How does an LBO type transaction create value for
investors in the mid-cap segment ?
Translation: Robin Monate
Note. The objective of this article is not to present in detail the mechanisms of an LBO transaction, but to understand the main strategic and financial leverages available for investors (institutional and individuals) to maximize their return on investment.
Preface. Before reading this article, it is important to understand how investors will realize a capital gain during an LBO transaction.
In order to facilitate private equity transactions at a global scale (including LBO), investors favor company valuations thanks to EBITDA multiple. This standardization allows to compare similar sizes companies. The objective is to quickly and fairly define the cost of acquiring the target company’s securities. The same method is used when reselling securities (under an average period of 5 to 7 years), often at Iso-multiple. Then, the capital gain for the investor is the difference between the acquisition value and the value of all sold securities held.
On that type of operation above, the average expected IRR is around 15/20% at 5 years (more or less 2x the initial securities price). A major part of the performance is explained by the leverage effect, allowing to drastically reduce the contribution of equity, while taking advantage of operational and financial performances of the company during the investment period.
In the context of securities valuation, three financial data are crucial to analyze:
- The EBITDA
- The target company’s debt value at the time of both the acquisition and the disposal
- Cash flows generated during the investment period
A DCF valuation is also entirely possible (even more for an LBO transaction), but will be mainly used to validate the valuation obtained with the transaction multiple method.
I. A new capital holder, with specific strategic aspirations
When a private equity or buyout fund stands alongside a managerial team during an LBO transaction, the company is expected to redefine the edges of its organization. Strategic ambitions evolve in order to satisfy the expectations of a new financial actor that have specific aspirations, which – if they are in line with those of the management team – are going to create a real turning point for the upcoming years.
The objective of this paper is to introduce the leverages available to investors at the moment of the qualification of their investment opportunities on the mid-cap segment, and in the meantime, how this entrepreneurs / investors relationship is going to create economic value for one and financial value for the other.
II. The mid-cap company’s characteristics
Often qualified by some financial aggregates (turnover, workforce, assets under management etc.), the mid-cap company also stands out for some other characteristics specific to the maturity of its entrepreneurial project, its organization and its future prospects.
A proven operational structure :
- An optimized cost structure : Optimized industrial process, optimal compression of fixed management costs (SG&A), positive EBITDA, investment policy allowing a fast ROI without endangering the company’s cash flow structure.
- An efficient commercial organization : Relevant acquisition channels, allowing to obtain an effective and secured customer / supplier mix.
- The capacity to generate positive cash flows, while facing major events linked to the company’s life (customers loss and evolution of the customers mix, suppliers renegotiations, debt repayment and shareholders compensations etc.)
More diversified strategic opportunities:
Due to the entrepreneurial project maturity and the quality of their organization, mid-cap companies are not confined to “conventional” operations (fundraising, horizontal external growth). They may go through deeper reflections, especially on the management of their value chain and potentially plan acquisitions for vertical integration. Expanding businesses abroad is also an important growth driver for mid-cap companies, through acquisitions or partnerships (Economic Interest Grouping, Joint Venture etc.).
A sufficiently long track record to underline some crucial events during analysis : End of major contracts, economic downturn, crisis etc.
A more solid financial structure :
The financial structure of the mid-cap company is often more consistent and better managed than a small-cap company, which is reassuring creditors and potential investors during more complex operations (buy-out, spin off, fundraising, disposal, merger etc.).
III. The pre-investment financial leverages during a mid-cap LBO transaction
PS. Remember that the value added is generally made at the moment of the exit during the transfer of securities, on an EBITDA multiple basis. Depending on the actual financial structure of the target company and its business perspectives, several leverages can be available for investors to improve their initial investment performance. Here are the three main leverages, classified chronogically during the company analysis.
A. The hypothesis’ relevance of the Business Plan of the target company
The Business Plan allows the potential investor to refine the valuation criteria, and so the IRR. Therefore, there should be a Business Plan that could be in line with the valuation, but also coherent when taking into account microeconomic and macroeconomic constraints of the company (underlying market, growth, penetration rate, drivers, competitors, bargaining power of customers and contractual constraints, exit/entry barriers).
B. The company’s valuation
If the expected performances described in the Business Plan can not be justified by the actual management team, a downward valuation will be proposed, in order to be aligned with the return on investment requirements of future investors. However, there is a last leverage available for investors to ensure a comfortable entry at the capital.
