There are two general categories of debt used in Leveraged Buyouts. The secured and unsecured debt are the two general categories. Both of these are often used collectively. In this article, we will talk about financing for leveraged buyouts and how these two categories play a part.
Two General Categories of Debt
Secured Debt
Secured Debt, or also known as asset-based lending, may also contain two subcategories of debt. These are the intermediate-term debt and senior debt.
These two categories may also be considered as one in some smaller buyouts. However, when it comes to larger deals, secured debt may have several layers. These layers vary according to the term of the debt and the types of assets used as security.
Unsecured Debt
We also have unsecured debt. This is also referred to as subordinated debt and junior subordinated debt. From the name itself, unsecured debt lacks the protection a secured debt has.
However, unsecured debts generally carry a higher return, this offset the additional risk for some. To the debt financing is added an equity investment.
Depending on the market condition, the percentage of the total financing that the equity component constitutes may also vary. However, it usually is between 20% to 40% range.
Sponsors or the dealmaker will usually work with providers of financing or investment banks in every leveraged buyout. It is the investment bank’s job to conduct due diligence and the proposed deal. Once they are finished doing their due diligence, the bank will decide if the deal meets the criteria, and they will present the deal to the banks they work with.
High-yield Bond
Additionally, the lead investment bank may also decide to conduct a presentation for the different prospective lenders. The presentation will show the bank’s analysis and the reasons why they think the lenders should feel secure providing capital to finance the deal.
Moreover, to develop more interest in an offering of high-yield bonds, a similar process may also be conducted. This is often done for high-yield bonds that may be part of the overall deal financing structure.
Oftentimes, these presentations are preceded by the distribution of a preliminary offering memorandum. The memorandum must be related to the bond offering. SEC approval is usually needed before the memorandum can be finalized. Otherwise, the bonds are forbidden to be offered publicly.
Banks will often provide a commitment letter first if they agree to provide debt capital to the deal. The commitment letter will put forward the stipulation of the loans.
There are also instances where banks choose to hold some of the debt in their own portfolio. Usually, this is done when the banks are still seeking commitments from different financing sources. The banks will then syndicate the rest of the debt.
Where Does Debt Capital Come From?
Most of the time, debt capital comes from two different main sources. On one hand, we have banker lenders who may choose to provide different types of loans or amortizing term loans.
These banks vary from commercial banks, finance companies, savings and loan associations, and more. On the other hand, debt commitments with longer-term usually come from institutional investors. These include insurance companies, hedge funds, pension funds, and more.
There will be times when one group can be seen providing different types of capital in different deals. Moreover, some parts of debt capital may even come from bond issuance.
A bond issuance may require the investment bank to provide a bridge loan. This is done so it can close the time gap between when all the funds are needed to close a deal and when the bonds can be sold in the market.
LBO Debt Financing
Moving on to leveraged buyouts debt financing, there are also two broad categories. One is the senior debt, and the other is the intermediate-term debt.
Loans that are secured by liens on particular assets of the company are what senior debts consist of. The collateral includes physical assets which maybe land, plants, and other equipment. This collateral provides the downside risk protection required by lenders.
Senior debt can have five or more years of terms. It also comes in various forms. Of course, it varies according to the nature of the target’s business and the type of collateral it can provide.
A senior debt may also constitute between 25% and up to 50% of the total financing of a leveraged buyout. The interest rates are usually between the 2% to 3% prime plus. Commercial banks, investments, and other institutional investors like insurance companies, finance companies, and mutual funds are the typical sources of this. The term is usually between 5 to 10 years.
Keep in mind that even though bank debt is the least costly form of debt, it also comes with maintenance covenants most of the time. These maintenance covenants often impose financial restrictions on the life of the loan.
Usually, bank debt is priced above some variable base market rate. A great example of this would be LIBOR or the prime rate. How much higher usually depends on the borrower’s creditworthiness.
Other Senior Debt Revolving Credit
Additionally, the company may also have access to a revolving credit in a leveraged buyout. The revolving credit may be secured by short-term assets. These short term assets may include but not limited to inventory and accounts receivable.
The company may also need to pay a variable rate that is pegged to some base rate. For instance, the crime rate in the prime plus a certain percentage. Additionally, revolving credit can also be repaid. It can also be reborrowed depending on the company’s agreement with the lender.
Usually, this form of credit is used to deal with seasonal credit needs. Its relevance often is contingent on the nature of the business. It is the sponsor’s choice to arrange a revolving credit line with a bank. This, in turn, may syndicate it with other banks.
Usually, the borrower is required to pay a commitment fee when it comes to these types of credit lines. This fee will give the borrower access to the credit even if it is unused.
However, if the credit is used, then the borrower is also required to pay the interest rate. Usually, the revolving credit line is secured by some specific assets. Oftentimes, it has a term of five years.
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