Understanding LBOs

Leveraged Buyouts

by Terry Stidham, President of Target Search Group

Wall Street has proven Archimedes' statement, "Give me a lever long enough and a place to stand, and I will move the earth" to be true through their use of Leveraged Buyouts. 

A Leveraged Buyout ("LBO"), is achieved by a Financial Sponsor acquiring a controlling interest in a company by financing a large percentage of the purchase price through leveraged borrowing. The buyer may be the current management, the employees or a private equity firm. The assets of the acquired company are used as collateral for the borrowed capital, sometimes with assets of the acquiring company. Leveraged buyouts use a combination of various debt instruments from bank and debt capital markets. The bonds or other paper issued for leveraged buyouts are commonly considered not to be investment grade because of the risks involved. Some leveraged buyouts occur in companies experiencing hard times and potentially facing bankruptcy, or they may be part of an overall plan.





Source Wikipedia

The concept of the process is not complex, and, if used correctly, can lead to a successful future for a company that may be at risk or crisis. 

Companies of all sizes and industries have been the target of leveraged buyout transactions, although because of the importance of debt and the ability of the acquired firm to make regular loan payments after the completion of a leveraged buyout, some features of potential target firms make for more attractive leverage buyout candidates, including:

• Low existing debt loads
• Historical financials that reflect stable and recurring cash flows
• Market conditions and perceptions that depress the valuation or stock price
• The potential for new management to make operational or other improvements to the firm to boost cash flows
• Hard assets (property, plant and equipment, inventory, receivables) that may be used as collateral for lower cost secured debt




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While some LBOs can lead to large layoffs and asset selloffs, some LBOs can be part of a long-term plan to save a company through leveraged acquisitions. Empirical evidence shows that many LBOs, like other types of buyouts, have resulted in significant improvements in firms’ performance (using a range of indicators from cash flow to return on investment), which can be explained by a combination of factors including tax benefits, strengthened management, internal reorganization, and change in corporate culture. 

On the other hand, LBOs, because of the leverage aspect, are controversial because they may cause disruptions and economic hardship in the company purchased: Its assets serve as collateral for the borrowed money, the purchasing company (often a holding company whose only purpose is corporate ownership and control) intending to repay the loan by using the future profits and cash flows from the purchased company or, failing that, by selling its assets (i.e., dismantling the company). 

LBOs have raised issues of ethics, notably about conflicts of interest between managers or acquirers and shareholders, insider trading, stockholders’ welfare, excessive fees to intermediaries, and squeeze-outs of minority shareholders (who may well receive a good price for their shares, an average of 30% to 40% more than the market price, but do not eventually benefit from the massive financial rewards of shrewd post buyout strategies).

Challenges and Demand for LBOs

Although LBOs still have the largest amount of funds available for investments the private equity industry has experienced some decline in their capacity for leveraged buyouts due to external pressures and investor preferences.



Top 7 Reasons for Trend 

 

1. Monetizing portfolio companies are talking longer in recent years. That traps investors' capital, reducing capacity for redeployment in new funds or in some cases for recycling existing funds.  
2. Newly launched buyout funds - even from established managers - are having an increasingly difficult time raising the same amounts of capital they did in earlier funds. Large institutional investors have been cautious on private equity due to liquidity constraints they encountered in 2008 as well as poor return expectations for the whole sector. 
3. Many pensions and endowments are staying away from some of the mega-funds with the belief they are too bulky to achieve superior returns. And in cases where major investors do come into large LBO funds, they often demand to directly co-invest with these funds on buyout deals. These co-investments, on which pensions do not pay fees, become a significant portion of investors' private equity allocations. Pension holding company shares directly on their books limit the amount of capital available for LBO funds. Some years back when deals were too large for a single fund, LBO firms would call each other to club on transactions. Now they call their investors to present co-investment opportunities. 
4. Companies have developed preventive strategies and defensive tactics (with “poison pills” meant to deter hostile bids, typically giving current shareholders particular rights to buy additional shares or to sell shares with severe economic penalties on the LBO acquirer).  
5. Changes in legislation make such takeovers more difficult (e.g., with Delaware’s merger moratorium law or Ohio’s control share acquisition law).
6. The rise of litigation against leveraged bids (for instance with allegations of violations of antitrust and securities laws) contribute to the difficulties in completing a LBO.
7. Ongoing re-balancing in retirement funding. Increasingly employers are shifting from defined benefits to defined contribution pensions. Defined contribution accounts are managed by individuals rather than pension funds and do not have access to alternative investments such as private equity. The slower growth in defined benefits accounts (as well as the ageing population of employees with these benefits) limits the overall demand for private equity, making fundraising for LBO shops enormously challenging in an already competitive environment.

