“Lending in an LBO is frequently syndicated amongst a group of banks in order to decrease the amount of lending exposure to any one borrower.”
In the case of bank loans, financing comes directly from banks, rather than purchasers of bonds in the capital markets. The interest expense of bank loans is also often calculated as a variable rate. It is common for bank loans to charge the borrower an interest rate of LIBOR (defined below) plus an additional amount, termed spread, which is indicative of the risk associated with the borrower and the seniority of the loan in the case of default. (LIBOR is short for ‘London Interbank Offered Rate’ and is a daily rate that banks charge to borrow unsecured funds from each other for given periods of time.)
Another important aspect of bank loans is that the lending is frequently syndicated amongst a group of banks in order to decrease the amount of lending exposure to any one borrower. Using this strategy, banks are able to lend money while reducing the risk of bad loan write-downs by lending across a broader range of borrowers. For example, let’s say we own a bank. We decide to call it Friends Bank because we have friendly rates. We have a couple of choices regarding lending options:
Option 1. We can lend $100 million to ABC Co and charge an interest expense of LIBOR plus 3.5%.
Option 2. We can lend ABC Co $10 million and get nine other banks to lend ABC Co the remaining $90 million. The rate of interest charged will still be LIBOR plus 3.5%.
As part of option 2, the other banks will also call Friends Bank when they have loans that they want to syndicate out as well. At Friends Bank, we will end up participating as a lender in nine other syndicated loans, which gives the bank a total of ten syndicated loan deals it participates in. All of the loans that we agree to participate in charge an interest rate of LIBOR plus 3.5%. Which option is more attractive?
If you said option number two, you are correct. Under both scenarios, the amount of money earned from interest income is theoretically the same. What makes option number 2 the better option is apparent under a default scenario. In option 1, if ABC Co is unable to pay back its loan, Friends Bank solely takes on all the losses associated with the bad loan. However, under option 2, losses are spread over the ten lending institutions and interest income is still coming in from the other nine borrowers that are current with their interest payments.
In general, bank loans are far more complicated and multi-faceted than bonds. There are several different kinds of bank loans, including term loans, revolving credit facilities, and payment in kind loans, but the important thing to realize is that bank loans can have floating interest rates and often times are syndicated amongst several lenders, whereas bonds are fixed-rate instruments that are sold in the capital markets.
Chapter 2: Leveraged Buyouts: The Purpose
Why do a leveraged buyout? Why would anyone go through the trouble? The answer is quite simple: money. The goal of any LBO transaction is to achieve higher returns on the initial equity investment of the investor. Leveraged buyouts are designed to enhance the returns attainable by equity investors; they do so by decreasing the size of the initial equity investment.
“The goal of any LBO transaction is to achieve higher returns on the initial equity investment of the investor.”
For example, a company is purchased for $100 million with 100% equity and the company is streamlined over the course of a year and later sold for $110 million. The investor just made a 10% return on investment. (Let’s ignore the time value of money for now.)
Alternatively, if the investors were able to get a secured loan on the company’s assets for $90 million and made an initial equity investment of $10 million, they would still be able to purchase the $100 million company. They would have to pay interest expense on the loan, which happens to be 7% annually. After one year, the investors are able to sell the company for $110 million. With the proceeds from the sale of the company the investors do the following:
pay down the $90 million loan
pay $6.3 million in interest expense due.
After paying interest expense and paying back the loan, investors are left with approximately $13.7 million for themselves. That represents a return of about 37%, more than triple the return on equity of the 100% equity transaction!
The bottom line is that leveraged buyouts are about achieving greater returns on equity for investors.
While levered transactions present several advantages to investors, at the same time they bring significant risks. It is the ability of corporations to execute restructuring plans (post LBO) that determine whether a company can sufficiently handle the interest burden taken on as a result of the leveraged buyout and drive the earnings that determine whether greater returns on investment can be realized by investors.
Advantages of Leverage
Given that the purpose of leveraged buyouts is to realize greater returns on investment, perhaps it would be useful to examine the several advantages that go hand in hand with leveraged transactions.
The advantages come in a number of diverse forms. Some advantages come in the form of the ability to close transactions while others come in the form of limiting losses. In the end the investor has to make a judgment call as to whether these advantages and the potential for returns are greater than the risks that are also taken on with every transaction.
Bigger is possible
One of the major advantages of leveraged buyouts is the smaller initial equity investment required to close a transaction. In our example $100 million transaction above, the investor would be required to put up the full $100 million to acquire the company. However, in the case of the leveraged buyout, the investor would only need to hand over $10 million dollars to get the deal done. The other $90 million, we are assuming, could be obtained in the form of a loan secured by the assets of the company being taken over. (We are assuming the company has limited debt prior to any transaction.)
The point is, if the investor did not have $100 million dollars, without leverage the investment would have been out of reach. Leverage allows the transaction to close with only a fraction of the upfront equity commitment. Now an investor can be the proud owner of a $100 million dollar company, even if he only has the ability to invest $10 million.
Alternatively, let’s say that the investor does have the $100 million. Rather than tie up the entire $100 million in this one investment, she may want to invest in several different investment opportunities. Using leverage allows her to do that. Our rich investor may wish to invest $10 million in our example opportunity as well as invest in nine other $10 million opportunities. By using leverage, our savvy investor has invested the entire $100 million dollars, but has diversified her risk across several different investments.
Limited losses
One of the beauties of equity investing is that you can only lose what you put in. The same truth applies with most leveraged buyouts. One of the main advantages for investors is the limited losses that accompany buying a company mainly with debt secured by the assets of that same company. You can substitute the word ‘debt’ in this case with ‘Other People’s Money’.
When an investor is required to commit just 10% of the capital required to purchase a company, it is significantly less than that of the 100% pure equity investor. The potential losses and therefore risk of the pure equity investor are far greater than those of the LBO equity investor. The levered investor has much less capital at risk should the acquired company not succeed. In the case of failure (or