Existing Debt in Leveraged

Buyouts:
Why It Doesn’t Matter
(Much)
LBO Models and Capital Structure
“How important is a company’s existing
capital structure, i.e. its Debt and Equity,
before it is acquired in a leveraged
buyout?”

“Some guides say that ‘ideal LBO

candidates’ should have minimal Debt.
But why does that matter at all?”
Capital Structure in Leveraged Buyouts
• SHORT ANSWER: These guides are incorrect – the existing capital
structure in a leveraged buyout does NOT matter! (Much)

• Why: In an LBO, the private equity firm replaces the company’s

entire capital structure with new Debt and Equity

• Typical Argument Against This: “But if a firm doesn’t have much

Debt yet, the PE firm can use more Debt to fund the deal!”

• PROBLEM: Nope… think about how the valuation and Debt

financing process works for a minute…
Capital Structure in Leveraged Buyouts
• Purchase Price: Almost always based on an EV / EBITDA multiple –
let’s say a 10x EV / EBITDA in this simple example

• Then: The PE firm will use an amount of Debt based on reasonable

leverage and coverage ratios, such as a 5x Debt / EBITDA median

• So: Regardless of whether the company has 0 Debt or 4x

Debt / EBITDA initially, it will still have 5x Debt / EBITDA afterward

• And: The PE firm will still have to contribute 5x EBITDA in the form
of Equity to do the deal!
Capital Structure in Leveraged Buyouts
• So: Since the multiple is based on Enterprise Value, existing Debt
would affect things only if it increased the company’s EV

• But: Does that happen? No! Raising additional Debt makes no

impact on EV since it increases both the company’s Cash and Debt

• Therefore: Existing capital structure doesn’t matter, unless you

believe that Debt increases a company’s Enterprise Value (wrong!)

• But: Are there any exceptions? Could existing Debt make a

difference? Yes, it could – time to go down the rabbit hole!
Rabbit Hole #1: Call Premiums
• Some Debt: Restrictions on early repayment – common with 10-Year
Unsecured Bonds

• Example: For the first two years, the Debt cannot be repaid; if the
company wants to repay it early after that, it must pay:
• Years 3-4: 105% of principal
• Years 5-6: 103% of principal
• Years 7-8: 101% of principal
• Years 9-10: 100% of principal

• So: “Call Premiums” make it more expensive to repay the Debt

early, increasing the company’s Purchase Enterprise Value in an LBO
Rabbit Hole #1: Call Premiums
• But: How much do they matter? Let’s say the company has
5x Debt / EBITDA already, and the Purchase EV / EBITDA is 10x

• If all the Debt has a 110% call premium, then the

Purchase EV / EBITDA increases to 10.5x

• Our Simple Model: IRR decreases by ~2%... Who cares?

• And: The call premium is usually much less than this

• Anything Else? Yes, let’s go down Rabbit Hole #2!

Rabbit Hole #2: Lender Familiarity
• People: Like what’s familiar – and investors are no different!

• So: If a company already has Debt, that could help its case in a
leveraged buyout because lenders might be more familiar with it

• Real-Life Analogy: If you want to borrow money for a home,

you need to show evidence of loan repayment history and not
being idiotic with credit cards

• Same Idea: If a company has borrowed responsibly, paid Interest,

and repaid its Debt in the past, it’s more reliable
Rabbit Hole #2: Lender Familiarity
• But: This point doesn’t affect the purchase price or the IRR – it just
makes it easier to get the deal done

• Maybe: You could argue that the company might get a lower
coupon rate or better terms if lenders know it… but that’s a stretch

• The Bottom Line: The company’s existing capital structure and

existing Debt barely make a difference
Recap and Summary
• Existing Capital Structure: Doesn’t matter – the PE firm replaces the
company’s Equity and Debt with all-new Equity and Debt

• Conflated Concepts: Yes, a company’s ability to service Debt matters

a lot, but that’s separate from how much Debt it has right now

• Exceptions: Call premiums can make a difference with some Debt,

especially longer-term bonds, and “lender familiarity” matters

• BUT: In the grand scheme of things, this is item #499 on the list of
criteria for ideal LBO candidates – purchase price, cash flow stability,
credit stats/ratios, etc. all matter far more