Recently, I find myself engaged in fascinating conversations surrounding the strategies and thinking behind deal structures specific to leverage. It has been interesting to hear all of the perspectives behind how and why buyers/investors employ leverage. While just about all debt burdens on the transaction spectrum from a fully leveraged buyout at 90% debt to an all cash transaction can find an appropriate case example, I have been troubled by the number of individuals who are operating with a standardized model, never actually performing the specific case optimization work. It is this disconnect between sound reasoning and appropriate case-based application which prompted my interest in composing an article. While the examples and arguments in this article are by no means intended to be an exhaustive representation of the considerations surrounding effective application of leverage as an investment tool, it is my hope to provide enough information to trigger deeper conversations and richer analysis in transaction and balance sheet modeling.
The Myth of Free Equity
It shocks me to hear savvy investors talking about how they leverage their acquisitions so that the business can generate “free equity” for the fund.
There is no such thing as a free lunch, and a debt facility paid off by the business is not free equity. The profit that is stripped out of a business for debt service is money that will not be used as dividend to the fund or a reinvestment in growth. Every financial decision carries an opportunity cost.
Rather than generating free equity, what leverage does is allow an investor to get a percentage more equity than their cash on hand. In other words, a diligent and successful use of leverage could make the money within a fund go further and work harder.
Let’s explore one example:
- A $50M investment fund could buy one $50M business outright, or it could be employed to secure 5 $50M companies with 20% cash and 80% leverage.
- While the second scenario in which the fund holds $250M in investment assets seems like the obvious best investment, there are risks inherent in this strategy.
Let’s take these two cases for a spin on real world modeling:
- Let’s assume (for the sake of simplicity) that all businesses were valued at an EBITDA multiple of 2.5
- Some Statistics
- The current prime rate (as of 05/20/2020) is 3.25 [WSJ]
- Typical conventional lending adds 1-2 points to prime, so we will use a conventional rate of 4.75% for our calculations
- Let’s say that the discount rate or required return is 5%
- 86% or almost 9 out of 10 leveraged M&A transactions fail to deliver anticipated returns whereas better than one in three unlevered transactions exceed projections
- The economic growth rate is anticipated to be 2.5% on average over the next 15 years
- In the first case, a business is acquired for $50 M
- Based on all assumptions the business will follow this path
- Initial EBITDA = $20,000,000
- Average Growth Rate = 2.5%
- Fifteen year EBITDA = $28,965,963
- NPV of the free cash flow (unencumbered by debt) = $176,824,048
- Anticipated Realization Rate 30%
- In the second case, 5 $50M businesses acquired at 80% leverage
- Based on all assumptions, the platform will follow this path
- Initial EBITDA = $100,000,000
- The truth is that for each of these businesses to be saddled with $40M of long term debt would mean that their annual maintenance for a fifteen year facility would be $33M, $12M greater than their initial $20M cash flow.
- Even at a 2.5 multiple and a 2.5% annual growth rate, this LBO would never succeed, and the investors would likely lose all of their investment.
- Let’s try a more conservative 50% LBO
- This would mean purchasing two $50M companies
- The annual debt maintenance fees would be $20,673,134
- Combined NPV of the free cash flow = $55,324,165
- Anticipated realization rate 86%
So if we look at these cases objectively, the ROI on an all cash transaction is significantly better than that of an LBO, all other things being equal.
Why, if all of this is true, would anyone ever perform an LBO? Well, there are a couple of good reasons for this. For starters, investors are not a terribly patient bunch, and they demand to see their money working for them within a fund. Capitalization tables, and fund reporting metrics are significantly more exciting and impressive if they can show $250 in AUM versus $50 in AUM irrespective of leverage. Many PE firms get paid on the basis of AUM. My team and I charge a 2% management fee, and the incentive to drive our fees from $1M to $5M annually is always present. Secondly, there is a prevailing desire amongst investors to be highly diversified.
While diversification is a smart, proven and winning strategy in public market portfolio management, and also a driving principle within individual organizations, it doesn’t always make sense in the PE sphere. For starters, private equity firms are typically small, specialized shops. They frequently have one or more partners dedicated to securing investors, a handful of partners and analysts sourcing, vetting, and negotiating deals, and the smallest portion of their teams or working hours dedicated to working with the organizations they acquire. In this situation, diversity means complexity, and complexity means risk. If investors were truly savvy, they would be looking for the firms who invest strategically in a small number of businesses and industries, but who are capable of facilitating strategic diversification within their platform investments.
In conclusion, I would like to advise all entrepreneurs, investors, and firms to step back and genuinely take stock of their leverage strategies. While there is always a strong argument for leverage in situations where it supports a team to be opportunistic in seizing a moment that is beyond their capital capabilities, debt and specifically LBOs are not the wealth generating magic pill that many people I have spoken with recently seem to believe them to be. Discipline, planning and execution can frequently excel far beyond diversification and expansion. Do the math, exercise discipline, and you will deliver strong outcomes for your team, your investors, and most importantly the employees that are pouring their heart and soul into the operations.