The complexity of LBO transactions determines the necessity of multiple players, each one of which carries out a specific role. The main players of an LBO transaction are financial sponsors, investment banks, banks, institutional lenders and target management.
The term financial sponsor indicates the buyer in LBO transactions. Commonly, the sponsor conveys the capital raised funds established as limited partnerships. The financial sponsor may be a typical private equity fund but also hedge funds, merchant banking divisions of investment banks, venture capital funds or other investment vehicles. The limited partnership usually takes shape as an investment vehicle where general partners (GPs) operate the day-to-day activities, and limited partners (LPs) play a passive role, providing capital when called by GPs for specific investments. Limited partners offer the majority of the capital and are usually represented by public and corporate pension funds, insurance companies, sovereign funds and wealthy individuals.
The LPs typically compensate the GPs every year with management fees representing 1% or 2% of the fund’s asset. However, the highest compensations for GPs tend to come from carried interest, which typically reaches 20%. The carried interest is applied after paying back LPs of their initial capital and only if the investment threshold or hurdle rate established is achieved at the exit. In that case, GPs would participate to 20% of the fund’s profits from the exit. Carried interest is not automatic and can be called back if the fund has underperformed over time. However, it benefits from tax regulation, since it is considered as capital gain instead of ordinary income, and it is therefore attributed a lower tax rate.
The financial sponsor typically hires investment banks to play two different roles, respectively those of M&A advisor and financing provider. The investment banks advise on both buy and sell side, providing networking and expertise. On the buy side, investment banks source deals and provide expertise, relationships or even in-house solutions. On the sell side instead, investment banks generate an entire sale process to market the portfolio companies of the financial sponsors. Sponsors and investment banks perform the due diligence together, where investment banks add an internal credit process to understand the ability of the target to operate in a highly leveraged condition. The financing structure may be decided by the sponsor or suggested by the investment bank.
After the approval of the credit committee, the investment bank may underwrite the funding commitment which includes: commitment letter, engagement letter and a fee letter. The commitment letter provides the engagement for the debt financing but also for a bridge financing which the investment bank provides to the financial sponsor in case the financial markets do not provide enough capital. The engagement letter indicates the promoter’s decision to hire the investment bank to underwrite the bonds on behalf of the issuer. The fee letter establishes the various fees the sponsor will pay to the investment bank, including the costs related to bridge financing.
Banks and Institutional Lenders
Whereas investment banks play the role of the arranger, the providers of bank debt are both banks and institutional lenders. Banks typically provide financing regarding the revolver of amortising term loan and include several different lenders like commercial banks, loan and savings institutions and finance firms. Banks mainly focus on the target business and credit profile, with particular attention to cash flows. Banks’ model is to concentrate on the target ability to pay interests periodically and principal at maturity. Besides, lenders pay attention to collateral or covenants to protect from potential downturns.
Institutional lenders, on the other hand, provide financing regarding limited amortisation term loans. Institutional lenders include different players such as hedge funds, pension funds or insurance companies. High yield bonds represent the riskier part of the financing structure. Ordinarily, the target management together with bankers from the lead underwriting investment bank attends one-on-one meetings called roadshows with potential investors.
Admittedly, bond investors may be hedge funds, pensions funds, insurance companies, high yield mutual funds, distressed debt funds or even collateralised debt obligation funds. The potential investors firstly receive an offering memorandum prepared by the target managers and bankers of the lead underwriter. The OM contains information regarding the target business, industry and financial reporting. On the other hand, roadshows present the target investment merits and the proposed transaction.
The destination management plays a key role in introducing the business and the virtue of the target company to buyers and lenders. The management deals with both the sponsor and the leading underwriter. Firstly, it presents the investment merits to the proponent. Secondly, the management team works closely with the leading underwriter to prepare marketing and financial materials. Indeed, a solid team management increases the value of the LBO target since it may generate favourable pricing and financing terms. Furthermore, the sponsor will pay more for a well-managed company.
Looking at the financial structure, the existing management – when is taken in place – regularly buys a meaningful equity stake in the post-LBO company aligning its interest with the sponsor. Moreover, incentives are even more aligned with stock options plans. In the end, the quality incentive structure is one of the main differences with public companies.
To sum up, financial sponsors like private equity or venture capital funds regularly act as equity providers. The debt providers, in a single transaction, are normally more players, which tend to buy different tranches of the financing structure. Certainly, banks and institutional lenders tend to buy the safer debt. Besides, insurance companies and pension funds tend to finance bond issuances and lastly specialised collateralized debt obligation funds, hedge funds or even pension funds and insurances invest in high yield or mezzanine debt.