4 Common Buyout Scenarios  

1. The Repackaging Plan - The repackaging plan is when private equity is used to purchase a currently public company. The purchased company is then taken private for a few years and "cleaned up" before being returned to the market as a fresh new IPO. 
2. The Split-Up - Splitting up happens when a company is deemed to be worth more if divided or sold off in pieces. An LBO occurs and then the acquired company is dismantled. This is the most feared form of LBO and is commonly seen with conglomerates. 
3. The Portfolio Plan - The portfolio plan or aggregation uses an LBO to acquire a competitor and thus enhance or add to its portfolio. This is risky because the acquired company must show a return on invested capital that exceeds the cost of acquisition. 
4. The Savior Plan - The savior plan is often drawn up with good intentions, but frequently arrives too late. This scenario is when the management and employees of a company borrow money to save a failing company. This is the least common form of leveraged buyout because to turn a failing company around generally requires changes in management and employees.

Regardless of what they are called or how they are portrayed, LBOs will be a part of our economy as long as there are companies, potential buyers and money to lend. 

Terry Stidham is the President and Founder of Target Search Group. He is a Business Development and Deal Flow Specialist with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment. He has served as the head of entrepreneurial organizations as well as Fortune 500 companies. He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

Q1 Funding

Private Equity Fundraising Outstrips Q1 Targets

by Terry Stidham

130 private equity funds raised $69.3 billion globally in the first quarter of 2013. This is similar to 2012 when on average $73.7 billion was raised in each quarter. However, the total represents a significant upside vs. fund targets of $59.9 billion. Although the LP's have improved confidence they continue to seek firms that can deliver.

PEI PRESS RELEASE

Private Equity Fundraising Outstrips Q1 Targets

• Private equity funds collected $69.3bn in Q1 – $9.4bn in excess of fund targets
• Buyout funds account for almost half all private equity closed funds
• High targets of funds in market indicate returning confidence

Private Equity International, the leading information provider for the global private equity, asset class (www.privateequityinternational.com), today publishes its quarterly report on global fundraising data.

Funds raised

The data, compiled by PEI’s Research and Analytics team, shows a total of $69.3bn raised globally, by 130 funds, across all private equity strategies in the first quarter of 2013. The figure is roughly in line with fundraising totals for 2012 – on average $73.7bn was raised in each quarter in the year – but represents a significant surplus on fund targets, with firms having aimed for an aggregate of $59.9bn.

“The totals being raised are still no way near peaks of the pre-crisis period but closed funds are evidence of consistent returning confidence,” said Dan Gunner, Director of Research and Analytics, PEI. “What’s most striking about these Q1 figures is the capital raised in excess of what fund managers were targeting. It reinforces the belief that for those managers with strong track records and a good story to tell, there’s ample opportunity.”

Funds with a focus on investment in North America proved the most popular, securing $23.3bn – a figure marginally higher than quarterly averages in the previous four years. Those looking to deploy capital globally raised $18.8bn. In 2012, such funds averaged quarterly fundraisings of $31.8bn.

The single largest fund close in the quarter was that of Cinven, with The Fith Cinven Fund collecting $6.5bn for pan-European investment. Both EnCap Investments, a US firm focused on investment in oil and gas, and Highbridge Principal Strategies, also US-based, raised $5bn.

Buyout funds proved most popular, accounting for $28.5bn of the total capital raised in the quarter. That figure is roughly in line with capital raised for the investment strategy in 2012 – $137bn was raised in the year, a quarterly average of $34.25bn.

Venture capital and growth equity funds also demonstrated a strong quarter, collecting $17.9bn. Such funds had targeted capital of $14.5bn.

