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Acquisition Financing

Step-by-Step Guide to Understanding Acquisition Financing (LBO Capital Structure)

Last Updated February 20, 2024

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Acquisition Financing

Acquisition Financing: Capital Structure of an LBO

A leveraged buyout (LBO) is a transaction where a financial sponsor – i.e. a private equity firm – purchases a business, with debt constituting a significant proportion of the acquisition financing.

Historically, the percentage of debt raised relative to the total capitalization ranged from 60% to 80% of the total purchase price. But over the course of time, the reliance on debt to achieve the target return has decreased in the private equity industry, albeit the debt component still remains a core value driver of returns in LBOs.

The participants in LBO transactions, such as private equity firms, family offices, and the lending institutions that underwrite the debt financing (e.g. corporate bank lenders, institutional investors) are nowadays more risk-averse and systematic when performing credit risk diligence.

Therefore, the capitalization of LBOs in the 1980s – wherein the traditional debt to equity ratio (D/E) typically consisted of an 80% to 20% split – has since undergone a structural shift downward to 60% to 40%.

  • Minimum Equity Contribution (%): In fact, requiring a minimum equity contribution of at least 25% of the total capitalization has become the standard among lenders and other institutional investors in an effort to protect their downside risk.
  • Covenants: The lenders that underwrite the debt financing can place restrictions that set parameters that the borrower must abide by, such as a maximum leverage ratio (i.e. Total Debt / EBITDA), or prohibit certain actions to reduce the risk of capital loss. However, the increased number of institutional investors that offer less restrictive debt financing has led to more covenant-lite loans.

The acquisition financing of LBOs tends to be cyclical and fluctuate based on several internal and external variables:

  • Internal Factors: Historical Profitability, Free Cash Flow Generation (FCFs), Asset Base (i.e. Liquidity), Credit Profile, Debt Capacity, Credit Rating
  • External Factors: Current State of the Credit Market, Interest Rate Environment, Economic Outlook, Industry Risks (e.g. Threat of New Entrants), Competition in Market

LBO Capital Structure: Sources and Uses of Funds

The “Sources and Uses of Funds” section of an LBO model outlines the total cost of the acquisition – i.e. the estimated financing required to purchase the target company, including the incurred transaction costs and financing fees – followed by the specific details regarding where the capital will be obtained.

Since the “Uses” side estimates the total amount of capital that must be raised from external financing sources (and the equity contribution by the sponsor), it should be intuitive to start here prior to the “Sources” side. As an analogy, if a buyer was interested in purchasing an item from a store, the first course of action is to determine the pricing of the item before figuring out a plan to budget and obtain enough funds to purchase the item.

  • Uses of Funds: The “Uses” side summarizes the total amount of capital necessary as part of funding the acquisition. Of the total capital needed to complete the buyout, the purchase price constitutes the most significant percentage, as one would reasonably expect. Unique to each acquisition, the transaction fees paid to investment banks for their advisory services and the financing fees paid to lenders can vary substantially based on the circumstances of the buyout and must not be neglected.
  • Sources of Funds: The “Sources” side of the schedule starts with the financing commitments formally obtained by the lenders who are interested in participating in the LBO and the initial equity contribution by the sponsor. Other sources of capital include rollover equity by the existing management team and co-investors that tag along in the LBO, but with far less risk is undertaken relative to the lead sponsor in most cases.

If the two sides of the “Sources and Uses” table are equal, the financial sponsor (and other participants) has enough funds to proceed with the acquisition. However, obtaining the necessary capital is not enough by itself for the completion of an LBO to make sense economically.

Instead, the initial outlay of cash by the sponsor – the required equity contribution – is utilized to determine if the fund’s minimum return threshold is met, i.e. the “hurdle rate” set by the firm, which is usually about 20% under a base case scenario.

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LBO Capital Structure Mix: Debt and Equity Components

The capital structure of an LBO is among the most critical return drivers because of the financial sponsor’s role of “plugging” the remaining gap in necessary funds in the form of an equity investment.

The returns earned by the financial sponsor on an LBO tend to increase if the initial equity contribution declines, all else being equal.

The implied returns on a leveraged buyout (LBO) – i.e. the internal rate of return (IRR) and the multiple on money (MoM) – are a function of the growth in the sponsor’s initial equity contribution starting from the date of purchase to the date of exit.

  • Internal Rate of Return (IRR): The internal rate of return (IRR) is the compounded rate of return earned on an investment, i.e. the implied growth rate of the initial equity contribution based upon the starting and ending value.
  • Multiple of Money (MoM): The multiple of money (MoM), or multiple on invested capital (MOIC), is the ratio between the sale proceeds received by the sponsor post-exit and their initial equity contribution.

The top of the capital structure consists of senior debt – frequently used interchangeably with the term “bank debt” – which is most often issued by risk-averse traditional bank lenders that require the borrower to pledge collateral as part of the financing arrangement.

