Today, let’s discuss the key participants involved in an LBO transaction and the role they play in leading the LBO to its success. But before proceeding further, you may want to take a glance at the following parts that highlight my previous write-ups on LBO.
Part1: Leveraged Buyout: An Overview
Part2: Leveraged Buyout: What makes a Strong LBO Candidate?
I’ll start this article with the financial sponsors and investment bankers, and offer insights in detail, followed by a note on investors and target’s management. As you read through it, you will unearth each of the stakeholder’s activities and how they look at the transaction. You will also discover that the sponsor, I-Banker and target management drive the deal.
(1) Financial Sponsors are the private equity firms (PE), merchant banking divisions of investment banks, hedge funds, venture capital (VC) funds and special purpose acquisition companies (SPACs). PE firms, hedge funds, and VC funds raise majority of their investment capital from third-party investors such as pension funds, insurance companies, endowments and wealthy families / individuals (also known as HNI).
This raised capital is organized into funds that are usually established as limited partnerships, in which the General Partner (GP) – the sponsor – manages the day-to-day activities of the fund and are compensated with 1-2% of the committed fund as management fee, besides 20% “carry” on the investment profit.
The Limited Partners (LPs) serve as passive investors, who subscribe to the fund without caring much about the investment plan(s) of the sponsor. However, while investing in any particular business, the sponsor cannot invest more than 10 – 20% of the fund’s capital.
Sponsors vary widely with respect to the size of the fund, investment strategy and focus. The fund size depends on the ability of the sponsor to raise capital. Its size, which typically ranges from tens of millions to tens of billions of dollars, helps in dictating investment terms. The focus varies from one firm to another, with some firms specializing in one sector like Technology, eCommerce and Media, while others focusing on certain situations like turnaround/distressed, roll-up and divestitures. There are also many firms that look at a broad spectrum of businesses across industries and investment strategies. Given this fact, it’s not uncommon for the firms to employ staff who fit into their focus and strategy. Investment professionals, investment bankers, industry experts (like former CEO) and operational professionals are some of the staffs that are hired to advise the sponsor in specific situation during the LBO process.
While evaluating the LBO candidate, the sponsor performs a detailed due diligence on the target to know it inside-out – its business, sector, regulatory, environment, legal, tax, accounting, financial and other information that are critical to their investment. Once done, they use the findings to develop a financial model and support the purchase price assumptions (including the preferred financing structure), often by hiring accountants, consultants and functional experts to assist them in the process.
(2) Investment Bankers
Investment Bankers play a key role in an LBO transaction in two ways:
- as a provider of financing, and
- as a strategic M&A advisor to the sponsor.
Sponsors rely on them heavily for developing and marketing an optimal financing structure. On the buy-side, sponsors engage investment bankers as their M&A advisors for sourcing deals and for their relationships, expertise and in-house resources, and on the sell-side, they engage them to market their portfolio companies to the potential buyers through an organized M&A sale process.
Investment banks perform a rigorous due diligence on LBO targets and go through an extensive internal credit process to validate the target’s business plan. They try to gain as much comfort as possible with the target’s ability to service the debt-laden capital structure and their ability to market the capital structure to the investors. They work closely with the sponsors to finalize the financing structure.
After the credit committee of the bank approves the financing structure, investment banks provide a financing commitment to support the sponsor’s bid in the form of legally binding letters – a commitment letter, an engagement letter and a fee letter – which promise funding for the debt portion against various fees and subject to certain conditions (including the sponsor’s contribution of acceptable levels of cash equity). This is known as underwritten financing. As underwriters of the high-yield bonds or mezzanine debt, the investment banks attempt to sell the entire offering to investors without holding any securities on their balance sheets.
(3) Bank and Institutional Lenders
Bank lenders typically comprises of commercial banks, savings and loan institutions and finance companies, whereas the institutional lenders consists of hedge funds, pension funds, insurance companies and collateralized debt obligation funds (CDO). Bank lenders provide the capital for revolvers (I’ll discuss it in “Primary Sources of Capital”) and amortizing term loans, while the institutional lenders provide capital for longer tenured, limited amortization term loans. But before providing the bank debt, they, like the investment banks, perform a due diligence on the LBO target and undergo an internal credit process, very much for the same reason the I-Bankers do.
(4) Bond Investors
Bond investors are the buyers of the high-yield bonds (also known as junk bonds) issued by the LBO sponsors as part of the financing structure. These investors are generally high yield mutual funds, hedge funds, pension funds, insurance companies, distressed debt funds, and CDOs.
Bond investors receive a preliminary offering memorandum (OM), a legal document that harbors the information on target’s business, industry, financials, detailed information on the bonds, preliminary term-sheet (excluding price), risks and notes (key terms, definitions and covenant). Unlike bank debt, bonds are registered with the SEC and are, therefore, subject to regulation under the Securities Act of 1933 and the Securities Exchange Act of 1934.
Before financing the LBO, bond investors attend the “road-show presentations” to meet the senior executives and learn the investment merits of the company and the proposed transaction. Typical stops for US road-shows include large financial centers such as New York, Boston, Los Angeles and San Francisco.
(5) Target Management
Management of the target plays a crucial role in the marketing the target to its potential buyers and lenders. They work closely with the I-bankers for preparing the marketing collaterals and financials. They represent the face of the company.
In an LBO, a strong management at the target can create tangible value by driving favorable terms on financing and pricing, and providing comfort to the sponsors to stretch the valuation.
Post-LBO transaction, the management holds a meaningful equity in the company. Several layers of its management also have an opportunity to participate in a stock option based compensation package, which is generally tied to the financial targets of the company. This structure provides the management with an incentive to improve the company’s performance. As a result, management interests are aligned with that of the sponsor in pursuing a superior performance.
In a nutshell, each participant has a stake in the success of the LBO transaction. While the sponsor leads the deal, the Investment Banker plays a critical role not only by providing its advisory services, but also by partnering with the stakeholders. This does not mean I’m undermining the Investors. After all, they are the capital providers for the debt portion – the people who actually take the risk of financing the transaction in return for a disciplined debt repayment.
In the next article, I’ll discuss the Economics of Leveraged Buyout, covering how an LBO generates returns for its investors. Stay tuned …
Gargfinanceblog 