When people think of leveraged buyouts (LBOs), they may first think of massive deals between megacorporations, backed by the biggest banks in the country. To the uninitiated, the possibility of a leveraged buyout deal may seem out of reach for many small to medium-sized companies. The reality, however, is much more favorable; in reality, most leveraged buyouts are actually conducted by small and mid-market enterprises (SMEs).
But leveraged buyout financing options from traditional banking institutions are limited for such companies, so how do they secure the additional funding needed to complete these transactions?
This is where alternative lenders, including business development companies (BDCs) like Saratoga Investment Corp., play a significant role, as they offer the flexibility often required by SMEs.
Despite concerns about economic slowdowns linked to the coronavirus pandemic, the buyout market is alive and well. Indeed, even amid the pandemic and the associated lockdowns, buyout investment activity in the U.S. showed a 23 percent increase from 2019 to 2020, reaching $262 billion, a high not seen since before the 2008 financial crisis. In the third quarter of 2020 alone, there was $146 billion in such activity.
Firms were looking to invest even more in leveraged buyout financing in the year’s final months. As of November 2020, private equity firms still had $1.6 trillion in dry powder to use towards LBOs, after sitting idle in the early months of 2020. For these firms (as well as BDCs and other alternative lenders), their target companies for buyouts tended to be in the healthcare and tech sectors. Both industries proved resilient to a potential economic downturn and exhibited a significant upside as well.
If one thing is clear, it’s that leveraged buyout lenders hold promising potential for small and medium-sized enterprises that are looking to grow through strategic acquisitions.
In this guide, we’ll discuss the most common types of leveraged buyout financing, what to consider during the planning process, and how to pick the right leveraged buyout lender.
What Is Leveraged Buyout Financing?
A leveraged buyout is a type of business acquisition, where the cost of buying another company is primarily financed through funds borrowed from a leveraged buyout lender. In many cases, leveraged buyouts are carried out by alternative lenders like business development companies that engage in debt financing or mezzanine financing in order to complete the deal.
There are two major types of leveraged buyout financing: Purchase financing, the funding that is used to make the business acquisition, and operational financing, which provides necessary working capital to integrate and grow the acquired company.
Some of the major types of purchase financing include the following:
- Seller financing, or deferred consideration: Seller financing typically takes the form of a loan that is, essentially, a delayed payout for the business. It can indicate that the seller has a great deal of confidence in the business’ ability to turn a profit for the buyer in the near future.
- Buyer financing: Here, a buyer contributes a portion of its own money, including taking loans on its own equity, to complete the transaction.
- Equipment financing: This type of financing uses equipment that the company already owns and has equity in to finance the purchase of the business. It can only work if the equipment is already fully paid off and is not itself part of a financing agreement.
- Senior debt financing: This type of debt financing comes with strict terms and conditions and sits above all other types of debt. It is often secured by assets and typically has lower interest rates but higher criteria for qualification.
- Subordinated or junior debt: This debt financing option sits below senior debt, receiving preference after senior debt and coming with higher interest rates along with higher risks for leveraged buyout lenders.
- Mezzanine financing: This form of financing, a hybrid between debt and equity financing, is based on historic and projected cash flow, making it more attainable for SMEs. It is also unique in that borrowers are able to finance unsecured intangible assets.
When it comes to operational financing, businesses may look toward other types of lending options, including traditional business loans, lines of credit, invoice factoring of accounts receivable, purchase order financing, asset-based loans, and vendor credits.
In most cases, a leveraged buyout proceeds through several steps:
- An entrepreneur finds the business they want to acquire — one that fits in well with their own balance sheet and business goals, and has a strong future upside.
- The entrepreneur finds the right leveraged buyout lender to complete a package of financing, including senior cash flow debt, seller financing, asset-based financing, mezzanine funding, and other types of debt financing.
- The lender completes due diligence to ensure the accuracy of the financial information involved.
- If both parties agree to the terms of the loan, the borrower receives the capital in accordance with the terms of the agreement.