Both distressed and secondary funds showed a marked decline relative to fundraising performance in 2012. The former raised just $1.2bn compared to a total of $15.3bn in the preceding 12 months. Secondary fund managers raised $2.1bn – in 2012 they collected $20.8bn.

Funds in the market

In addition to funds outstripping targets in Q1 2013, a review of those in the market also suggests a returning confidence among private equity managers. Seven funds are currently each aiming to raise at least $10bn with three firms, Apollo Global Management, TPG, and Warburg Pincus, targeting $12bn to invest globally.

Funds aiming to invest in Asia-Pacific are notable for their growing confidence. In 2012, $34.6bn was closed by general partners (GPs) with funds targeting the region. Currently, however, there are 417 – almost a third of all funds in the market – aiming to collect $195bn.

“Fundraising activity since 2009 has shown a gradual, steady improvement and the number of funds in the market is high”, said Dan Gunner. “The example of Asia-Pacific demonstrates neatly the disparity between what funds have raised in recent years and what they are aiming for now. There’s clearly an improved confidence globally but it’s never been more competitive... LP investors are increasingly choosing established managers with good track records so some of these funds on the road may not raise what they hope.”

 

Terry Stidham is the President and founder of Target Search Group. He is a Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.
 

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.

 

LinkedIn

Generalist Funds Prevailing

Capital is Available for Funds that have Delivered Strong and Consistent Results

Mary Kathleen Flynn with Source Media recently wrote the following post on how firms like Huron Capital Partners are going against the common wisdom of the last few years that generalist funds were waning.

“Huron Capital Partners LLC is among a handful of private equity firms that have recently raised new generalist funds, going against the common wisdom of the last few years that generalist funds were waning. At $500 million, Huron Fund IV is the Detroit firm's biggest fund to date. Like Huron's previous funds, it will make control investments in lower middle-market companies.

The fundraising climate today is "tough overall," reports partner Gretchen Perkins. "But capital is available for funds that have delivered strong and consistent results."

Although the firm raised funds quickly - fundraising began in October, and the fund closed in December - the process was more challenging than it had been for the previous fund, which was raised during the exuberant market of 2007.

"Limited partners are much pickier today," explains Perkins. "They conduct a far greater level of due diligence, and it requires more resources internally to respond to all of that."

Huron went into the process well prepared, Perkins says. "We found that great LPs were prepared to move, with lots of detailed, comprehensive backup."

The firm added some new investors, as well as retaining past investors.

The new fund will invest in companies with the same criteria as previous funds, without a focus on particular industries. "While we do invest in a range of industries and sectors, we do focus very specifically on solid companies where we believe we can improve operations to create value," explains Perkins about the firm's investment thesis.

"We will continue to invest $10 million to $50 million of equity in lower middle-market companies in the new fund. Additionally, we can invest up to $100 million and, therefore, close deals with no outside financing."

The last three businesses that Huron has invested in from its third fund are "representative of the types of businesses in which we will continue to invest from our new fund," she says. These include Six Month Smiles, a provider of cosmetic orthodontics; Ronnoco Coffee, a coffee roaster and distributor; and Bloomer Plastics, a producer of engineered plastic films.

When asked how the dealmaking environment is shaping up in 2013, Perkins responds, ‘I would say stable. We are closing on three companies now, which is on pace with 2012."’

Terry Stidham is the founder and principal of Target Search Group. He is a B2B Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.

PE Assets in Unsold Companies at Record Levels

PE Sets on Record Collection of Unsold Portfolio Co's in the Asset Class. Investors Take Notice.

Arleen Jacobius recently wrote the following post elaborating on several of my recent posts that looks at  the overhang of unsold companies and LP's sentiment. 

The glut is enormous: an estimated 6,500 unsold portfolio companies as of year end, representing 69% of private equity firms' total assets under management as of Sept. 30. That is the highest number of unsold portfolio companies ever recorded by PitchBook Data Inc.  It is estimated to double that of 2006.

Institutional investors are beginning to ask managers about these portfolio companies and the likelihood of achieving exits — before committing capital to new funds. Whether these holdings are sold for sizable profits could affect private equity returns in years to come.

For example, both the $41 billion Los Angeles County Employees' Retirement Association, Pasadena, and the $38 billion Teachers' Retirement System of the State of Illinois, Springfield, tracked Silver Lake Partners' portfolio company exits before making commitments to its latest fund, Silver Lake Partners IV. Each eventually committed $150 million.

