How can you determine the best capital structure for an LBO?

1 What is an LBO?

An LBO is a transaction in which a PE firm acquires a target company using a large amount of debt, typically 60-80% of the purchase price. The debt is secured by the assets and cash flows of the target company, which is expected to generate enough earnings to repay the interest and principal over time. The PE firm aims to improve the performance and value of the target company through operational and strategic changes, and then exit the investment by selling the company or taking it public.

2 Why does capital structure matter?

The capital structure of an LBO affects both the profitability and the risk of the deal. On one hand, using more debt increases the leverage ratio, which is the ratio of debt to equity. A higher leverage ratio means a lower equity contribution from the PE firm, which can boost the ROE and the internal rate of return (IRR) of the investment. On the other hand, using more debt also increases the interest expense, the debt service coverage ratio (DSCR), which is the ratio of earnings before interest and taxes (EBIT) to interest expense, and the debt-to-EBITDA ratio, which is a measure of leverage and debt capacity. A higher interest expense reduces the free cash flow available to the PE firm, while a lower DSCR and a higher debt-to-EBITDA ratio indicate a higher risk of default or distress for the target company.

3 How to find the optimal capital structure?

There is no definitive answer to what constitutes the optimal capital structure for an LBO, as it depends on various factors such as the characteristics of the target company, the industry dynamics, the availability and cost of debt and equity, and the PE firm's objectives and preferences. However, a common approach is to use a spreadsheet model to test different scenarios and compare the key metrics such as ROE, IRR, DSCR, and debt-to-EBITDA ratio. The goal is to find the balance between maximizing the returns and minimizing the risks, while meeting the constraints and expectations of the lenders and investors.

4 What are some tips and best practices?

When determining the best capital structure for an LBO, it is important to start with a base case scenario that reflects current market conditions and assumptions. Then, use sensitivity analysis to assess how changes in key drivers affect returns and risks. Benchmark the target company's leverage and performance with its peers and industry averages, and adjust accordingly. Debt covenants and credit ratings should be used to limit the amount and type of debt that can be used, ensuring that the target company can meet its obligations and maintain its creditworthiness. Finally, a WACC analysis should be used to determine the optimal mix of debt and equity that minimizes the cost of capital and maximizes the value of the target company.

5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?