Existing Debt in Leveraged Buyouts: Why It Doesn't Matter

[@alexandervaltsev6937]

Great video! Totally changed my perception on LBO candidates. The bottom line is: if you know accounting well, tricky questions are not a problem

[@financialmodeling]

Thanks for watching!

[@Viper4ever05]

I asked my professor this same question recently and your answer makes much more sense.

[@financialmodeling]

Thanks for watching!

[@maxsteelwe]

Thank you so much for your videos. I am always looking forward to them here on KZbin.

[@留下來-z2v]

In corporate banking credit risk approver's perspective, the existing debt matters a lot.

[@financialmodeling]

Existing debt "doesn't matter" in the sense of determining whether an LBO is feasible mathematically. As mentioned here, yes, it can matter in terms of credit ratings, the ease of issuing new debt for the company, etc., but these are difficult to quantify in a 60-minute case study.

[@frankshtein]

Great video! I do have questions though. Can't the target company keep operating as it has been, with the same structure? Shouldn't the loan be on the PE firm's balance sheet instead of the acquired company's BS? Also, in your experience, if it's secured senior debt loaned to the PE firm, (small/medium sized lbo) what collateral would banks usually ask for? Again, great video!

[@financialmodeling]

In theory, yes, the company could maintain its capital structure the same way before and after the LBO. But in practice, it almost always changes by some amount. No, the loan will never be on the PE firm's Balance Sheet. PE firms always create holding companies to own the acquired companies, and the loans go on the HoldCo's Balance Sheet. Collateral for Senior Secured Debt might be Inventory or PP&E.

[@peetabread97]

@M&I/BIWS Thank you very much for this informative video! I'm currently a college student studying finance and I have a question regarding when you talked about an increase in debt resulting in an increase in existing cash (about 5:30 in the video). In this case, debt and cash both increase and thus the enterprise value stays the same; however, what if the company used the cash raised from the debt and bought an asset? Then debt would remain higher (at 700), but the existing cash would decrease and be invested in an asset instead of staying as working capital. In that case, would the enterprise value not increase and therefore be affected by the increased debt? Thank you!

[@financialmodeling]

It depends on the nature of the asset. If it is a core-business Asset, such as a factor that the company will use to produce equipment to sell to customers, then the company's Enterprise Value would increase because Enterprise Value represents the value of the core business to all investors in the company. But if it's a non-core Asset, such as securities, a side business, or real estate that the company is renting out, then the company's Enterprise Value would stay the same.

[@peetabread97]

Mergers & Inquisitions / Breaking Into Wall Street That makes sense, thank you!

[@brucehan6454]

Hey Brian, I am confused by one thing. If the after LBO capital structure is less levered than that of current one, the PE fund will prob not be able to get a higher IRR comparing to just keep using the firm current Capital structure right?( assume the company will grow and prosper) Then, what is the point of this deal? To my understanding, PE want to find companies that are under levered comparing to its peers, and then lever it up for higher returns. Basically, reshape its balance sheet, and slowly unlever it as time goes by. So there is no motivation for a PE to find an already very levered firm no?

[@financialmodeling]

No, not necessarily, because leverage is only one driver of the returns in a leveraged buyout. If the company can grow EBITDA more quickly or pay down more debt, the PE firm could still earn an acceptable return. Sometimes PE firms try to find under-levered companies, but it's less important than people claim because the capital structure gets wiped out anyway.

[@jzk2020]

How would you go about buying a tiny asset - when you're just starting out? Something worth less than $50k using other people's money. Do you think you could make a case study on something like that?

[@financialmodeling]

Thanks for the suggestion. It's not in our area of expertise, so probably not. You may want to see some books on the topic or ask a lawyer for a good reference.

[@andremorales819]

@@financialmodeling Do these formulas and methods work for companies in the 5m - 10m revenue range? If not what does this video and your channel focus on?

[@financialmodeling]

@@andremorales819 We focus on deals involving large, public companies. Most of the methods and financial modeling still applies, but you will need to tweak it depending on the company. Please see the private company valuation tutorials.

[@rishabhgarg8489]

Please help me with explanation of this line, v.v. important, "X is a private equity firm which is aquiring Y and it can use maximum D/E of 3:1(Debt raised by X and not against the target)". What does this mean?

[@financialmodeling]

If the company is worth $100 million, it means the PE firm can use $75 million of Debt and Equity of $25 million to do the deal and that those funds will be the PE firm's responsibility to repay, not the company's.

[@noboudaries10]

Hypothetically, what would happen to the debt in a scenario where the company's standalone cap structure is more levered than it would be after a LBO? So if TEV is $1,000 and debt is $900, equity is $100, but sponsor buys out using $500 cash, $500 equity. Is the sponsor essentially "refinancing" some of the company's debt with its equity?

[@financialmodeling]

Yes.