Investment Concerns

LACERA's staff named exits of unsold portfolio companies as one of its two “investment concerns” related to investing in Silver Lake's fourth fund, according to a staff memo for the Feb. 13 board of investments meeting. The staff noted Silver Lake has about $7.6 billion invested in 24 still active companies. Some 70% of the capital invested in Silver Lake's second fund, which closed in 2004, and 75% of the capital invested in Silver Lake's third fund, which closed in 2007 is still active.

And it's not just Silver Lake. LACERA staff noted in the memo that a “lingering impact of the financial crisis is the large quantity of unsold portfolio companies building up in large buyout funds.”

Andrew R. Cristinzio, McLean, Va.-based partner in PricewaterhouseCoopers LLP's deals practice, estimated the overhang in assets is double 2006 levels.

“If you look at private-equity-backed portfolio companies back at pre-crisis levels, current private-equity-backed portfolio company overhang at the end of 2012 was somewhere around 6,500, which is estimated to be double that of the pre-2006 period,” said Mr. Cristinzio, citing PitchBook data.

Indeed, of the more than $3.27 trillion in total worldwide private equity assets under management as of Sept. 30, $2.27 trillion is “unrealized portfolio value” or unsold portfolio companies, according to data prepared for Pensions & Investments by Preqin, a London-based alternative investment research firm.

The worst offender in terms of vintage year is 2007 funds, which as a group have the highest unrealized value of portfolio companies — $527 billion — compared with total assets under management of $617 billion, the Preqin data show.

When Preqin compared the proportion of private equity companies invested in each year since 2006 that are still being held by fund managers, 70% of companies invested in throughout 2006 are still being held, said Nicholas Jelfs, Preqin senior analyst and press officer.

The overhang in unsold private equity portfolio companies has never been higher in the history of the asset class, asserted Michael G. Fisch, president and CEO of American Securities LLC, a private equity firm in New York.

“The overhang that is not sufficiently talked about is not the overhang of capital, but the overhang of older portfolio companies and older funds that have not been sold and need to be sold,” Mr. Fisch said.

What ends up happening to this glut of unsold portfolio companies could have a big impact on the private equity industry.

Some firms can't sell some of their portfolio companies because they are worth less than their original investment, Mr. Fisch said.

“What will happen to them? Who will buy them? When will they get sold? What will happen to the returns of the industry when they do get sold?” Mr. Fisch asked.

Every situation will be different, he said. If a manager's relationship with the firm's limited partners is good, investors will give the general partners more time to sell their portfolio companies.

Where the general partner-limited partner relationship is not good, the entire private equity fund might be sold to another general partner, or investors might bring in a new general partner because they have lost faith in the original one, Mr. Fisch said.

New Commitments
Holding onto portfolio companies also can affect investors' ability to make new commitments, said Sanjay R. Mansukhani, senior manager research consultant in the New York office of Towers Watson Investment Services Inc. That's because exiting companies is a prime source of distributions back to limited partners. “When net asset value is not coming back in distributions, investors find themselves overallocated” to private equity, Mr. Mansukhani said.

Given the lessons of the financial crisis, when overexposure to alternative investments made the entire portfolio less liquid, investors are loath to increase their target allocation in order to commit capital to additional private equity funds, he explained.

Portfolio company refinancing, called recapitalizations, has led to some distributions to limited partners, but most distributions in Towers Watson's portfolio are from portfolio company exits, Mr. Mansukhani said.

This makes it tougher for general partners to raise money, even when their portfolio valuations are rising from the effect of the uptick in the equity markets in the U.S. and the value general partners have added to the portfolio companies, Mr. Mansukhani said.

"Even core investors are giving less money, even for great-performing funds,” he said.

Distributions also are a sign that a private equity firm is a solid performer, noted David Fann, president and CEO of TorreyCove Capital Partners LLC, a San Diego private equity consulting firm.

“Most private equity investors would like to see at least a portion of the prior fund's investments achieve realizations before committing to a new fund,” Mr. Fann said. “Realized investments validate performance and success.”

Damage to Returns
Another aspect of this historic overhang of portfolio companies is the damage it is expected to do to overall private equity returns.

