What does a leveraged buyout transaction look like?
In this three part series we will give readers a look behind the curtains of one of the most captivating types of deals on wall street: the leveraged buyout (“LBO”).
There are ten primary steps to an LBO (see exhibit A). This is the first installment of our trilogy and will cover the first four steps: sourcing, screening, the non-disclosure agreement, and due diligence.
Step I: Sourcing
Before a buyer ever talks to a seller, before any negotiation happens, before a deal even gets off the ground, there’s a fund partner sitting somewhere in America looking at the entire universe of deal opportunities and deciding on which one he wants to spend the next six years of his life.
This is what we call sourcing.
During the sourcing stage, the primary player is the buyer. He’s combing the landscape, sifting for enterprises possessing certain core traits, researching them, weighing (and recording in acute detail) investment risks and benefits, and using all this knowledge to inform his next move.
Fund partners turn to several channels in this process. First, they’ll reach out to personal contacts including buddies at other funds, investment bankers in the sector, and company executives with whom they have relationships cultivated over many years. Second, they’ll use dealmaking tools such as Axial and LinkedIn to substantively improve sourcing scale and reach. And finally, they’ll use databases such as Capital IQ, Factset, and Bloomberg to make sure that they’re not missing something of which every other market player is aware.
The primary driver of LBO returns is the degree to which the investor is able to source on a comprehensive level. Why is this the case? Because in order to generate a strong internal rate of return (“IRR”) a fund needs to be able to both deliver extremely profitable improvements to the business, and buy it for a fair price at the start of the deal. Unfortunately, most transactions are auction processes wherein multiple capital providers — each with strong capabilities — are all bidding on the same asset. As a result, funds that have identified channels that enable them to source efficiently are almost always able to access proprietary deals that end up delivering huge dividends.
Step II: Screening
Once a capital provider has potential targets on the table, a rigorous screening exercise commences. The goal of this process is first to reach a shortlist of high-value opportunities and ultimately to agree on a single target that it will pursue to deal close.
The skill with which a fund is able to identify the right target is arguably the second most influential factor on performance, next to its ability to source at scale. Indeed, there are a number of critical factors that make a good buyout candidate (to be discussed in detail on our forum next month) but every fund’s angle is different. As a consequence, the process by which a fund selects the opportunities with which it has the best angle is of critical importance to its financial success (defined predominantly by IRR).
During this stage, a fund will typically take from several days to several weeks to construct a robust view of a business. First, it’ll start with whatever public information the company has made available. This will include anything on the website, press releases, shareholder presentations, customer pamphlets, ownership change announcements, and any financial figures the management team has released. If the deal opportunity arrived on the investor’s desk as a result of a teaser from an investment bank, he’ll also look over any business or financial data disclosed in that document.
Second, he’ll comb the landscape for anything that may shed light on the core foundation and health of the business. This includes third party news mentions, independent profiles on the business and its leadership team, customer testimonials, customer complaints; basically, anything that he can find on Google, and beyond. This is a critical step as — similar to a product you would consider buying in a store — third party commentary is often more comprehensive when it comes to the good, the bad and the ugly.
The partner then undertakes a thorough assessment of the industry in which the company plays. Who are the competitors? What are their relative market shares? What differentiates our guys? Who is the target consumer? Are there product or service substitutes? What are the performance drivers? What are the typical margins (e.g., gross margin, EBITDA margin, net income margin, etc.)? How much do players typically spend on capital expenditures, working capital, the like? What does the average accounts receivable and accounts payable cycle look like? Who are the upstream providers? How fast is the sector growing?
Fourth, the fund will take the data it does have and build a financial model of the potential transaction. The model answers the key question that fund partners ask themselves: what would the LBO look like if we were to execute it? It includes not only available (or often assumed) financial projections, but details on how much debt the transaction would entail (3.75x EBITDA? 4.50x EBITDA?), how much they would pay, how long they would hold it, how much value they plan on creating during the holding period (usually 3 to 10 years), what they would do to create that value (reduce cost of goods sold? grow topline?), how much they would sell it for on the exit date, and what % return this all sums up to.
