Private equity & Leveraged Buyouts (LBOs)

Private equity & Leveraged Buyouts (LBOs)

Author: Joris Kersten, MSc

Kersten Corporate Finance: Selling/ buying companies in The Netherlands (M&A). www.kerstencf.nl

Valuation training: 4th – 8th November 2024 @ Amsterdam – Valuation training: DCF modelling, LBO modelling, M&A modelling, EBITDA multiples, ROIC/ WACC, adjusted net debt. In addition, I provide inhouse training at leading institutions all over the globe from New York to Hong Kong. www.joriskersten.nl

Source used: Bedrijfsovername. Wolters Kluwer 2023. Overnames door private equity. A. van Holthe tot Echten & H. Kaemingk.

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Introduction

Private equity is risky capital, supplied by professional investors, for a limited time period, to non listed (private) companies, with the goal to make a financial return.

Financial sponsors, the so called private equity firms, undertake Leveraged Buyouts (LBOs).

This basically is the acquisition of a target company by a set up legal buying vehicle.

And this buying vehicle is owned by the private equity investor and the managers of the target company.

The acquisition financing creates a “double leverage structure” and consists out of:

-Debt (money loans), supplied by banks and specialised debt funds;

-Equity, supplied by the private equity investors and the managers of the target.

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Concerning the equity, this is often sub divided in:

-Common shares, held by all shareholders;

-Cumulative preference shares, held by the private equity investors.

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The Leveraged Buyout

A Leveraged Buyout (LBO) consists out of three components:

1.?????? The acquisition of the target by the buyer (“newco”) with a sale & purchase agreement (SPA);

2.?????? The financing of the buying holding with debt in a loan agreement or senior facilities agreement (SFA);

3.?????? The financing of the buying holding with equity, by the private equity investors and managers of the target, with a shareholders agreement (SHA), and articles of association.

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The amount that is financed with equity in an LBO is basically divided by the private equity investor and the managers of the target.

Again divided in 1) preference shares, and 2) common shares.

The reason for this is to create another form of leverage (double leverage), next to the leverage on the bank debt.

The returns on the preference shares are limited to for example 8%, 9% or 10% dividend on the cumulative preference shares.

The result of this is that when the value of equity grows enough, then the returns on common shares (the most subordinated shares) grow extra fast !

And this is the so called “double leverage structure” by using relatively cheap debt to leverage the return on equity.

And within equity, relatively cheap preference shares leverage the return on the common shares.

Another option is using a subordinated loan by the shareholders with “payment in kind” interest (paying back loan & cumulated interest at the end).

But due to restrictions on tax advantages on interest, this is getting less and less popular.

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The managers of the target company

For private equity it is a must that the managers of the target company are involved in the deal.

From managers who are for the first time involved in an LBO is expected that they are willing to invest the equivalent of 1 year salary.

From managers who are doing this for the second time (or even more), is expected that they invest half of their net proceeds of the sale into the new buying holding of the target (rolling 50% of the net equity proceeds).

For deals like this always a good tax lawyer needs to be consulted !!

This because the price the managers pay for the shares needs to be based on a decent valuation.

So you need to be very careful with what the managers pay for the shares, because if it is too less, the tax authorities can see this as an un-legitimate profit that will be taxed.

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I hope this blog was useful,

See you next week again, best Joris???

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Source used: Bedrijfsovername. Wolters Kluwer 2023. Overnames door private equity. A. van Holthe tot Echten & H. Kaemingk.