LBO Capital Structure

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While each leveraged buyout is structured slightly differently, there is a typical structure to the LBO that occurs on deal after deal.

Roughly speaking, about half (50%) of an LBO’s capital structure typically includes Senior Debt, also known as Bank Debt financing. Senior Debt is the “cheapest” of all of the financing instruments used to buy a company via LBO: it has a lower cost of capital than other tranches of the capital structure, as it is the first in line in the capital structure to receive value during a liquidation of the company. Thus it will typically have lower interest rates than other debt components of the company’s capital structure.

The typical pricing (interest rate) on Senior Debt is the LIBOR rate plus 200 to 400 basis points (bps). In addition, Senior Debt (like most debt instruments) will require closing fees in the form of financing fees plus an Original Issue Discount. These are effectively upfront charges paid to the lenders for the consideration of lending the company/sponsor the money to purchase the company.

High Yield Debt, or Subordinated Debt, often represents about 20% to 30% of the capital structure of the newly acquired company. High-yield debt has higher financial costs than senior debt. However, high-yield debt typically has less restrictive covenants or limitations and interest-only payments with pay down due upon maturity of debt (bullet payment).

In a liquidation scenario, high-yield bondholders typically will not receive any compensation until the Senior Debt holders are paid in full. For this reason, High-yield bonds are often referred to as Junk Bonds, because the potential loss of investment capital is significant in many cases, and the bonds have little security for the investors aside from the cash flow generated by the company.

Subordinated debt can also consist of various types of mezzanine financing such as PIK notes, convertible preferred debentures, etc. Mezzanine financing is sometimes referred to as equity-like securities. These additional securities are typically smaller slices of the capital structure (usually around 5% apiece), and are junior to other forms of debt. They thus require an even higher expected return than other forms of subordinated debt, but decrease the amount of equity consideration the sponsor must contribute to purchase the company.

Equity, which represents the private equity fund’s capital in an LBO, is the most junior tranche of the capital structure. In other words, common equity shareholders are paid last during a liquidation of a company, after all other stakeholders. The equity is typically around 20-30% of the notional value of the capital structure, though it is sometimes more for certain deals.

Because the company is so heavily leveraged at acquisition, equity holders require a large projected internal rate of return on investment—typically, investors seek annual returns in the range of 20% to 40%.