  • Senior Debt: Revolving Credit Facility (“Revolver”), Term Loan, Unitranche Debt
  • Subordinated Debt: High-Yield Bonds (“Junk Bonds”), Subordinated Notes
  • Mezzanine Financing: Convertible Debt (i.e. Equity Conversion Feature), Securities with “Equity Kicker” (e.g. PIK Component, Warrants, Co-Invest Option)
  • Equity: Preferred Stock, Common Equity

Senior lenders tend to possess a lien on the collateral of the borrower and are far more likely to be “made-whole” in the event of bankruptcy, so the pricing of the interest rate (%) on such debt tends to be the lowest.

In contrast, the lower the claim held in relation to the entire capital stack in terms of seniority, the higher the minimum rate of return required by the capital provider to compensate for the incremental risk undertaken. With that said, common equity is placed at the bottom of the capital structure, so the required rate of return – i.e. the cost of equity (ke) – is the highest.

The equity component of LBO acquisition financing consists of rollover equity – i.e. when the existing management team re-invests their exit proceeds post-sale into the new entity to participate in the upside of the LBO – followed by the equity investment by the financial sponsor to complete the LBO. For larger-sized LBOs, co-investors can also participate and contribute capital, which reduces the equity contribution of the primary private equity firm, which is called the “lead sponsor” in such transactions.

Acquisition Financing Formula

The formula to calculate the acquisition financing of an LBO – i.e., the total capitalization ratio (i.e. the ratio between debt and the sum of debt and equity) – is as follows.

Capitalization Ratio (%) = Initial LBO Debt ÷ Total Sources of Funds

The initial LBO debt refers to the total debt financing raised as part of the transaction, whereas the total sources of funds represents the sum of the total debt and total equity contribution.

Initial LBO Debt = Σ Debt Capital + Interest-Bearing Securities
Total Sources of Funds = Total Debt + Total Equity Contribution

Acquisition Financing Calculator – Excel Template

We’ll now move on to a modeling exercise, which you can access by filling out the form below.

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Step 1. Entry LBO Model Assumptions

Suppose a private equity firm is interested in acquiring a company that generated $60 million in LTM EBITDA at a purchase multiple of 8.0x.

  • LTM EBITDA = $60 million
  • Purchase Multiple = 8.0x

The purchase enterprise value (TEV) can be determined by multiplying the LTM EBITDA by the entry multiple, which comes out to $480 million.

  • Purchase Enterprise Value (TEV) = $60 million × 8.0x = $480 million

On the “Uses” side of our schedule, there are three more outflows aside from the purchase price itself:

  1. Transaction Fees = 2.5% of TEV = $12 million
  2. Financing Fees = 2.5% of Total Debt = $6 million
  3. Cash to B/S = $2 million

The “Total Uses” is the sum of all four parts that we have computed thus far, which amounts to $500 million.

  • Total Uses = $480 million + $12 million + $6 million + $2 million = $500 million

Note: The LBO transaction is assumed to be structured on a cash-free, debt-free (CFDF) basis, i.e. the purchase price is equal to the enterprise value.

Step 2. LBO Acquisition Financing Calculation

Since we’ve quantified the total amount of funds required in the prior section, the next step is to complete the “Sources” side of our LBO model, which summarizes the acquisition financing of the purchase.

Of the financing sources, there are three tranches of debt with the following leverage ratio assumptions on the date of initial purchase.

  • Revolver = 0.0x
  • Senior Debt = 3.0x
  • Subordinated Debt = 1.0x

The revolving credit facility, or “revolver”, is left undrawn on the date of initial purchase.

The senior leverage ratio is 3.0x while the subordinated debt ratio is 1.0x, so the debt raised in each tranche is $180 million and $60 million, respectively.

  • Senior Debt = $60 million × 3.0x = $180 million
  • Subordinated Debt = $60 million × 1.0x = $60 million

The total debt raised amounts to $240 million, so the remaining capital necessary – the total uses of funds minus the sum of debt raised – is the implied equity contribution from the sponsor, which comes out to $260 million.

  • Sponsor Equity = $500 million – $240 million = $260 million

Once acquired, the free cash flows (FCFs) generated by the post-LBO company (i.e. the “portfolio company”) are used to meet the payments on the debt raised as part of funding the transaction, which is formally referred to as “deleveraging”.

Step 3. LBO Capitalization Ratio Calculation

In the final part of our exercise, we’ll calculate the capitalization ratio based on the values derived from the “Sources and Uses” section of our LBO model.

The initial LBO debt is $240 million, whereas the total sources of funds is $500 million.

  • Initial LBO Debt = $240 million
  • Total Sources of Funds = $500 million

Thus, the capitalization ratio of our hypothetical LBO – the initial acquisition financing attributable to debt, expressed as a percentage – is 48.0%.

  • Capitalization Ratio = $240 million ÷ $500 million = 48.0%

Acquisition Financing Calculator

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