Definition
Capital structure refers to the mix of equity and debt instruments that a company employs to finance its ongoing operations and growth initiatives. For each company, there is typically an optimal capital structure that aims to minimise the weighted average cost of capital WACC, thereby maximising returns
In the context of a Leveraged Buyout (LBO), the target company’s capital structure undergoes a significant change, characterised by high levels of debt financing the purchase . An LBO involves the purchase of a company by a small group of private investors with a limited investment horizon.
Key Aspects of Capital Structure in an LBO:
Debt Financing
A substantial portion of LBO funding comes from various debt instruments. These are generally ranked in the capital structure:
- Bank Debt: Typically the least expensive and often secured by collateral. It usually includes a revolving credit facility and term loans.
- Revolving Credit Facility: Can be drawn upon and repaid, with interest charged on the drawn amount. A commitment fee is often paid on the undrawn portion.
- Term Loans: Fully funded at close with a set amortisation schedule. Term Loan B (TLB) often has a low annual amortisation (e.g., 1%) with a bullet payment at maturity. A “100% cash flow sweep” may be used for optional repayment of prepayable debt like term loans.
- Senior debt is typically underwritten by banks and may be syndicated.
- High Yield Bonds/Notes: Unsecured, considered more junior than bank debt, with longer maturities and higher coupons. Examples include Senior Subordinated Notes.
- Mezzanine Debt: Situated between debt and equity, often subordinated, and may include a mix of cash and Payment-In-Kind (PIK) interest, potentially with warrants. PIK interest accrues to the ending debt balance instead of being paid in cash currently, increasing the debt principal at maturity.
- Other forms may include second lien debt (second claim on assets/cash flow, bullet repayment, higher cash interest), senior subordinated debt, and PIK/PIYC notes (deeply subordinated, bullet repayment, fully PIK).
Equity Contribution
The remaining portion of the purchase price is funded by equity, primarily from the financial sponsor. This equity acts as a cushion for lenders. The equity structure can include:
- Common Stock
- Preferred Stock: May have a PIK yield
- Rollover Equity: Existing management and/or key shareholders may contribute a portion of their equity, often to align incentives. The rollover amount can be a hardcoded dollar amount or a percentage of new equity.
- Shareholder Loans: May have a PIK yield.
Significance for LBO Analysis:
- Pro Forma Balance Sheet: Created post-transaction to reflect the new capital structure, detailing debt instruments and equity.
- Sources and Uses Table: Summarises how the acquisition is financed (sources) and how funds are used (uses), including equity purchase and debt repayment. The sum of sources must equal the sum of uses.
- Leverage Ratios: Such as debt-to-EBITDA and debt-to-total capitalisation, are directly impacted by the capital structure and assess the target’s debt burden. The total debt divided by leverageable EBITDA (often forward EBITDA) is a key leverage.
- Coverage Ratios: Such as EBITDA-to-interest expense, indicate the target’s ability to service its debt obligations.
- Financing Structure Analysis: A central part of LBO analysis involves crafting an optimal and viable financing structure that can be supported by the target’s financial projections under various conditions. Underwriters focus on the target’s ability to service interest and repay bank debt. A toggle function in the LBO model can allow analysis of different financing structures.
The chosen capital structure is critical for maximising returns for the sponsor while being marketable to investors and providing the target with sufficient flexibility.
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