Buy-out is used to describe the majority of those acquisition transactions which equity houses and acquisition financiers seek to finance. Regarding to basic buy-out structure, Newco gets funds to acquire target from acquisition financiers(debt) and from sponsor and management team (Equity). There is a sale and purchase agreement between Seller and Newco. Seller is the owner of the target. As for public-to-private buy out structure, Acquisition financiers(Debt) and Sponsor & management Team (Debt) contribute to Bidco to provide enough fund to purchase target. There is an offer and acceptance between Bidco and the shareholders of target company. Bidco acquirers target's shares.
Where the purchaser of a business is financing aquisition by a significant amount of debt, which generally means that its level of debt exceeds the amount of its equity, the acquisition is said to be highly leveraged. In the case of a buy-out a special purpose vehicle will be set up to make the purchase and the amount of debt taken on by this purchaser a significant portion of the total purchase price, at least 50%. This is why buy-outs are often described as leveraged buy-outs or LBOs.
In general the LBO tend to work best if the following conditions are met: Firstly, Equity Return Rate must be more than 25%. Secondly there should be strong qualitative aspects which includes market leadership, attractive industry, superior management, differentiated product/service offering, cost saving opportunities and expansion, Thirdly there should be Quantitative aspects which includes cash flow coverage and growth potential. Finally, There should be a clear exit strategy. The principal rationale for buyouts is to achieve a value gain for the third party investors and the management team by introducing operating efficiencies, asset disposals and then selling the company through an exit route, typically flotation or a trade sale. The high gearing of buyout vehicles enhances the returns on equity.
One of the two basic components of newco's financial resources will be the capital contribution of its shareholders( the management team and the institutional investor). Management equity will take the form of ordinary shares subscribed from the management team's personal resources. Of all the forms of finance in a buy-out it carries the maximum risk and the maximum reward. The management team may also occasionally subscribe for quasi-equity in the form of redeemable preference shares or subordinated loan capital. Institutional Equity will take the form of ordinary shares and quasi-equity in the form of either redeemable preference share or subordinated loan capital.
Senior debt provided by senior banks is the other one of the two core elements of all acquisition financing. It will take the form of a core medıum term loan and other facilities requıred to meet specific funding requirements such as a loan to finance specific capital expenditure projects and/or a working capital facility to meet the business's working capital requirements after completion.
Having determined the respective amounts of equity and senior debt available, the total of these amounts should ideally satisfy the funding requirement. If not, there will be a price gap and there are a number of ways in which this gap may be filled. Junior Debt( mezzanine and high yield) which is subordinated to the senior debt may be used to fill a funding gap and it may also be used to produce a more favourable financial structure generally.
a) Mezzanine Finance as the most commonly used form of junior debt, is the traditional answer to a funding gap, although it may be used to enhance a financial structure generally, usually by allowing the total amount of debt to increase. It will take the form of a medium term loan repayable after senior debt. It will carry a higher rate of interest to reflect the higher risk of it not being repaid. The mezzanine lender will be considering the other major element to a mezzanine finance package, in the form of the equity kicker, or warrants, which it can expect to be granted by newco in return for filling the funding gap. A warrant is an option to subscribe for ordinary shares in newco in certain circumstances, usually where an exit is about to ocur.
b) High yield Debt: The debt takes the form of a bond issue by newco or a vehicle company related to newco for such purpose and ,to becommercially viable, relies on very strong and proven cashflow streams underlying the target business.
If there is a gap between price which the vendor requires for the target and the amount of acquisition finance available, the vendor may agree to defer payment of part of the purchase price. This deferred consideration is effectively a further source of finance and will either be structured in the same form as institutional equity, that is, as a subscription for ordinary shares, redeemable prerence shares or subordinated loan capital in newco or as a straight loan, which will be subordinated behind the senior debt and any junior debt. The terms of the deferred consideration will ytpically give the vendor a lower return than that required by the institutional investor.
There is a balance between the rewards that each of the parties investing in a buy-out can expect and the risk facing such investment. Simply put, the greater the potential risk to a party the greater the reward expected. The subordination arrangements will effectively ensure that the order of risk will be as follows: 1) least risk, senior debt 2) Junior debt 3) Institutional quasi-equity 4) Institutional equity 5) Highest risk, management equity.
Atty Gonenc Yay, LL.M