Investment Banking: Leveraged Buyout Exit Strategies

By Matt Krantz, Robert R. Johnson

In the investment banking world, private equity sponsors know that even before they purchase a company, they’ll be preparing for the day when they’ll sell the firm. Identifying a proper exit strategy in both form and time are among the most important decisions made by any LBO sponsor. A well thought-out exit strategy can make or break a private equity deal.

Set a target for exit in time

Private equity LBO sponsor firms generally have a relatively short timetable in mind when they purchase a firm through an LBO transaction. This is largely due to the fact that most of the private equity structures are limited partnerships that have a planned life of ten years or less.

On average, the holding periods for the sponsors of LBOs tend to be three to eight years. Many critics contend that private equity sponsors are like vultures that quickly flip it like many real estate investors flip houses. This generally isn’t the case with LBOs, as private equity sponsors add significant value by bringing in management expertise, reducing costs through process reengineering, and making meaningful changes to the target firm.

These kinds of changes don’t take place overnight — they generally require a time commitment of several years. If the changes were cosmetic and not substantive, the financial markets wouldn’t be fooled and the returns to private equity wouldn’t be attractive.

Consider how the exit will happen

There are three primary methods for LBO sponsors to exit their positions and realize the ultimate return on their investment: an IPO, a sale to a strategic buyer, and another LBO.

Initial public offering

The Holy Grail for LBO sponsors is often a successful IPO of the target firm. Of course, this is the case only if the resulting organization is seen by investors as a desirable individual company. If timed properly, an IPO allows the LBO sponsor to effectively cash in on the investment in the firm and provides the desired cash flow to limited partner investors in the private equity sponsor firm.

The LBO sponsor enlists the help of a lead investment bank to bring the company public. The lead investment bank is responsible for determining the value of the company and arriving at the IPO share price.

Determining what the market will bear is an extremely important function of the lead investment bank, as a price that is set too high will result in an undersubscribed new issue and investors will see the share price decline upon initial trading in the public markets.

This leads to very unhappy IPO investors and negatively impacts the reputation of the investment banking firm with investors of future IPOs. On the other hand, a significantly underpriced issue results in an opportunity loss for the sponsor firm.

Investment banks generally strive to set an IPO price that is just slightly below what the market will bear. The prototype of a successful IPO is one in which the price in the secondary market is just slightly higher than the IPO price. If on the first day of trading the IPO closes up around 5 percent above the IPO price, the investment bankers feel that they’ve done their job.

Now, investment banks don’t operate alone when bringing firms to market. Investment banks generally form a syndicate of other investment banks to ensure widespread distribution of the issue.

Each member of the syndicate agrees to be responsible to sell a certain portion of the issue. This makes distribution of the issue easier and spreads the risk among several investment banking firms.

The biggest disadvantage of this exit strategy is that IPOs generally involve high transaction costs. Those investment bankers don’t buy their homes in the Hamptons and their luxury automobiles because they work for free. The investment banking infrastructure and due diligence necessary to ensure a smooth public offering is costly.

The best laid plans of LBO sponsors are, however, often thwarted by conditions in the financial markets. An LBO sponsor can have done everything correctly and have a firm primed and ready for an IPO only to find that the IPO market is soft due to prevailing market conditions.

Sale to a strategic buyer

This exit strategy is the most common, and the one that is most preferred in the private equity industry because it’s quick and simple. A strategic buyer is an entity that believes that the target company offers synergy to its existing business line. Simply put, synergy is the concept that some businesses are worth much more in the hands of one entity than another.

Synergies can be realized in any number of ways involving, for example, product line expansion, geographical expansion, or the purchase of suppliers or distributors.

From the seller’s standpoint, this exit strategy is very clean because the LBO sponsor is negotiating directly with the strategic buyer and their investment banking advisors. The strategic buyer is also likely to pay a premium for the purchase. In essence the firm is worth much more in the hands of the strategic buyer because of the synergies that can be realized.

Another leveraged buyout

The exit strategy for a minority of private equity deals involves simply selling the company to another private equity firm that will essentially put the firm through a secondary LBO. This can happen when the original LBO sponsor needs to exit the deal, most likely because the partnership holding the deal is being unwound and capital is being returned to the limited partners.

The biggest disadvantage of exiting an investment using a secondary LBO is that the sponsor private equity firm is dealing with another professional private equity firm that will likely drive a hard bargain.

The over-exuberance sometimes witnessed in the IPO market by individual investors is less likely to be realized in a market characterized by sophisticated buyers who realize that the seller is likely under some pressure to unwind the deal and realize their return.