One of many types of management transfer deal structures is the leveraged buyout (LBO). From the book Private Capital Markets by Robert T. Slee, leveraged buyouts typically use a relatively small amount of equity in the deal’s capital structure. LBOs rely on some equity by management and layers of bank and mezzanine debt to make the acquisition.
An LBO is designed to maximize the leverage of the management’s equity contribution, which is sometimes only 10% of the total capital required. Management teams negotiate simultaneously with both secured and unsecured lenders. A seller note is usually the last piece of the structure to be determined because most sellers will not voluntarily finance a meaningful part of the structure, as they are in a second or third security position. The seller financed part of the deal is essentially assuming equity level risk while receiving only debt returns.
Sellers who finance deals may want to protect themselves by financing less than 50% of the transaction; requiring the buyer to obtain life insurance naming the seller as beneficiary for the amount of the loan; making sure the buyer has adequate bank financing for operations; receiving a personal guarantee from the buyer; limiting the note to 60 months; and making sure the agreements among other lenders allow for continued payments on the seller note, unless a major covenant is tripped.
An LBO structure that is too highly leveraged may fail with unexpected losses or cash shortages. Management’s performance after the transaction is key. Managements structure deal terms to defer payments with such instruments as interest only loans for an initial period of time. They also negotiate preferred payment terms with vendors and attempt to speed up payments from customers.
In an LBO, managements trade additional deal risk for an increased equity interest, allowing managers to obtain control of the company with very little of their own money.
An LBO is designed to maximize the leverage of the management’s equity contribution, which is sometimes only 10% of the total capital required. Management teams negotiate simultaneously with both secured and unsecured lenders. A seller note is usually the last piece of the structure to be determined because most sellers will not voluntarily finance a meaningful part of the structure, as they are in a second or third security position. The seller financed part of the deal is essentially assuming equity level risk while receiving only debt returns.
Sellers who finance deals may want to protect themselves by financing less than 50% of the transaction; requiring the buyer to obtain life insurance naming the seller as beneficiary for the amount of the loan; making sure the buyer has adequate bank financing for operations; receiving a personal guarantee from the buyer; limiting the note to 60 months; and making sure the agreements among other lenders allow for continued payments on the seller note, unless a major covenant is tripped.
An LBO structure that is too highly leveraged may fail with unexpected losses or cash shortages. Management’s performance after the transaction is key. Managements structure deal terms to defer payments with such instruments as interest only loans for an initial period of time. They also negotiate preferred payment terms with vendors and attempt to speed up payments from customers.
In an LBO, managements trade additional deal risk for an increased equity interest, allowing managers to obtain control of the company with very little of their own money.
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