Private Equity and the LBO

by Jeffrey Presogna

Some business owners wish to cash out of their companies and retain an equity interest and a management position.  Private equity funds and private partnerships seek out profitable companies with solid free cash flow.  Additionally, these investors are looking for solid management with the appropriate tenure.  The combination of excess free cash flow and solid management may lead to a higher multiple for the company, thus a greater value to the selling stockholders.  Additionally, this combination is the ingredient for a leveraged buyout.  

Certain private equity investors operate as leveraged buy-out (LBO) firms.  An LBO is the acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital.  This type of transaction is dependent upon the target company having enough free cash flow to pay the debt service and a solid management team to continue the operations of the target company.

In an LBO, there is usually a ratio of 70 percent debt to 30 percent equity.  Leveraged buyouts have had a notorious history, especially in the 1980’s when several prominent buyouts led to the eventual bankruptcy of the acquired companies. This was mainly due to the fact that the leverage ratio was nearly 100 percent and the interest payments were so large that the company's operating cash flows were unable to meet the obligation.  As of 2006, the largest LBO to date was the acquisition of HCA Inc. in 2006 by Kohlberg Kravis Roberts & Co. (KKR), Bain & Co., and Merrill Lynch. According to the Washington Post, the three companies paid around $33 billion for the acquisition.

LBO firms generally raise capital through private investment partnerships.  Some capital is also raised in the public marketplace.  Although, raising capital through the public marketplace can be a milestone for certain companies and a necessity for other companies.  A successful company that is growing rapidly can access the public marketplace to raise capital to create liquidity for expansion purposes.  A company that is having operational problems may also need to access the public marketplace to raise capital for liquidity purposes.    Most of us view raising capital as a function for companies that are only traded in the public marketplace.  While this may generally be true, private companies may also have an opportunity to raise capital in the private marketplace. 

Private companies can raise growth capital through internally generated funds, bank loans and the private placement of their securities.  Many companies can generate the capital they need through traditional bank financing methods.  However, bank financing is often not enough to achieve the necessary capital needed for the task at hand.  Private placement transactions are usually needed to generate the additional amount of capital in excess of bank financing needed by a company to facilitate the task.  Thus, the LBO firm will usually need to tap the public and or private market for capital.

The most common leveraged buyout arrangement among small businesses is for management to buy a substantial amount of the outstanding shares of the company's stock, using company assets as collateral for a loan to fund the purchase. The loan is later repaid through the company's future cash flow or the sale of company assets.  Often times management cannot come up with the required 30 percent equity portion to satisfy the requirements of the deal.  Finding the right LBO firm to partner with management will provide the necessary equity infusion to accomplish the task.  The drawback to management is that they will have to give up some equity to the LBO firm.  Many management-led, small business LBOs also include employees of the company in the purchase, which may help increase productivity and increase employee commitment to the company's goals. In other cases, LBOs are orchestrated by individual or institutional investors, or by another company.

It is obvious that the LBO transaction will not be the appropriate structure for every deal.  The LBO is considered a restructuring and must be applied with great care.  As always, it is important to consider all options available and have your M&A advisor quarterback the process.