Investment Banking: How Seniority and Maturity Affects LBO Financing - dummies

Investment Banking: How Seniority and Maturity Affects LBO Financing

By Matt Krantz, Robert R. Johnson

Seniority and maturity are extremely important concepts for investment bankers to know, especially when it comes to the suppliers of capital in an LBO. Seniority is where the provider of funds stands in the line of priority with regards to being paid. Like any line, you want to be close to the front of the line. And in terms of supplying capital to LBOs, that principle is no different.

There is a direct relationship between the expected return to a specific form of capital with respect to seniority. The more senior the claim of the form of financing, the lower the expected return. That is why, for instance, revolving bank debt has the lowest expected return of all the types of financing and why equity has the highest expected return.

Revolving bank debt is the least risky form of financing to the LBO — that is, it has the highest likelihood of being paid back (revolving credit providers are at the very front of the line). On the other hand, equity is the riskiest form of financing.

Equity holders are only entitled to returns after all other claims have been satisfied — they’re at the back of the line. There is certainly no guarantee that the firm will be successful and that anything will be left over for the equity holders after all the debt holders’ claims have been satisfied.

In fact, it’s possible that all the debt holders can receive what they were promised, yet the firm doesn’t generate sufficient cash flow for anything to be left over for equity holders.

Another critical aspect of understanding the way debt comes into play with LBOs is maturity. Maturity refers to when the debt comes due and needs to be paid back. As was indicated earlier, a revolving credit line never matures, but it’s expected that it will be periodically paid down. That is, the amount of revolving credit will vary across time for the typical firm.

Term loans issued in LBO transactions typically have maturities between four and eight years. Junk bonds issued to fund LBO transactions typically have maturities that are longer than term loans but shorter than investment-grade bonds. At the time of issue, original-issue junk bonds typically have maturities between five and ten years.

This contrasts with investment-grade bonds that are typically issued with much longer maturities — up to 30 years. Equity has no maturity and is, in essence, a perpetual claim.

Now, just because a particular form of debt has a specific maturity does not mean that the debt will be in existence until the maturity date. For instance, much like mortgage loans for individuals, term loans typically have no prepayment penalties — the company can retire the debt before maturity without incurring a penalty.

On the other hand, junk bonds typically don’t allow the company to pay them off early. That is definitely an advantage for junk bond holders, because issuers generally want to pay off debt early only if the cost of debt has gone down. Refinancing filings generally take place when interest rates have fallen and the individual can obtain a less expensive mortgage.