“It's just on the math of the internal rate of returns,” Mr. Mansukhani said.

A longer portfolio company holding period will affect internal rate of return because IRR is time based.

“General partners may gain a little multiple by holding out for a better price, but what it is going to do is dilute the internal rate of return,” he said. “You have to balance those two things.”

It also becomes an issue of capacity, whether a manager with a collection of portfolio companies in older funds and a new fund has enough executives to manage the entire portfolio, Mr. Mansukhani said.

“It's about bandwidth,” Mr. Fann said. “Understanding the capacity of general partners to make new investments is critical. Investors want their GPs to work solely on their behalf. Investors don't want to commit to funds whose general partners are consumed working on the previous fund's investments.”

However, some industry executives are betting the portfolio company overhang might diminish if the economy, at least in the U.S., continues to improve and debt for deals remains available.

“Clearly, there's a general acknowledgement that there's been an increase in the average hold time from investments made in the 2007-2008 time frame,” said PricewaterhouseCoopers' Mr. Cristinzio. “But if the economy continues on the current trend and financing continues being available as it is, we will see an increase in exits.”

Terry Stidham is the founder and principal of Target Search Group. He is a B2B Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.

5 Year Overhang for PE

Buyout Firms’ Cash Payouts Hit Record by Terry Stidham

Private equity firms are faced with returning record levels of cash to their investors even though the value of their portfolios are rising faster, swollen by trillions of assets that they are struggling to sell.

Fund managers distributed $318bn to their limited partners as of June last year, and $330bn in 2011, through dividends and asset disposals, according to data compiled by pension fund adviser Hamilton Lane. This exceeded distributions in 2007 – $305bn – the peak of the leveraged buyout boom.

But payouts have shrunk as a percentage of private equity investments as firms have battled to dispose of companies acquired in mega-deals at the peak of the credit boom. Even with these record distributions, investors’ exposure to private equity is actually increasing.

This means investors stay close to their maximum allocation targets and therefore do not need to commit as much new money to reach those targets.  The investors are looking to diversify their investment among new funds.

Investor Allocations to New PE Funds:

Source: Preqin Investor Intelligence

The value of all private equity holdings increased to more than $1.8tn last year, up from $1.73tn in 2011 and $938bn in 2007, largely helped by rising public stock markets, which fund managers use to evaluate assets.

As a result, annual distributions as a percentage of total net assets fell from 24 per cent in 2011 to 18 per cent in 2012. They represented 43 per cent of total assets in 2007 and 25 per cent on average since 2003.

The record pile of investments on the ground makes it difficult for private equity firms to raise new funds as investors wait for more distributions before committing fresh money.

Ted Koenig of Monroe Capital LLC, said: “The current overhang is unsustainable, given the nature of private-equity fund structures; firms lose the ability to invest this capital once their investment period runs out. At today’s deal flow pace, it would take around five years to invest the current overhang, which means that private-equity firms must start investing now at a much higher rate if they want to invest their full fund (and collect the fees and carry on those remaining commitments). These private-equity firms will try their hardest to put this capital to use, which should result in a plethora of M&A activity.”

Since the appetite for mega deals has cooled, what do you think they will be looking for? Primarily this: add-on or bolt-on companies to existing platforms. Keep in mind that many of these platform companies were acquired prior to the Great Recession hitting in 2009. As we saw a few days ago, add-ons as a percentage of deals closed grew to just under 50% of all deals equity firms invested in 2011. And according to Pitchbook’s latest data, add-ons broke the 50% barrier of all PE deals closed in 2012 for the first time ever.

Implications for Small to Mid-Size Business Owners

Many private equity groups are seeking to buy something specific that matches their buying criteria.  If you are a business owner and/or major shareholder in a privately held company with cash flow of at least $500,000 annually and any of these following points apply to your situation contact me to discuss:

• You are considering your exit plan, either now, or over the foreseeable next couple of years
• Your company needs additional capital to grow
• Your company could benefit from having the additional resources of highly educated, accomplished, professional management

There is plenty of private equity capital seeking good companies in which to invest.  For many company owners, this translates into the optimal recapitalization and/or exit strategy.

About the author Terry Stidham
Terry Stidham is the founder and principal of Target Search Group. He is a B2B Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.