Private Equity

In finance, private equity is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange.

A private equity investment will generally be made by a private equity firm, a venture capital firm or an angel investor. Each of these categories of investor has its own set of goals, preferences and investment strategies; however, all provide working capital to a target company to nurture expansion, new-product development, or restructuring of the company’s operations, management, or ownership.

Among the most common investment strategies in private equity are: leveraged buyouts, venture capital, growth capital, distressed investments and mezzanine capital. In a typical leveraged buyout transaction, a private equity firm buys majority control of an existing or mature firm. This is distinct from a venture capital or growth capital investment, in which the investors (typically venture capital firms or angel investors) invest in young or emerging companies, and rarely obtain majority control.

Private equity is also often grouped into a broader category called private capital, generally used to describe capital supporting any long-term, illiquid investment strategy.

Leveraged buyout (LBO) and Management buyouts (MBO)

A leveraged buyout (LBO) is an acquisition (usually of a company but, can also be single assets such as a real estate property) in which the purchase price is financed through a combination of equity and debt and in which the cash flows or assets of the target are used to secure and repay the debt. Since the debt, be it senior or mezzanine, always has a lower cost of capital than the equity, the returns on the equity increase with increasing debt. The debt thus, effectively serves as a lever to increase returns that explains the origin of the term LBO.
LBOs are a very common occurrence in today's " Mergers and Acquisitions " (M&A) environment. The term LBO is usually employed when a financial sponsor acquires a company. However, many corporate transactions are partially funded by bank debt, thus effectively also representing an LBO. LBOs can have many different forms such as Management Buy-out (MBO), Management Buy-in (MBI), secondary buyout and tertiary buyout, among others, and can occur in growth situations, restructuring situations and insolvencies. LBOs mostly occur in private companies, but can also be employed with public companies (in a so-called PtP transaction -- Public to Private).

As financial sponsors increase their returns by employing a very high leverage (i.e., a high ratio of debt to equity), they have an incentive to employ as much debt as possible to finance an acquisition. This has in many cases led to situations, in which companies were "overleveraged", meaning that they did not generate sufficient cash flows to service their debt, which in turn led to insolvency or to debt-to-equity swaps in which the equity owners lose control over the business and the debt providers assume the equity.


LBOs have become very attractive as they usually represent a win-win situation for the financial sponsor and the banks: The financial sponsor can increase the returns on his equity by employing the leverage; banks can make substantially higher margins when supporting the financing of LBOs as compared to usual corporate lending, because the interest chargeable is that much higher.

The amount of debt banks are willing to provide to support an LBO varies greatly and depends, among other things, on:

  • The quality of the asset to be acquired (stability of cash flows, history, growth prospects, hard assets and so on)
  • The amount of equity supplied by the financial sponsor
  • The history and experience of the financial sponsor
  • The economic environment

For companies with very stable and secured cash flows (e.g., real estate portfolios with rental income secured with long term rental agreements), debt volumes of up to 100% of the purchase price have been provided. In situations of "normal" companies with normal business risks, debt of 40% to 60% of the purchase price is normal figures. The debt ratios that are possible vary also significantly between the regions and between the industries of the target.

Depending on the size and purchase price of the acquisition, the debt is provided in different tranches.

  • Senior debt: This debt is secured with the assets of the target company and has the lowest interest margins
  • Junior debt (usually mezzanine): This debt usually has no securities and bears thus a higher interest margins

In larger transactions, sometimes all or part of these two debt types is replaced by high yield bonds. Depending on the size of the acquisition, debt as well as equity can be provided by more than one party. In larger transactions, debt is often syndicated, meaning that the bank who arranges the credit sells all or part of the debt in pieces to other banks in an attempt to diversify and hence reduce its risk. Another form of debt that is used in LBOs is seller notes (or vendor loans) in which the seller effectively uses parts of the proceeds of the sale to grant a loan to the purchaser. Such seller notes are often employed in management buyouts or in situations with very restrictive bank financing environments. Note that in close to all cases of LBOs, the only securities available for the debt are the assets and cash flows of the company. The financial sponsor usually is not willing to provide other securities outside of the acquisition target as securities.

As a rule of thumb, senior debt usually has interest margins of 3–5% (on top of Libor or Euribor) and needs to be paid back over a period of 5–7 years, junior debt has margins of 7–16%, and needs to be paid back in one payment (as bullet) after 7–10 years. Junior debt often additionally has warrants and its interest is often all or partly of PIK nature.
Types of Acquisitions in which LBO's are used

  • MBO

A management buyout (MBO) is a form of acquisition where a company's existing managers acquire a large part or all of the company from either the parent company or from the private owners.

Purpose of an MBO
Management buy outs are conducted by management teams as they want to get the financial reward for the future development of the company more directly than they would do as employees only. A management buyout can also be attractive for the seller as he can be assured that the future stand-alone company will have a dedicated management team thus providing a substantial downside risk against failure and hence negative press. Additionally, in the case the management buyout is supported by a private equity fund (see below), the private equity will, given that there is a dedicated management team in place, likely pay an attractive price for the asset.

