High Leverage Buyout:- At the start of 2018, financial news offers us the opportunity to come back to a subject that has been debated many times: the takeover of companies carried out through a strong leverage effect, more commonly known as LBO (Leverage Buy Out).
At a time when the company Solocal seems to glimpse a thinning with its financial restructuring plan adopted in AGE December 16, we forget that this company, like many others before it, was the subject of several years ago, an LBO. The source of his current difficulties is to be found in the way in which this operation was carried out and the consequences that followed.
What is an LBO
But what is an LBO? What does it consist on? What are the possible variants? What are the conditions for his success (and the blow of his failure)? Finally, through a simple illustration we can demonstrate how a well mounted operation at first glance can quickly slip and become a nightmare.
The Assembly of a Leverage Buyout (LBO)
A leveraged buyout (LBO) is for a buyer to buy back a business mainly through debt and a marginal share of equity.
This transaction involves the creation of a holding company owned by acquiring investors. This company holds 100% of the capital of the target company. The holding company borrows to acquire the shares of this target.
The debt will be repaid by the dividends paid by the target. The shareholders of the holding company are also remunerated by the payment of dividends from the target company.
In this type of arrangement, most of the interest lies in the amount of debt raised: the more important it is, the more the leverage can play and the tax saving is important (1). It is not uncommon to see fixtures with 25% equity for 75% of debt.
This arrangement is coupled with another tax interest which is that of benefiting from the system of fiscal integration (mother-daughter) which makes it possible to offset profit-making results with loss-making results and to be taxed only on a very low share of the net result of the group.
The Variants of an LBO
If the target managers are involved in the buy-back (in the form of a stake in the holding company), we will talk about LMBO (“M” for Management)
If the buyers bring themselves a management team to replace the current team of the target we talk about MBI (Management Buy In).
By combining the LMBO and the MBI (that is to say by associating with the purchase of the managers of the target of the managers coming from the outside and brought by the purchasers) one realizes what one calls a BIMBO (Buy in Management Buy Out).
Debt a Regulator of return on Equity
Most of the time, the holding company will carry the debt and the target (s) will not, even if they bear the consequences. The target (s) may have incurred debt prior to the LBO, which will be refinanced by the holding company at the time of the transaction to substitute new borrowing against the target’s current borrowings.
During the life of the LBO, it is common that the buyers decide to re-debt the structure (we talk about “to raise ” the structure) by contracting a debt at the level of the target whose sole purpose is to finance an exceptional dividend for the benefit of the shareholders of the holding company; this technique is called the technique of debt push-down.
As will be understood, the LBO intends to fully use the target’s debt capacity to reward itself.
How to get Out?
LBO releases are diverse:
- Either the buyers sell to an industrialist after a few years of detention (3-5 years, 7 years being a maximum). This is the case of Picard sold in 2015 in Aryzta;
- Either the buyers decide to sell to another LBO fund: this is the case of SIACI in 2015 sold by Cie E. de Rothschild in Ardian
- Either the buyers decide to bring the company on the stock market: Elior is introduced in 2014 in favor of the release of the Charterhouse fund.
In circumstances where things do not go as expected, the issues are less attractive. There are two main differences:
- The takeover by creditors: in order to avoid bankruptcy creditors make debt equity swap and become the majority with financiers (minority) because they consider that the operating company has a business model healthy but that its debt is excessive. This is the case of companies like SAUR, Vivarte Solocal.
- Bankruptcy: if the dividends are insufficient the holding goes bankrupt. This is the worst of issues.
Who is Involved in this Market?
Vendor side, we find for nearly 50% of family businesses. 25% of the market is represented by disposals of subsidiaries of large groups. Finally, 30% of the secondary market is driven by the LBO funds themselves who buy their holdings from other funds.
In terms of equity investors, we mainly have specialized LBO funds whose target profitability is 20-25%. There are more than 100 funds in Europe active in this field (BC Partners, Bridgepoint, Cinven, CVC, PAI, Pereira …). These funds are often involved in co-investment.
The share of equity contributed often represents 30 to 50% of total funds for non-aggressive LBOs (however aggressive LBOs can only have 20-25% equity) and they are often paired with dilutive instruments such as bonds.
On the debt side, we can have a single bank involved for a small unit ticket (10m €) or several (4-5 banks) in the form of a club deal. Debt is often structured into a tranche of senior debt and a subordinated debt tranche, sometimes supplemented by a seller’s credit.
Senior debt often represents between 3 and 5x EBITDA and is divided into several tranches that are distinguished by their maturity:
- A Tranche A often short and reimbursed linearly in 6-7 years
- Slice B and C: longer, refunded in fine
Each tranche has a high yield spread relative to the risk-free rate.
Subordinated debt, sometimes takes the form of a bond debt high yield (HY). Rarely below € 200m, this debt is often in fine and has duration of between 7 and 10 years. It has a senior debt subordination clause, which means that the principal repayment and the payment of the interest on that debt pass after the creditors of the senior debt are repaid.
In the category of subordinated debt, we also find mezzanine debt, subordinated, bond or bank debt, unlisted, OBSA type, OCA ORA (2), with a high yield, a conversion right, exercise or reimbursement giving access to the action. Its dilutive nature and its proximity to equity give management the right to control those who own it.
Its profitability is around 12-15%. An alternative to this type of remuneration includes a low interest rate paid “cash” each year doubled with a capitalized interest (PIK for Pay In Kind) between 5 and 8%. Finally, this debt is similar to equity in that its timing (in both interest and principal) is indicative and is not mandatory. The company is not obliged to respect it (only its cash position dictates its conduct in this respect) without this non-compliance leading to a default.
A typical mix combines the three forms of capital – equity, senior debt and subordinated debt. In recent years there has also been a change in the design of montages with a greater share of equity.
Complementary financing can finally be set up at the level of the target company, in particular to finance the working capital needs of this target. We find there:
- The revolving credit line and the VAT credit for financing the WCR
- The acquisition facility, which as its name indicates, participates in the financing of the acquisition when the load of the latter is borne by the target
The Investment Facility to finance a previously identified investment program at the target level at the time of acquisition.
Margins and Prices
Under the influence of the highly turbulent environment of recent years (particularly post GFC (Global Financial Crisis)) margins on LBOs have been significantly stretched, reflecting the perception (which is also a reality) of the risks taken.
As for asset purchase prices, and after reaching a record high in 2007-2008 (multiple of enterprise value), prices have become more reasonable and the rising price wave has come down.
However, since 2012-2013, we have seen a rise in acquisition multiples in both business value and debt multiples compared to the EBITDA to reach a new high in 2014.
The stage is now set and the reader who had the courage to stay with us until then have a better understanding of the operation of the LBO. He legitimately wonders what distinguishes a good from a bad LBO, which recipe will make it a success or a failure.
We will maintain the suspense to address this point in a second part where we will discuss the factors discriminating the success of an LBO. In addition, through a simple case, we will make the reader aware of the fragility of a company in an LBO situation, a situation that can quickly tip it into a difficult position.