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LBOs - funding, sources and cost Back  
This is a good time for leveraged buy-outs, with a variety of funding structures and different cost levels to consider, writes Peter Coyne.
There has probably never been a better time to contemplate a leveraged transaction than is presented by the current environment. Low, albeit rising, interest rates, a benign environment for borrowing, a surfeit of venture/development capital providers chasing non-technology deals (trying to balance the portfolio) and hordes of genuinely experienced advisers to strike the best deal on behalf of those who have not been through the experience before!

Given the number of public companies experiencing strong corporate earnings and cash flows but still not achieving a fair market rating, many management teams must be considering the possibility of taking their company private. Private company shareholders, similarly, who might reasonably have expected to look to the stock market for liquidity may prefer to hold off going down the LBO route and consider an IPO when stock market valuations seem sensible again!

So where to start?

The key in a leveraged transaction is to get the right blend of funding in place that will satisfy all the stakeholders, typically all of whom come to the table with competing objectives.

What can promoters expect to achieve from the market in 2000? Every case will be examined on its own merits but following rules of thumb are some suggested rules of thumb when building the leveraged buy out model.

Price to pay

It all depends on the company, the market dynamic, the growth prospects, management team etc. There is no private company price index published for Irish deals but based on what we see in the stock market and our own recent experience of private company transactions EBIT multiples in the 7 – 11 range for solid, strong cash producing privately held entities may be achievable and fundable.

Funding structure

Equity Component Even through the late 80’s when LBO structures were at their raciest (i.e. seeking to maximise equity return), rarely would core equity of less than 25% support the structure in an LBO.

If in present day circumstances the equity constituent of the funding structure is outside of the 27% - 35% range, you would want to know why. If it’s more than this, is the promoter getting the maximum benefit of leverage? If less than this, are you tempting fate and leaving yourself exposed in a downturn?

Senior Debt It will not be unusual to see senior debt in the range of 4 to 5 times EBIT. Much depends on security available (fixed and floating) but cash flow profile (allowing for all necessary capital expenditure and working capital investment) is key. This will determine the term (can it all be repaid over say 6, 7 or 8 years) and available interest cover (not less than 1.5 to 2 times in early years).

Intermediate Capital Intermediate Capital (sometimes called "Stretched Senior" for obvious reasons) fills the gap where the equity providers are at the limit of what they will invest relative to the return that they can reasonably foresee and when senior debt likewise is at it's limit.

The intermediate capital layer will feature subordinated debt, perhaps with a second floating change, a further layer of debt convenants, perhaps an element of interest roll up or deferral, bullet repayments and the real cream for the provider of this layer of finance coming in the form of an equity kicker such as a warrant to subscribe for shares. The precise nature and shaping of this layer depends entirely on the profile of cash flows arising after senior debt service.

What will it all cost?

The key elements of cost are:
Transaction costs legal, tax, accounting, financial advisers; stamp duty; arrangement fees (for all providers of finance); transactions less than ?50m – costs may be in the range of 2.5% to 5% all in.

Debt service costs Senior debt margins run at 2% - 2.5% typically for an LBO structure. This may seem like a lot relative to what an unleveraged, strong corporate can borrow at in the market right now. The attitude/risk appetite of senior debt providers means it is difficult to achieve tighter margins than this in an LBO structure. Our experience suggests that in European LBOs the senior debt margins are trending even higher. In the US senior debt providers will usually not accept margins of less than 3% in an LBO structure.

Intermediate Capital Providers like to achieve a margin 3% - 4% over cost of funds on a running yield basis on subordinated debt, particularly where the debt is non-amortising or if it is not capable of repayment on the base case cash flows for say an 8/9 year period. In an LBO structure, the intermediate capital provider will look to an IRR of 10% - 12% over costs of funds. This equates to a total IRR of around 15% - 17% in the current climate, the return in excess of the running yield being achieving through the equity kicker.

Institutional equity Providers of institutional equity are IRR driven. Many factors apart from the pure risk associated with the business influence their IRR requirement. Matters such as likelihood of a call for second round finance, possibility of early exit and the possibility of no exit feature largely in the return calculation. The 30% IRR mantra in the early '90s, became a 25% IRR mantra in the mid '90s but for a good deal who knows, maybe early 20%s is achievable?

The stakes are high when playing the LBO market. It pays to be well advised.

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