In a leveraged buyout (LBO), the company uses leverage, or debt, in order to acquire another company or one of its parts. In an LBO, private equity funds can use multiple types of debt or capital as leverage. The most common types of capital or debt used are a Revolver, Bank Debt, and High Yield Debt. Each of these can have advantages and disadvantages for the buyer and seller.
A revolver is a type of debt that works when a senior banks debt, functions like a line of credit. When the company is in need of capital, they will draw the revolver to meet the credit limit and then repay the revolver with excess cash when it is available. Using a revolver is advantageous in that it provides companies flexibility with capital and allows them to not seek additional finances.
The drawbacks of a Revolver, however, are its associated costs. The first cost is the interest rate charged on the amount withdrawn from the revolver. This is generally structured to charge a premium that varies based on the credit of the borrowing company. The other cost is an undrawn commitment fee. This fee compensates the bank for the loan and is based on the difference between the revolver limit and the amount drawn.
Bank Debt is another type of debt used in an LBO. Bank Debt is generally a lower interest rate security, but is associated with a strict payback plan. These debts are arranged over a five to ten year period and in that time the bank can restrict a company’s ability to make other acquisitions.
Although this structure is an effective way for a company to gain capital, some see the restrictions as a drawback. If a company is seeking to make further acquisitions without the strict financial schedule, then Bank Debt may not be the best type of capital.
High Yield Debt
The other popular type of debt used for capital in an LBO is High Yield Debt. This type of debt is unsecured and named for its high interest rate. The high interest rates are in place in order to compensate investors for the risk taken in the debt. These debts are popular because in a High Yield Debt investors are willing to provide more capital than banks. This type of debt also provides the company with a flexible payment plan.
This High Yield Debt has many advantages, however has a higher interest rate than that of a Bank Debt.
When deciding the type of capital that a company should use for an LBO, considering the benefits and drawbacks are important. The specific debt structure can impact the success of the investment and future investments for a given company.
For more information on leveraged buyouts, read our recent blog post.