Investment Banking: How to Decide on a Method of Financing for a Leveraged Buyout
When constructing an LBO deal, investment banking analysts will consider market conditions to determine just how much debt they think the market will support. Investment bankers want to construct a deal that maximizes the amount of debt capital and minimizes the amount of equity capital, while still putting together a package that will ensure the long-term success of the firm.
After all, if the firm can’t generate sufficient cash flow and survive over the long run, the equity holders will lose because their positions will ultimately be worthless.
Let’s assume that market conditions are fairly good and will support a total debt to EBITDA multiple of six times. Let’s also assume that our crackerjack investment banking analysts have crunched the numbers and that the EBITDA level of our target firm is $300 million annually. This means that the total debt supported by the market for our hypothetical deal is likely to be in the range of $1.8 billion.
But the deal isn’t going to be financed solely with debt. Analysts will also look to comparable deals for some gauge as to how much equity cushion other comparable deals are commanding. In poorer markets, when investors are more risk averse, the amount of equity required to successfully undertake LBOs expands.
Conversely, in strong markets when investors’ risk appetites inflate, the amount of equity required for LBOs decreases. For the sake of our hypothetical LBO, let’s assume that the amount of equity provided in similar LBOs is 1.5 times EBITDA, or $450 million.
Thus, the financing for our LBO will consist of $1.8 billion in total debt and $450 million in equity, for a total capitalization of $2.25 billion. The purchase price of this LBO is effectively 7.5 times EBITDA.
Now, it’s very likely that the debt that is issued in this LBO will be of different varieties. A typical LBO structure may have 50 percent to 60 percent of the debt consisting of term bank loans and a revolving credit commitment and the other 40 percent to 50 percent consisting of mezzanine debt (because this hypothetical transaction would be awfully small for the junk bond market).
Thus, our LBO capital structure might look like the following:
|Revolving credit agreement (LIBOR plus 2%)||$100 million|
|Five-year term loan at 8%||$900 million|
|Mezzanine debt||$800 million|