A Guide to Private Equity - BVCA admin

in repaying much higher levels of debt, financial engineering and multiple arbitrage have become
less important. Buyouts are now much more dependent on operational improvements and
earnings enhancement to generate value.
Buyout structure
The financial structure of a management buyout deal is carefully tailored to the cash and profit
generating characteristics of the company that is the subject of the buyout.
A special purpose vehicle (Newco), which is a separate legal entity and usually a limited company with
local or offshore incorporation, is created to make the acquisition of the target company (the company
subject to the buyout). The equity capital is provided to Newco by the private equity firm and the
management team. Bank (loan) finance is used to part fund the purchase of the target and to provide
working capital. The security for the bank finance is the target’s fixed assets, operating assets, book
debts plus usually a charge from Newco over the capital it will hold in the target. The funding is only
committed once the acquisition actually takes place.
Simple buyout structure
Vendors:
loan notes
Banks:
senior debt
NEWCO
TARGET CO
Investors:
shares/loan notes
Managers:
shares
The use of debt in the form of the bank loans helps maximise the equity returns, eg. a debt/equity ratio
of 80/20 can double the return on equity that would be achieved by a debt/equity ratio of 20/80. The
debt element of the transaction has historically been between 70% and 95% of the total finance required.
Debt finance in a management buyout transaction
Banks can produce a blend of debt instruments, matched to their varying appetites for risk and
demands for return and tailored to the forecast cash generating capacity of the target company. The
range of debt products include senior debt, including revolving loans, term loans, capex term loans,
second lien debt, mezzanine finance and high yield bonds, all of which rank behind the senior debt
in terms of security and repayment in the event of a liquidation. There might also be the possibility of
vendor financing from the seller of the company being acquired or an earn-out arrangement (deferred
purchase consideration).
The return (usually in the form of interest) expected by the debt provider increases as the risk increases.
Senior debt is secured on collateral, usually the assets of the target being acquired pledged as security
for the loan. In the event that the borrower defaults on the terms of the loan, the assets may be sold,
with the proceeds used to satisfy any remaining obligations. High-quality collateral reduces the risk to
the lender and results in a lower rate of interest on the loan. In the event of bankruptcy, the senior debt
provider is considered a secured creditor, which means the creditor receives proceeds from the sale of
the collateral to satisfy the debt. Secured creditors, including the senior debt provider, must have their
debts satisfied before any unsecured creditors receive any funds.
Other than straight cash, senior debt has the lowest risk financing, has the highest priority for interest
and principal repayments and therefore requires less in terms of return (interest payments). Interest
also increases proportionate to the term of the loan.
The investment process
A Guide to Private Equity 33