How Equity Firms Execute Leveraged Buyouts

Private equity firms like the Carlyle Group, Kohlberg Kravis Roberts and many others have made huge returns for investors through leveraged buyouts.  Using financial engineering and a lot of debt these firms buy companies with little money down.  While these types of transactions create spectacular returns for investors, they often shortchange the seller and management teams that drive the business.  Thankfully, owners and managers can use these same financial tactics to buy and sell their business and have the benefit accrue to them.  

How Most Leveraged Buyouts are Done 

Private equity firms do hundreds of leveraged buyouts a year. Their typical approach is to offer to buy a controlling stake in a company using leverage they obtained from banks based on the financials of that company.  Often times these firms commit very little of their own money to purchase the business.   With little cash invested, these deals create spectacular returns for the buyout firm.  

Buyout firms also collect large fees up front, as well as additional advisory fees while operating a company they've acquired, and a big share of the investment profits. The average annual management fee to do business with a private equity firm is about 1.5% to 2.5%. The average share of profits is about 20%.  While buyout firms give management ownership, it’s usually less than 20% of the company.  This type of buyout is the most common and is typically called a   Sponsored Leveraged Buyout, where the equity player is the “Sponsor.”

Non-Sponsored Leveraged Buyouts

For financially healthy businesses, there is another approach that utilizes the same financing techniques but management gains operating control.  In fact, management can end up owning 85% to 100% of the Company depending on the situation. These types of buyouts are called Non-Sponsored Leveraged Buyouts.

Keys to Non-Sponsored Leveraged Buyouts

The process of completing a non-sponsored leveraged buyout is pretty much like any other kind of business financing.  The key requirements for a successful non-sponsored leveraged buyout include:

1. Quality Company and Team – An ideal situation is for the buyer(s) to already be running a profitable business.  Common situations would be a CEO that buys a company from a passive owner or a limited partner buying out his or her majority partner(s).  The key is for would-be lenders or investors to have confidence in the management team once the owner walks about the door. 
   

Lantern’s experience encompasses helping managers and minority shareholders execute non-sponsored buyouts that realize control of the business while allowing them to create significant value.

1. Proactive Management – Many prospective buyers never ask for the opportunity to buy their owner’s business or buyout a partner.  Many are reluctant because they are unfamiliar with the process or believe they can’t qualify for financing.   Interestingly, it’s the financials of the company, not the individuals that drive the ability to perform a non-sponsored buyout.  The best way to start such discussions is to informally ask if the owner is open to discussing it. Once you get a ‘yes’ (even a tentative ‘yes’), more homework can begin.    
   

2. Agreement on Purchase Price - Agreeing on a purchase price can be as complicated or as simple as both parties want to make it. Still, most small to mid-sized companies are valued at a multiple of between 4 to 7 times cash flow (commonly called ‘EBITDA’ – for earnings before interest, taxes, depreciation and amortization).   As an example a company that makes $2 million a year EBTIDA would be worth $10 million at a 5 multiple (5X).   Knowing this, the most direct way to get a price is to ask the owner their price.   Any purchase price within a 4 to 7 range will probably work. In fact, our experience has shown buyers will end up owning more through a non-sponsored buyout than a sponsored buyout even if they have to overpay some in order to buy the company.
   

3. Understanding of Financing Options - Most companies know they can get debt from banks and equity from buyout funds.  However, a there are a variety of lesser known funding sources such as subordinated debt lenders, insurance companies, corporate development companies, hedge funds and other specialty lenders that will lend beyond a traditional bank.  These are the same institutions that buyout firms use.  Depending on the economic climate many of these firms will lend up to and sometimes over 4 times cash flow (EBITDA).
   

Buyout Math: Putting it all together

Should the financing fall short of what is desired by the owner, management and the owner can still execute the transaction, but the owner may retain a portion of the business until their “equity” is repaid.  Following the math here, if a buyer purchases a company for $10Million (5X EBITDA) and can borrow $8Million (4X EBITDA) they end up owning 80% of the Company, and the Seller would retain a portion of the company, but their piece would become “the equity”.  Owners are satisfied because they get a majority of their cash up front with no recourse. Buyers like it because they get control either upon the initial buyout, or as the equity is paid out to the seller over time.  The Seller can be repaid over a period of time (decreasing their ownership over time).  Also, most of these specialty lenders do not require personal guarantees limiting the downside risk to new owners.  Over time the owner’s remaining interest can be bought out, often at a higher valuation.  Most important, the value to all parties is directly driven by the buyer’s performance rather than financial engineering by outside investors.

Next:  Buyout How To:  Buying Out A Business Partner or Owner With Lantern Capital Advisors