Posted on: July 27th, 2021
Independent sponsors in the middle market are great at finding deals but less skilled at bringing equity to the table to close. Many assume after the deal is signed that they will source the needed equity from family offices or other institutional sources. Cash equity is a key when undertaking a leveraged buyout transaction as lenders need to see skin in the game from the buyer to consider making a loan.
Leveraged Buyout Financing Structure
There are several cash equity alternatives, which all have merit and should be strongly explored when designing your leveraged buyout financing structure. These alternatives when combined with cash equity, provide a potent equity solution that will unlock quality leveraged buyout financing options for the sponsor. The three primary forms of cash equity alternatives are seller notes, contributed equity value and purchase price equity.
- Seller note – Negotiating a seller note holdback is a smart move for a buyer, but the structure of the note is the key to having it count as equity for the buyer. Seller notes count as equity if a) the note principal is 100% repaid after the maturity of the lender’s loan; and b) the loan is subject to a subordination agreement with the lender. Too often, seller note principal pays back quickly within the term of the leveraged buyout loan. This disqualifies it as a form of long term, at-risk equity.
- Contributed Equity Value – This means the equity value contributed by the Company-sponsor or the value of residual equity left in the deal by the seller. Companies sponsoring the leveraged buyouts usually have existing equity value. In addition, like a seller note, if a seller leaves 20% equity in the Company, the lender will treat that as equity.
- Purchase Price Equity – occasionally leveraged buyout sponsors, especially in a management buyout, will get a sweetheart deal from a seller at below fair market value. If you can purchase a company at 15% discount below the market level, some lenders will count that as contributed value.
While these forms of alternative equity are acceptable to lenders, they are usually not sufficient on their own, unless combined with cash equity. The middle market is awash with many fund less sponsors seeking 100% debt deals using seller paper as their only contribution to the deal. These transactions usually do not get too far as few serious lenders will consider a deal in which there is no capital at risk beneath them. Often lenders get comfortable if there is a minimum 30% total contributed equity in the deal, with cash accounting for at least 15% of the total purchase price.