C. The complexity of the leverage effect
After reaching an agreement on the financial perspectives of the company and its valuation, several financial products are possible in order to maximize the leverage effect during the acquisition of the company. All of them are not exposed here, but we count some classics described below :
- The senior debt. Without specifying the different ranges existing where each of them has to respect some precise covenants, classic senior debt is a debt service composed by a nominal and constant interests under the subscription period. Interests are tax deductible and will decrease the available cash at the end of each period.
- The mezzanine and mezzanine like. This range subordinated to senior debt (or junior debt if exists) intervenes at the moment when the maximum leverage effect is reached with classic banking players. This debt has not only the particularity to be repaid in fine (the nominal repayment takes place at the end of the contract, which can exceed the LBO), but it also leaves the choice to capitalize a part/the whole interests dedicated to the mezzanine. In practical terms, capitalized interests are tax deductible, but they don’t any cash impact on the investment period because they are reinstated in the nominal that should be repaid at the end. Therefore, the nominal becomes more and more important after each period, as well as the basis for calculating interest, causing a drastic decrease of the taxable basis over the investment period. However, beware since the interest on this type of product is particularly high, the impact on cash flow at the time of repayment will be all the more important!
- The quasi-equity debt security. A part of equity contributions can be transformed in bonds. It is an important fiscal parade as it allows the deduction of interests received from the bond, but without having an impact on cash during the investment period even upon termination of the bond contract (contrary to mezzanine debt, under the contracts conditions). Indeed, in this type of transaction, capital gain for investors mainly (or even exclusively) happens on the final resale of their securities. It is different from a classic creditor who gains capital thanks to the interests received.
The good financial package should also be justified by a coherent forecast, in order to avoid putting in danger the available cash and the sustainability of the company, but also the investors exit once the investment period is over.
IV. The organizational and strategic post-investment leverages during a mid-cap LBO transaction
PS. Remember that capital gain is generally made at the end on the basis of an EBITDA multiple. Those examples are not exhaustive, but allow to correctly assess where are the cash impacts both in the balance sheet and in the income statement.
The consolidation of the organization. Different strategies can allow to improve operational performances of the company, especially the evolution of the top-line (mix in the turnover), the redesign of SG&A, customers/suppliers contracts renegociation (especially contractual clauses such as payment delays that can have a significant negative impact on cash and increase cash generated on the investment period by cash offsets), the evolution of the industrial process etc.
The evolution of the perimeter. The objective is to carry out relevant acquisitions/disposals during the investment period on behalf of the target company, and to whether integrate them or take them out of the valuation perimeter. Acquisitions can be executed through a full buyout of the company’s shares with the cash available of the target company, by the creation of an SPV in order to realize an LBO on the external growth target, or with a line of debt available to the target company in the context of this type of transaction. Depending on the perimeter, subsidiaries contributions can be integrated, and mechanically improve the margin and/or strengthen the cash position.
The forecast of a major event in the capital of the target company at the exit. Regarding the overall economic conditions, the company’s performances and its market, investors forecast the reselling of their shares as part of a high value added transaction, as an IPO or the disposal to an industrial (often much more remunerative comparing to a reselling between institutional investors).
The previous non-refinanced debts structure’s renegotiation. The arrival of new investors may allow to redesign the debt structure, with better conditions.
The valuation of the work done by the management. LBOs are also a chance for historic shareholders to take part of a new strategic thesis, and to take advantage (at the termination of the investment) of a partial/total withdrawal from their financial investment with a significant value-added.
An adapted and orchestrated exit strategy. A private equity fund realizes a large part of capital gain during securities cession. Therefore, it is better to plan the exit options at the very moment of investment in a company. The growth strategy planned by the investment fund and the management team during the LBO phase is directly part of this exit strategy. The most widespread strategies are the reselling to an industrial (the industrial considers it the opportunity to integrate a new technology to its assets, new clients, a new supply, a first step at a global scale), the disposal to another fund (as part of a new LBO or not) and more rarely, an IPO (in order to become a listed company).
LBO transactions have experienced some setbacks, and several “ brutal ” investment methods not well calibrated by malicious financial players have led to economic tensions sometimes resulting in fatal ends for many companies. Even today, many LBOs (especially secondaries) are by default, the result of poorly calibrated debt, internal conflicts between management and the board of investors or a strategy that has failed to provide economic satisfaction (i.e. improve the profitability of the company).
However, the leveraged effect transactions world is contrasted by famous success stories. This is especially the case in the Large Cap segment of the Hilton Group in 2007 or HCA in 2006, alongside recognized historical players such as KKR or Blackstone.