This article is the second installment in our three part series on the leveraged buyout (“LBO”). There are ten primary steps to executing an LBO (see exhibit A) and part I covers the first four steps of the deal process: sourcing, screening, the non-disclosure agreement, and due diligence.
This chapter will cover the sequence of actions that take you from the indication of interest, to the letter of intent, and to final deal negotiation.
Step V: Indication of Interest
After a cursory round of diligence (see part I for details) the seller will give its potential buyers a deadline by which all interested counter-parties must submit their indication of interest (“IOI”).
Put simply, an IOI is a first round bid for the business. It’s a non-binding, generally conditional document that reflects available data, moves buyers onto a shortlist, and moves them through to the second round.
In the IOI the buyer will generally outline:
- Approximate price range for the business; this can be expressed as an absolute dollar amount (e.g., $15 – $20 million) or multiple of EBITDA (e.g., 3.0 – 5.0x EBITDA)
- Details on available funds (i.e., cash and equity) and debt financing sources
- Potential transaction structure (e.g., cash vs. debt ratio, leverage tranches)
- Management retention plan
- Intended role of equity owner(s) after the deal has closed
- Key items needing further diligence
- Planned diligence timeline
- Expected timeframe to close
There are four primary purposes of the IOI.
First, it allows the seller to retain higher participant quality by asking that buyers demonstrate a threshold level of commitment to advance to the next round. Second, it gives the seller color both on buyer seriousness and approximate valuation range. Third, it allows the seller to focus its time on a few players with which to have more intimate discussions. And finally, it limits the number of parties that are privy to the seller’s wealth of internal company data. Indeed, one of the biggest tradeoffs of having a very broad process is that a seller, in the process of executing a deal, risks giving away its most valuable trade secrets to an audience that’s larger than it needs to be.
After the buyer sends its IOI over, the seller can choose to either accept, negotiate, or deny the buyer’s terms.
Step VI: Letter of Intent
Assuming the seller and buyer agree on the terms of the IOI, the buyer enters the next round of bidding and begins an in-depth course of due diligence (“DD”). The aggregate time involved with diligencing a buyout target is generally between two and six months. However because of the high time and resource commitment involved, the buyer will usually negotiate and sign a letter of intent (“LOI”) with the seller after it has performed some diligence, but before it completes full DD.
By definition, the LOI is the agreement that documents, in detail, the buyer’s intention to execute the transaction and is substantively more thorough and legally declarative than the IOI. In an LBO, it outlines the investor’s plan to buyout the business and discloses the most important deal terms.
More importantly it gives the buyer exclusivity, which is effectively the right to purchase that business within a certain timeframe. It’s now common for buyers to request an exclusive negotiating period, which is meant to ensure that the seller is not shopping their deal to other bidders while appearing to negotiate in good faith. This is particularly important because buyers will frequently involve outside consultants and legal counsel to help with diligence, and as such, need assurance that it’s not throwing money at an assumed transaction while five other buyers are still in the mix.
The contract can be from two to ten pages long. It will usually include:
- Details on the format of payment, whether cash, stock, seller notes, earnouts, rollover equity, or contingent pricing
- Transaction structure specs defining the deal as a stock or asset purchase; generally speaking, asset deals protect the buyer from prior liabilities and provide a stepped-up tax basis and stock deals benefit the seller from a tax and legal perspective
- Updated estimate of closing date
- List of tasks that need to be completed by closing
- Approvals needed by the buyer (e.g., board of director vote) or seller (e.g., permissions from regulatory agencies) to complete the deal
- Binding period of exclusivity; this is usually one of at least three binding clauses in the contract and typically lasts between 30 and 120 days; while the duration might be negotiable, the presence of an exclusivity clause will almost always be non-negotiable
- Binding break-up fees; deals greater than $500 million in aggregate value usually include a fee schedule that protects the buyer from an owner withdrawal; this can either be a percentage (typically 6%) of the total transaction value or a fixed dollar amount
- Binding confidentiality terms that go beyond the original NDA
- Management compensation plans detailing which current executives should be retained post-transaction, their equity plans, and their employment terms; this is often worded vaguely to give the buyer latitude since it may not be in a position to make broad commitments to executives
- Any additional areas of due diligence required by the buyer
- Depending on the deal, a summary of the buyer’s expected escrow terms; this allows it to hold back a percentage of the purchase funds to cover future calls for past seller liabilities; this is generally highly negotiable and will sometimes be excluded from the LOI, and presented for the first time in the purchase agreement
The LOI is an important milestone in the successful sale of a company. While it doesn’t guarantee a closed deal, it’s a clear signal that the buyer has serious intentions.
Step VII: Negotiation
The negotiation process involves two primary parties — the seller and buyer — and, depending on the deal, several additional players — the sellside advisor (i.e., investment bank), sellside legal counsel, buyside advisor, buyside legal counsel, and buyside lenders.
The seller’s primary goals are to complete the sale, maximize its sale price, and secure a favorable buyer (meaning one that brings specialized experience to the table and / or with which it has a synergistic relationship). As a result, though its advisors are almost always involved in negotiations (more below) the seller has the final say in valuation conversations and bidder selection.
The buyer’s primary goals are to achieve a high internal rate of return (“IRR”) and a strong money multiple, the two most common measures of investment profitability. Funds are under pressure to hit a certain performance level because it (a) drives the amount of carry received upon exit, (b) influences future management fees and (c) determines whether future funds can even be raised. The three main drivers of performance are entry price, exit price, and leverage. As a result, buyers are rightfully focused on price and leverage during the negotiation.
The final acquisition price will be a balance between intrinsic valuation, market conditions, the buyer’s ability to reach its fund performance targets, seller expectations, and competition for the asset. Most LBO investors begin the valuation process (which launches months before the LOI) by identifying the maximum amount that they could pay in order to hit their return target.
The sellside advisor’s primary goals are to close the deal and maximize sale price. During negotiations it will provide support, counsel, and often represent the seller in conversations with buyers.
The buyside advisor is focused on helping the buyer find the right investment, closing the deal, and building relationships to support future business. It will create internal financial models to check valuation, assign independent credit ratings to the target, and validate the target’s ability to service a certain amount of debt.
The buyside lenders are the capital providers that fund the debt portion of a leveraged buyout (i.e., the revolver and term loans). Their primary goal is to put their cash into investments with a balance of decent risk and return characteristics. As a result, not only do they run their own due diligence, but also often step in to negotiate debt covenants aimed at mitigating borrower behaviors that might increase default risk.
To continue the series, read on to part III. It goes over what happens when the deal is executed, how investors create value during the multi year management period, and the most popular exit strategies.