Borrowing for profit

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f you are a CEO, business owner or executive looking to sell your company, your potential buyer group will most likely include private equity firms. To gauge the potential interest level of private equity firms, you should develop an understanding of what private equity firms look for in an acquisition and why. Here is a primer on the acquisition method typically used by private equity firms, the leveraged buyout.

A leveraged buyout (LBO) refers to a transaction in which an investor (typically a private equity firm) acquires a controlling interest in a company and a significant portion of the acquisition is financed through debt. In order to borrow the money, the investor (who will now own the company) will pledge the assets of the company as collateral to the lender. For larger, established companies, lenders will also look to collateralize the loan via the company’s operating cash flow. The lender will have the first right to the cash flow generated by the company for both interest and principal payments. Therefore, if the lender believes in the future cash flows of the company, they will be willing to lend beyond the value of the assets of the company. In this scenario (known as a “cash-flow loan”), lenders will base the amount the investor is able to borrow on a multiple of the company’s cash flow.

A leveraged buyout is generally the preferred acquisition method of private equity firms as borrowing money (known as “leverage”) to consummate an acquisition enhances the returns to the equity holders—as long as the debt doesn’t overwhelm the company. To illustrate the impact leverage has on equity returns let us use a simple example:

Suppose two private equity (PE) firms, Firm A and Firm B, both find two completely identical companies. Each firm acquires one of the identical companies for $10 million. PE Firm A uses all equity capital and writes a check for $10 million.

On the other hand, PE Firm B borrows $5 million from the bank to finance a portion of the acquisition. PE Firm B then only has to commit equity capital of $5 million. In five years, both private equity firms look to realize a return on their investment. They go out and sell their respective companies for $20 million. In analyzing the performance of the two transactions, we look at the initial cash invested, the amount of cash returned and the time period. Two common measures of performance are internal rate of return (IRR) and cash-on-cash return. Comparing the performance of PE Firm A and B.

As you can see, PE Firm A realizes $20 million with the sale and PE Firm B realizes only $15 million (since it had to repay the bank the $5 million borrowed to make the acquisition). However, PE Firm B had the superior return profile. In analyzing performance, you have to consider not only the total amount of capital realized, but also the dollar amount that was invested.

PE Firm A turned $10 million into $20 million in 5 years. PE Firm B turned $5 million (half the amount of PE Firm A) into $15 million (three-quarters of the amount of PE Firm A) during the same period. Admittedly, this is a simplified example as it does not take into account interest payments on debt, the tax-shield benefit of using debt in the capital structure, the increased risk of bankruptcy that occurs when companies take on debt, the ability to make dividend payments and other capital structure nuances. Even if we added these factors, the outcome will remain the same. The addition of leverage enhances the return to equity holders.

The next logical question (and an important one for business owners looking to potentially sell to a private equity firm) is: what makes a company a potential candidate for a leveraged buyout transaction? Typically, companies that are attractive LBO targets will have 3 critical characteristics:

• Stable cash flows

• Ability to increase earnings

• Strong management teams

Each of these traits requires a more thorough discussion, and I’ll address them in future columns.

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