that management's incentives will be aligned with its own. To better understand the basics, here are the key terms and concepts regarding LBOs:

  • Transaction fee amortization. This reflects the capitalization and amortization of financing, legal, and accounting fees associated with the transaction. Transaction fee amortization, like depreciation, is a tax-deductible noncash expense. In most cases the allowable amortization period for such fees is five to seven years (although in some cases LBO firms may choose to expense all such fees in year 1 so as to present the cleanest set of numbers possible going forward).
  • Interest expense. For simplicity, interest expense for each tranche of debt financing is calculated based on the yearly beginning balance of each tranche. In reality, interest payments are often made quarterly, so interest expense in the case of the target LBO may be slightly overstated.
  • Capitalization. Most leveraged buyouts make use of multiple tranches of debt to finance the transaction. A simple transaction may have only two tranches of debt, senior and junior. A large leveraged buyout will likely be financed with multiple tranches of debt that could include (in decreasing order of seniority) some or all of the following:
  • Revolving credit facility (revolver). This is a source of funds that the bought-out firm can draw upon as its working capital needs dictate. A revolving credit facility is designed to offer the bought-out firm some flexibility with respect to its capital needs; it serves as a line of credit that allows the firm to make certain capital investments, deal with unforeseen costs, or cover increases in working capital without having to seek additional debt or equity financing.
  • Bank debt. Often secured by the assets of the bought-out firm, this is the most senior claim against the cash flows of the business. As such, bank debt is repaid first, with its interest and principal payments taking precedence over other, junior sources of debt financing.
  • Mezzanine debt. Mezzanine debt is so named because it exists in the middle of the capital structure and is junior to the bank debt incurred in financing the leveraged buyout. As a result, mezzanine debt (like each succeeding level of junior debt) is compensated for its lower priority with a higher interest rate.
  • Subordinated or high-yield notes. Commonly referred to as junk bonds and usually sold to the public, these notes are the most junior source of debt financing and as such command the highest interest rates to compensate holders for their increased risk exposure.

Each tranche of debt financing will likely have different maturities and repayment terms. For example, some sources of financing require mandatory amortization of principal in addition to scheduled interest payments. Some lenders may receive warrants, which allow lenders to participate in the equity upside in the event the deal is highly successful. There are a number of ways private equity firms can adjust the target's capital structure. The ability to be creative in structuring and financing a leveraged buyout allows private equity firms to adjust to changing market conditions.

In addition to the debt financing component of an LBO, there is also an equity component. Private equity firms typically invest alongside management to ensure the alignment of management and shareholder interests. In large LBOs, private equity firms will sometimes team up to create a consortium of buyers, thereby reducing the amount of capital exposed to any one investment. As a general rule, private equity firms will own 70 to 90 percent of the common equity of the bought-out firm, with the remainder held by management and former shareholders.

Another potential source of financing for leveraged buyouts is preferred equity. Preferred equity is often attractive because its dividend interest payments represent a minimum return on investment while its equity ownership component allows holders to participate in any equity upside. Preferred interest is often structured as pay-in-kind (PIK) dividends, which means any interest is paid in the form of additional shares of preferred stock. LBO firms will often structure their equity investment in the form of preferred stock, with management and employees receiving common stock.

  • Cash sweep. A cash sweep is a provision of certain debt covenants that stipulates that any excess cash (namely free cash flow available after mandatory amortization payments have been made) generated by the bought-out business will be used to pay down principal. For those tranches of debt with provisions for a cash sweep, excess cash is used to pay down debt in the order of seniority. For example, in the case of the target the cash sweep does not begin to pay down junior debt until year 4.
  • Exit scenario. As a general rule, leveraged buyout firms seek to exit their investments in five to seven years. An exit usually involves either a sale of the portfolio company, an IPO, or a recapitalization (effectively an acquisition and relevering of the company by another LBO firm).

Buyout Firm Structure and Organization

The equity that LBO firms invest in an acquisition comes from a fund of committed capital that has been raised from a pool of qualified investors. These funds are structured as limited partnerships, with the firm's principals acting as general partner, and investors in the firm (usually investment funds, insurance companies, pension funds, and wealthy individuals) acting as limited partners. The general partner is responsible for making all investment decisions relating to the fund, with the limited partners responsible for transferring committed capital to the fund upon notice of the general partner.

As a general rule, funds raised by private equity firms have a number of fairly standard provisions:

  • Minimum commitment. Prospective limited partners are required to commit a minimum amount of equity. Limited partners make a capital commitment, which is then drawn down (a takedown or capital call) by the general partner in order to make investments with the fund's equity.
  • Investment or commitment period. During the term of the commitment period, limited partners are obligated to meet capital calls upon notice by the general partner by transferring capital to the fund within an agreed-upon period of time (often 10 days). The term of the commitment period usually lasts for either five or six years after the closing of the fund or until 75 to 100 percent of the fund's capital has been invested, whichever comes first.
  • Term. The term of the partnership formed during the fund-raising process is usually 10 to 12 years, the first half of which represents the commitment period (defined above), the second half of which is reserved for managing and exiting investments made during the commitment period.
  • Diversification. Most funds' partnership agreements stipulate that the partnership may not invest more than 25 percent of the fund's equity in any single investment.

The LBO firm generates revenue in three ways:

  1. Carried interest. Carried interest is a share of any profits generated by acquisitions made by the fund. Once all the partners have received an amount equal to their contributed capital any remaining profits are split between the general partner and the limited partners. Typically, the general partner's carried interest is 20 percent of any profits remaining once all the partners' capital has been returned, although some funds guarantee the limited partners a priority return of 8 percent on their committed capital before the general partner's carried interest begins to accrue.
  2. Management fees. LBO firms charge a management fee to cover overhead and expenses associated with identifying, evaluating, and executing acquisitions by the fund. The management fee is intended to cover legal, accounting, and consulting fees associated with conducting due diligence on potential targets, as well as general overhead. Earlier fees, such as lenders' fees and investment banking fees, are generally charged to the acquired company after the closing of a transaction. Management fees range from 0.75 percent to 3 percent of committed capital, although 2 percent is common. Management fees are often reduced after the end of the commitment period to reflect the lower costs of monitoring and harvesting investments.
  3. Co-investment. Executives and employees of the leveraged buyout firm may co-invest along with the partnership on any acquisition made by the fund, provided the terms of the investment are equal to those afforded to the partnership.
The above material is adapted from The Handbook of Financing Growth: Strategies and Capital Structure by Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser. Copyright ©2005.This material is used by permission of John Wiley & Sons, Inc.