[@vatosiranos]

Hey Brian I need your advise. Through my research I found the email of a VP of a large investment bank. The working area is ECM (Emerging Markets). We have already written a few days but now I would like to give him back as a thank for his previous adivce. And I want to create a list with the most important points to the BRIC's Top 10 companies or the Next Eleven Top 10 companies. The list should list whether these companies need capital increases in the form of equity or borrowed capital. Do you think this idea is good or should I add something. I would appreciate your quick opinion. Best regards

[@financialmodeling]

You could send the link if you want, but just mention it very casually and say that you saw it and thought he might find it helpful.

[@myungsanglee9123]

In this video, you are saying the existing debt and equity must be replaced by new equity and debt. What would happen if you assume all the existing debt? Shouldn't that change the amount of debt and equity actually paid by the PE firm in the deal?

[@financialmodeling]

Yes, assuming Debt will change the amount of new Debt and new Equity required for the deal... but it's not ideal to think about it that way because in practice, PE firms just think about leveraged buyouts in terms of the total amount of leverage *after* the transaction closes and what the company can support. If it's 6x Debt / EBITDA and the company currently has 2x, sure, the 2x might be assumed, in which case the PE firm will just add an additional 4x. But the Equity contribution is still the same, and so is the total amount of Debt. The only difference is that if Debt is assumed rather than replaced/refinanced, then the interest rate and other terms will be slightly different.

[@MyTerminator32]

Why do you use the entreprise value as your purchased price ? Usually is the equity value which is your purchased price. In your exemple for me is like if you roll all your debt no ?

[@financialmodeling]

Because Enterprise Value represents what the firm really has to pay for another company, including both the company's Debt and Equity (Uses), and including both the Investor Equity contribution from the PE firm and the Debt it uses (Sources). Also, it's much easier to answer interview questions if you think about the purchase price in terms of Enterprise Value because it lets you do the math more quickly for quick IRR approximations and other calculations.

[@MyTerminator32]

Mergers & Inquisitions / Breaking Into Wall Street Thanks for your response I understand but it's right than most of the time I use to put the equity value in my uses and new equity and debt in my sources Banks use to consider the existing debt + the new one in their total net debt / EBITDA Do I make mistakes ? Thank you

[@financialmodeling]

I don't understand your question. In almost all LBOs, existing Debt must be replaced with new Debt or repaid with Equity. So, existing Debt and existing Equity almost always need to be under Uses. The main question you have to answer is whether you're using new Debt or new Equity to replace the existing Debt. The Net Debt / EBITDA calculation is based on the total amount of post-transaction Debt that exists after the deal closes. So, in most cases, that will be equal to (New Debt - Cash) / EBITDA.

[@MyTerminator32]

Ok i understand how you are thinking ! Thank you very much and good job

[@Steve48989]

Is it Brian who narrates?

[@financialmodeling]

Too expensive - elves or White Walkers are cheaper voice actors.

[@Steve48989]

Mergers & Inquisitions / Breaking Into Wall Street hahaha ha! Very true.

[@nicholas8722]

Would the fact that a firm is underleveraged in turn be a positive when evaluating a company because a sponsor could increase the leverage the make full use of the tax shield, thereby bringing value added. Or does this not make sense?

[@financialmodeling]

It's a minor point. The "tax shield" makes little difference in most LBO contexts, despite the fact that people like to obsess over it. Existing debt can sometimes make a difference in deals, but is much less of a factor than points like purchase/exit multiples, EBITDA growth, FCF conversion to repay debt, etc.

[@michaelnassif7393]

This is surely a dumb question so I am sorry but In an LBO, is the debt capital that is raised through the sponsor always placed on the target company’s balance sheet? Is there ever cases where it is placed on the private equity firm’s balance sheet instead? It just seems a bit backwards to me that a firm can finance an acquisition (LBO) and have that debt be placed on the targets balance sheet before the acquirer technically owns it. Thanks for your info and tips, much appreciated

[@financialmodeling]

Yes. No, the capital never goes directly on the PE firm's Balance Sheet.

[@akustik_prog1601]

Correct but actually a bridge loan for the acquisition goes into the Newco structured by the PE firm and then, after the closing, the debt for the acquisition financing rolls down to the Target Co balance sheet.

[@hk7012]

While I love your videos, I don't agree that existing debt doesn't matter in real transactions. When you do an LBO you are looking to 'hock' the assets of the company to borrow enough for the closing payment. If the assets are already 'hocked' (i.e. there is existing debt) you won't be able to raise funds to do the deal. The value of the company is the value of the stock plus the value of the debt. Here's an article from HBS (scroll down to the debt section): hbr.org/1988/01/lbos-for-smaller-companies

[@financialmodeling]

The existing capital structure may matter in some contexts, but it is pretty low on the list of things that matter (relative to purchase price, potential exit, stability of cash flows, etc.). I don't think an article from 1988 is too relevant here because LBOs were executed differently 30+ years ago, and overall leverage levels were much higher. With the types of deals we usually look at, for mid-sized-to-large public companies, this isn't really an issue.