Finally, the fund will take all this information and aggregate it into a central document ranging from a brief investment overview to a comprehensive deal memo. The memo will include not only an overview of the company, the competitors, and the industry, but a thorough assessment of the risks and benefits involved with a buyout of the enterprise. Indeed, it’s not uncommon for buyers to do a thorough round of internal analysis before they ever talk to a company owner.
Step III: Non-Disclosure Agreement
If the buyer decides that it wishes to move forward, it’ll want significantly more detail than what’s publicly available or provided in the teaser. To access this data, he and the seller will sign a confidentiality agreement, also frequently referred to as a non-disclosure agreement (“NDA”). In short, the NDA is a legal document that protects any confidential operating and financial information shared by the buyer with the seller throughout the transaction process, from being disclosed with third parties.
The execution of the NDA officially kicks off the deal. It’s the first point in which the potential investor is given access to information that any public bystander won’t have. Moreover it’s the first time that the buyer and seller will sit down at the table to negotiate. In more complicated transactions, either a sellside investment bank, sellside legal counsel, buyside investment bank, buyside legal counsel, or all of the above, will also weigh in on the negotiations.
Here, the buyer will review a copy of the NDA, usually provided by the seller, mark it up with any changes it wishes to make, send it back to the seller for approval or some negotiation and, when they have reached a consensus, send over a copy of the executed contract.
Step IV: Due Diligence
A signed NDA kicks off the first of — assuming all goes well — many rounds of due diligence (“DD”).
Put simply, due diligence is the investigation of a target’s business by the potential buyer. This step involves the buyer, the seller, and if engaged, the buyer and seller’s advisors.
Buyside deal teams typically start with an initial 2 to 3 week diligence round, followed by a non-binding indication of interest (more on that in Part II of this series), and then a much deeper diligence round lasting 2 to 6 months that will precede the letter of intent (also covered in more detail in Part II).
During the multistep saga that is the diligence process, the investor will start with a review of the seller’s confidential information memorandum (“CIM”). A well prepared CIM will generally include a robust overview of the:
- Operating history
- Industry dynamics
- Competitive landscape
- Barriers to entry
- Core customer base
- Go-to-market strategy
- Primary performance drivers
- Assets (e.g., intellectual capital, patents, facilities, etc.)
- Growth opportunities
- Management team
- High level financials (ideally five years of historicals plus five years of projections)
- Discussion of the company’s ability to execute on said projections
- Summary of the auction process, the proposed structure of the deal, and expected timeline for expressions of interest (a.k.a. bids)
Next, the buyer will set up meetings with the management team alongside site visits, supplier meetings, customer interviews, and expert interviews, as appropriate.
In addition the seller, sometimes aided by sellside counsel, will usually set up a virtual data room. The seller will then upload the following types of information to this storage space:
- Specific information that potential buyers have requested; for example, a buyer considering the merits of consolidating real estate and shuttering underperforming stores might ask the target for a list of retail locations and the lease expiration date for each location
- Information that gives the buyer improved visibility but was too data heavy to include in the teaser or CIM; for example, scanned copies of the seller’s seven primary supplier contracts, or perhaps original terms for its two outstanding bank loans
- Information that gives deeper insight or detail than the CIM; for example, a seller distributing organic milk products might want to break down performance by product type, flavor, fat content, size, and SKU
- Information that becomes available over the course of the deal process; for example, a seller launched the sellside process in November 2013 and posts its 2014 financials to the data room in March 2014
All else equal, the volume of information presented in the seller’s data room will increase with its size, the complexity of the transaction, and the number of potential suitors involved in the process.
In most transactions, the diligence process is a two-way conversation. While the target will usually kick off DD by circulating the CIM and giving investors access to its data room, by midway through diligence buyers are often emailing the target’s management team, investment bank, and legal counsel to request information. The primary goal of diligence is to provide a comprehensive picture of the target, communicate risks, answer any questions, and — possibly most importantly — present the information that will fuel the buyer’s thinking around operational improvements.
To continue the saga, read on to part II.