Secondary and tertiary buyouts

A secondary buyout is a form of leveraged buyout where both the buyer and the seller are private equity firms or financial sponsors (that is, a leveraged buyout of a company that was acquired through a leveraged buyout). A secondary buyout will often provide a clean break for the selling private equity firms and its limited partner investors. Historically, given that secondary buyouts were perceived as distressed sales by both seller and buyer, limited partner investors considered them unattractive and largely avoided them.
There are many advantages and disadvantages concerning leveraged buyouts. First, this type of agreement can allow many large companies to acquire smaller-sized enterprises with very little personal capital. Second, since corporate restructuring can take place, the acquired company can benefit from necessary reorganization and reform. In addition, management buyout can prevent a company from being acquired by external sources or from being shut down completely. However, there are many disadvantages imposed by LBOs as well. Often times, the restructuring can lead a company to downsize and can even result in hostile takeovers. The high interest rates from the high debt-to-equity amounts can result in a corporation’s bankruptcy, especially if the company is not generating substantial returns after acquisition. Lastly, management buyouts can produce conflicts of interest among employees, executives, and management teams as well as possible mismanagement by the buyout owners. With the potential for enormous profit, it is no wonder that leveraged buyout strategies expanded throughout the 1980s and have recently made a comeback in modern corporate America.
Mezzanine Finance
Mezzanine capital, in finance, refers to a subordinated debt or preferred equity instrument that represents a claim on a company's assets which is senior only to that of the common shares. Mezzanine financings can be structured either as debt (typically an unsecured and subordinated note) or preferred stock.

Mezzanine capital is often a more expensive financing source for a company than secured debt or senior debt. The higher cost of capital associated with mezzanine financings is the result of it being an unsecured, subordinated (or junior) obligation in a company's capital structure (that is, in the event of default, the mezzanine financing is only repaid after all senior obligations have been satisfied). Additionally, mezzanine financings, which are usually private placements, are often used by smaller companies and may involve greater overall leverage levels than issuers in the high-yield market; as such, they involve additional risk. In compensation for the increased risk, mezzanine debt holders require a higher return for their investment than secured or more senior lenders.
Mezzanine financings can be completed through a variety of different structures based on the specific objectives of the transaction and the existing capital structure in place at the company. The basic forms used in most mezzanine financings are subordinated notes and preferred stock. Mezzanine lenders, typically specialist mezzanine investment funds, look for a certain rate of return which can come from (each individual security can be made up of any of the following or a combination thereof):

  • Cash interest — A periodic payment of cash based on a percentage of the outstanding balance of the mezzanine financing. The interest rate can be either fixed throughout the term of the loan or can fluctuate (that is, float) along with LIBOR or other base rates.
  • PIK interest — Payable in kind interest is a periodic form of payment in which the interest payment is not paid in cash but rather by increasing the principal amount by the amount of the interest (for example, a $100 million bond with an 8% PIK interest rate will have a balance of $108 million at the end of the period but will not pay any cash interest).
  • Ownership — Along with the typical interest payment associated with debt, mezzanine capital will often include an equity stake in the form of attached warrants or a conversion feature, similar to that of a convertible bond. The ownership component in mezzanine securities is almost always accompanied by either cash interest or PIK interest and in many cases by both.

Mezzanine lenders will also often charge an arrangement fee, payable upfront at the closing of the transaction. Arrangement fees contribute the least return and are aimed primarily to cover administrative costs and as an incentive to complete the transaction.
The following are illustrative examples of mezzanine financings:

  • $100,000,000 of senior subordinated notes with warrants (10% cash interest, 3% PIK interest and warrants representing 4% of the fully diluted ownership of the company)
  • $50,000,000 of redeemable preferred stock with warrants (0% cash interest, 14% PIK interest and warrants representing 6% of the fully diluted ownership of the company)

In structuring a mezzanine security, the company and lender work together to avoid burdening the borrower with the full interest cost of such a loan. Because mezzanine lenders will seek a return of 14% to 20%, this return must be achieved through means other than simply cash interest payments. As a result, by using equity ownership and PIK interest, the mezzanine lender effectively defers its compensation until the due date of the security or a change of control of the company.

Mezzanine financings can be made at either the operating company level or at the level of a holding company (also known as structural subordination). In a holding company structure, as there are no operations and hence no cash flows, the structural subordination of the security and the reliance on cash dividends from the operating company introduces additional risk and typically higher cost. This approach is taken most often as a result of the company's existing capital structure.

Uses of Mezzanine Capital:

In leveraged buyouts, Mezzanine capital is used in conjunction with other securities to fund the purchase price of the company being acquired. Typically, Mezzanine capital will be used to fill a financing gap between less expensive forms of financing (e.g., senior loans, second lien loan and high-yield financings) and equity. Often, a financial sponsor will exhaust other sources of capital before turning to mezzanine capital.
Financial sponsors will seek to use mezzanine capital in a leveraged buyout in order to reduce the amount of the capital invested by the private equity firm. Because mezzanine lenders typically have a lower target cost of capital than the private equity investor, using mezzanine capital can potentially enhance the private equity firm's investment returns. Additionally, middle market companies may be unable to access the high yield market due to high minimum size requirements, creating a need for flexible, private mezzanine capital.

Real Estate Finance

In real estate finance, mezzanine loans are often used by developers to secure supplementary financing for development projects (typically in cases where the primary mortgage or construction loan equity requirements are larger than 10%).These sorts of mezzanine loans are often collateralized by the stock of the development company rather than the developed property itself (as would be the case with a traditional mortgage). This allows the lender to engage in a more rapid seizure of underlying collateral in the event of default and foreclosure. Standard mortgage foreclosure proceedings can take more than a year, whereas stock is a personal asset of the borrower can be seized through a legal process taking as little as a few months.

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