What is Minimum Equity Ratio?
The Minimum Equity Ratio is the threshold requirement established by lenders to determine the equity contribution by a financial sponsor in a leveraged buyout (LBO).
The standard minimum equity ratio—or percent contribution to the financing of the leveraged buyout (LBO)—is between 20% and 30%, or 25% on average.
How to Calculate Minimum Equity Ratio
The minimum equity ratio serves as a constraint on the total debt that can constitute the total purchase price.
The minimum equity ratio is a common parameter in the private equity industry intended to prohibit firms from the over-reliance on leverage to fund the purchase price of an acquisition.
In particular, the minimum equity ratio protects the downside risk and potential incurrence of capital losses of lenders that contribute debt capital to fund an acquisition.
From the perspective of a lender, the risk of default can impede the retrieval of interest and the repayment of principal in-full at maturity (and reduce the yield).
Therefore, risk-averse lenders mandate private equity firms to have “skin in the game” via the minimum equity ratio, for the sake of protecting their downside risk.
Why? If the financial sponsor is not at risk, the likelihood of reckless decisions by the firm is substantially higher. In other words, the decision of a lender to undertake risk is irrational if the equity investor is not also taking on some sort of risk.
The necessity for the incentives to be aligned cannot be emphasized enough between all stakeholders with a vested interest in the outcome of the fund, including the GP/LP dynamics.
The method to calculate the minimum equity contribution is a two-step process.
- Step 1 ➝ Determine Minimum Equity Ratio from Lender(s)
- Step 2 ➝ Multiply Minimum Equity Ratio by Total Acquisition Price
Minimum Equity Ratio Formula
The maximum debt to fund an acquisition is equal to the product of the minimum equity ratio and the total acquisition price.
If we rearrange the formula and solve for the minimum equity ratio, the formula is equal to the minimum debt multiplied by the total acquisition price.
To reiterate from earlier, the minimum equity ratio is set near 25% on average — albeit, the fundamentals of the target and external factors such as the credit environment can impact the minimum requirement.
The formula to arrive at the minimum equity contribution is the difference between the total acquisition price and maximum debt.
In recent times, lenders and other institutional investors have increasingly becoming more reliant on minimum equity ratio requirements (25% of the total capitalization) to protect their downside risk.
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On the subject of analyzing a potential acquisition target, the criteria of private equity firms tends to contain many recurring characteristics.
- Financial Stability ➝ First and foremost, the acquisition target must demonstrate financial stability in its historical performance.
- Stable Cash Flow ➝ Considering the debt burden placed on the balance sheet post-LBO, the continued generation of stable cash flows is necessary to meet interest and principal amortization.
- Predictable Operating Performance ➝ The operating performance of the company must be relatively predictable, with minimal cyclicality or sudden spending requirements.
- Minimal Capex Requirements ➝ The capital expenditure (Capex) requirements should be predominately maintenance Capex, rather than growth Capex. The gradual convergence from growth to maintenance Capex is often a signal that growth opportunities are gradually declining with time.
- Margin Expansion ➝ The acquisition targets with clear-cut opportunities for cost-cutting to improve profit margins (and enhance operating efficiency) are favorable.
- Market Position ➝ The target company must provide a value proposition (or possess an “economic moat”) that differentiates itself from the competition and protects its long-term profit margins.
Minimum Equity Ratio Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
LBO Minimum Equity Ratio Calculation Example
Suppose we’re tasked with calculating the minimum equity ratio of a private equity firm’s acquisition target. The company generated $60 million in LTM EBITDA, while the entry multiple on the date of purchase is 5.0x.
The transaction structure of the leveraged buyout (LBO) is on a “cash free, debt free basis” (CFDF), so the purchase enterprise value (TEV) flows into the “Uses” section of the “Sources and Uses” schedule.
- Purchase Enterprise Value (TEV) = $60 million × 5.0x = $300 million
The cash to B/S—the minimum cash balance required for operations to sustain itself—is assumed to be $5 million. The transaction fees and financing fees are $6 million and $10 million, respectively.
- Cash to B/S = $4 million
- Transaction Fees = $6 million
- Financing Fees = $10 million
Therefore, the “Total Uses” side is complete and comes out to a total of $320 million.
The “Total Sources” side, on the other hand, will assume 3.0x and 1.0x for the term loan B (TLB) and seller note, respectively.
Since the “Total Sources” must equal the “Total Uses”, the “Sponsor Equity” contribution can be estimated by subtracting $320 million by $240 million.
The required sponsor equity contribution is $80 million, which we’ll confirm by calculating the sum of each row on both sides and subtracting the two values.
In closing, the minimum equity ratio can be calculated by dividing the $80 million in sponsor equity by “Total Uses”.
- Minimum Equity Ratio = $80 million ÷ $320 million = 25.0%
