Private Equity and Leveraged Buyouts

What is Private Equity?

Many start up companies need to raise money to finance growth. Very often the business plans and strategies do not give opportunities to make profit in the short terms which hesitates many banks from lending the money. In fact many start up projects have negative profits for the first few years. For this reason start up needs to go to specialized private equity firms like venture capitalists to raise money. Other examples include a distressed company which is deemed to be high risk. Banks are not open to the option to lending them the money.

Private equity firms very often invest in troubled companies by carefully analyzing the financial structure and potential high profits to determine if the profit risk ratio makes the investment viable. This is especially valuable. In many cases these companies declare themselves bankrupt which in turn forces them to sell assets instead of using the current structure of the company to create value. Other forms exist such as hostile takeovers, tender bids as well as buyouts for strategic purposes.

What are Leveraged Buyouts?

Leveraged buyouts (LBO’s) as the title suggests are buyouts of target companies or divisions of a companies using leverage. This could be in the form of debt and equity. The LBO firm will raise the money from loans and acquire the company in a similar way one acquires a mortgaged house. The borrowed money is used to acquire the asset and the house is used as collateral. Similarly in an LBO the target company which is acquired is used as collateral (this is the equity portion of the transaction).

If and when the company makes money the cash flows generated are used to service the debt repayment just as the rental income of a house is used to pay off the mortgage. If the LBO proves to be successful then the equity holders receive the highest returns. This is because the loans are paid with fixed interest a

nd the amount of profit the LBO can generate is unlimited. Thus the motive of LBO investments is to generate very large cash flows.

The capital structure of an LBO takes three forms depending on the duration of the debt. The most common type is senior debt with a duration of around 5-7 years. This is mainly funded by credit companies, commercial banks and insurance companies. Mezzanine Financing provides for more long term loans, approximating 7-10 years with higher interest rates. This type of debt is more risky as the loan is unsecured. It is also used if a buyout doesn’t have sufficient capital to use as collateral. This type of debt is most commonly originated by the public market, insurance companies and LBO hedge funds. Buyout funds can also raise capital using equity, from the funds that have been given by investors.

LBO investors generally expect to receive returns within 3-5 years. After which they have 3 main exit strategies, in the form of 1. The sale of the company, 2. A public offering of shares of the company, 3. Recapitalization.

The sale involves selling the entire entity outright to another strategic acquirer of investor. It is expected the sale price should be higher than the acquisition price, the difference being the return generated. An LBO fund can also originate a public offering of shares and receive cash from the buyers of the new shares. The fund can also recapitalize the equity of the entity by swapping it for more debt. This is especially efficient if debt is offered cheaper than in the past. This allows the investors to take away cash.