- After this, the acquisition can be completed, with the acquiring company following any repayment terms from the loan agreement.
What To Consider When Planning One
Most companies consider leveraged buyouts because, quite simply, they want to grow and expand, becoming more profitable and producing greater returns. Of course, in some cases, it may be most possible to achieve these gains through innovation, improved technology, or cost-cutting measures.
However, in other situations, acquisitions can be one of the most effective options for business growth and expansion. When interest rates remain as low as they are now, acquisitions and leveraged buyouts are particularly appealing.
In some cases, the right leveraged buyout can lead to a sharp spike in productivity and market share. For example, Harley-Davidson’s managers bought the company from a larger firm, AMF (known mainly for bowling equipment), in 1981. With their focused expertise, they turned the company around and successfully paid off their buyout loans as the company grew.
In order to make these kinds of acquisitions, the acquiring company needs to find the right leveraged buyout financing. In most cases, financing is based either on the target company’s assets, including its real estate, inventory, and accounts receivable, or on its cash flow and potential for future sales and earnings. In each case, the asking price needs to be aligned with a reasonable analysis of the assets or cash flow at stake in order to satisfy a potential lender.
If the buyer engages in due diligence before an LBO, the business that is acquired should be able to service the debt as well as cover its operating expenses at some point in the near future following a successful buyout. This is what lenders look for when determining whether to become involved in an LBO.
One big part of this equation is risk assessment. If the transaction is excessively leveraged, the business may be unprepared to deal with changes or problems as it must dedicate a large portion of its assets or income to debt service.
While any buyer seeking success must carry out due diligence, leveraged buyout lenders will do the same, looking for information to clarify and validate the borrower’s financial position and the details of the transaction.
The Benefits of Seeking Financing
There is a major, obvious benefit to seeking leveraged buyout financing: That is, the buyer winds up with a profitable company producing enough cash flow to service the debt obligations from the buyout while also showing promise for continuing growth for the future. This can be a win-win proposition for shareholders of the acquired company as well, who will see a greater value in their own investment now that the company has more resources and a new management vision.
Acquiring companies, depending on their structure, may use cash or issue stock to fund their purchases, if they are public firms. However, both public and privately-owned companies seek to grow and expand in the market, and various types of financing come with compromises. Issuing more stock may dilute profits among more shares, and cash flow may be tight or unavailable for financing an entire acquisition. Therefore, leveraged buyout financing may be the best option to meet their goals for profitable expansion.
Finding The Right Lender
When finding the right leveraged buyout lender, the process begins with an informed buyer that has done due diligence. A buyer should be able to present clear and detailed information about the financial health of the targeted company as well as a detailed five-year plan for the company’s future after the acquisition.
Lenders will want to see that the funds they invest can be paid back, and this analysis is critical to bringing a lender on board to back the leveraged buyout. Part of this process includes obtaining at least three financial statements from the target company, calculating present and projected cash flow, developing schedules for interest and debt repayment, producing models for credit metrics, calculating the free cash flow of the sponsor company, performing a sensitivity analysis, and determining the rate of return.
The right lender is one that is experienced, keeps lines of communication open, and provides a simplified application process. Experience matters, and a business development company like Saratoga Investment Corp. has the proven experience in LBOs to know what works as well as a strong eye toward working with small and mid-sized businesses to acquire the financing to make their growth and upward mobility possible.
Speed and flexibility are also key when choosing the right business lender, and these are two places where traditional banks often lag behind BDCs and other alternative lenders. Unlike traditional banks, business development companies are known for their flexible lending options and innovative approaches to financing, and are also able to carry out their due diligence quickly in order to allow a transaction to move forward.
As one of the nation’s leading business development companies, Saratoga Investment Corp. helps produce win-win-win LBO transactions: profits for the owner of the target company, expansion for the buying company, and rewards for the investors. Review Saratoga’s investment profile to see if your company would be a good fit.