What is Deleveraging?
Deleveraging refers to the reduction of debt by a company in order to lessen the degree of financial leverage.
In the specific context of a leveraged buyout (LBO), deleveraging describes the incremental reduction in the acquired company’s net debt balance (i.e. total debt minus cash) across an investment firm’s holding period.
Deleveraging: Debt Paydown in Leveraged Buyouts (LBOs)
The value of the financial sponsor’s initial equity contribution (and returns) increases in tandem with the reduction of debt.
In leveraged buyout (LBO) transactions, deleveraging is one of the positive levers that drive strong returns.
In a traditional LBO, a significant portion of the purchase price was funded using debt financing, i.e. borrowed capital that must be repaid on a future date.
Throughout the holding period of the LBO — i.e. the time horizon in which the target remains a portfolio company under the ownership of the private equity firm (PE) — the cash flows of the company are used to pay down its outstanding debt balance.
The repayment of outstanding debt to lenders that had provided debt capital by the post-LBO company represents the concept of “deleveraging”.
But while deleveraging creates value by reducing the original leverage from the transaction, this approach requires the portfolio company to generate stable cash flows (i.e. be non-cyclical and non-seasonal).
LBO Value Creation from Deleveraging
The primary drivers of returns in LBOs are the following three items:
- Deleveraging → The gradual pay down of the original debt raised to fund the buyout.
- EBITDA Growth → Growth in EBITDA stemming from implementing operational improvements that improve the company’s margin profile (e.g. cost-cutting) and new growth strategies (e.g. entering new markets, introducing new products/services, upselling / cross-selling, raising prices).
- Multiple Expansion → The private equity firm (i.e. financial sponsor) exits the investment at a higher multiple than the entry multiple on the date of the original purchase.
As the company’s carrying debt balance decreases, the equity contribution of the sponsor increases in value as more debt principal is repaid using the acquired LBO target’s free cash flows (FCFs).
From the process of decreasing the amount of debt on the target’s balance sheet, the value of the sponsor’s equity grows.
Deleveraging and Interest Tax Shield
The benefits of relying on leverage to fund a buyout diminish as more debt is paid off.
For that reason, many financial sponsors actually try to restrict the amount of debt repaid, i.e. to no more than the mandatory repayment of debt required per the loan agreement.
- Access to “Cheap” Capital → One major benefit to using debt is that debt is widely viewed as carrying a lower cost of capital, i.e. a cheaper source of financing.
- Interest Tax Shield → Additionally, the interest expense owed on debt is tax-deductible, meaning that earnings before taxes (EBT) are reduced by interest (and the income taxes recorded are lower). The favorable outcome of having less taxes owed is known as the “interest tax shield”.
Given those benefits, many sponsors would rather use cheap debt capital to fund growth plans and expansion strategies, or even make add-on acquisitions (i.e. “roll-up investing”) — and benefit from the tax shield mentioned earlier.
If a private equity firm is aggressively deleveraging the amount of debt on a portfolio company, that typically is not a positive sign, as it tends to imply that there are no (or limited) opportunities to invest the capital elsewhere.
Alternatively, the company might be at risk of default or close to breaching a loan covenant.