As leveraged buy-out professionals, debt (i.e. leverage) is fundamental to what we do. When used properly, it enables us to generate higher returns on invested equity. It also instills valuable disciplines and practices in the companies we have invested in or acquired.
Although often feared – particularly by entrepreneurs – properly used debt can provide business owners the same benefits. Some things to consider about debt are: How much is desired? How much can be supported? What type? What is the lending environment?
How much debt is desired? This depends on how the debt will be used. Most often, debt is used to fund growth or to bridge working-capital cycles. Debt also can be used to buy new facilities, fund acquisitions or provide partial realizations to business owners. Potentially, any capital needs of a business can be funded with some form of debt.
How much debt can be supported? This is the key question. For the answer, look at your company’s trailing 12-month cash flow – or earnings before interest, taxes, depreciation and amortization (EBITDA). The appropriate amount of debt typically is talked about as a multiple of EBITDA. For example, if your company is not expected to grow much but has a very high certainty of stable EBITDA, the right amount of total debt likely will range from 1.5 to 2.5 EBITDA. If your company is on a high-growth trajectory, then the right amount of debt might be as high as 4 or 4.5 times EBITDA.
However, when doing this calculation, BE CONSERVATIVE! The reason debt is feared by many business owners is that, if things go badly, the lender(s) can become very intrusive and expensive and potentially take your company. In our investing, we are far more conservative than most other professionals. It is very rare for our leverage to exceed 2.5 times EBITDA, regardless of the company’s projections. Things can go very differently than planned.
What type of debt? Essentially, there are three types of debt: senior term, senior revolver and sub.
Senior term is typically partially or completely unsecured, will have scheduled principal reduction payments, and often requires additional principal reduction based on cash flow. Because it is not wholly secured, lenders charge more for this debt (
usually at least a point or two) and want it paid off as quickly as possible.
Senior revolver, known as asset based lending (ABL) is the most commonly available debt. It is wholly secured – typically by receivables, inventory and other more liquid assets. Virtually all senior lenders offer and compete for this type of debt, and it is the most competitively priced.
Sub debt (or mezzanine debt) generally is not asset secured and is far more expensive than senior debt. Sub debt should be viewed as the middle ground between senior debt and equity.
What is the current lending environment? For the most part, lenders are cyclical “pack” actors. The availability of debt ranges from too much (like we experienced from 2004 to 2007, where debt was often more than five times EBITDA), to very little (like now, when most lenders struggle to lend over 2.5 times EBITDA). Regardless of where we are in the cycle, it will change. Because a number of lenders have done very well over the past year or so because of their low cost of funds, we are again starting to see more aggressive, competitively priced proposals.
The amount and type of debt you seek will dictate which lenders to approach.
Regardless, you probably should use some debt – but use it wisely!
Dan Lubeck is founder and managing director of Solis Capital Partners (www.soliscapital.com), a private equity firm headquartered in Newport Beach, Ca. Solis focuses on disciplined investment in lower-middle market companies. Lubeck was a transactional attorney, and has lectured at prominent universities and business schools around the world. Reach him at firstname.lastname@example.org.
Have you ever thought of leading a management buyout of the company or division you are running? Now could be the ideal time.
You should consider leading a management buyout if:
- The owner is absentee or is thinking of selling
- You and your team drive the growth, and customers would follow if you left
- It is a noncore division of a much larger (preferably public) company
- It has done well over the past few years and/or is positioned to do well going forward.
Here are the key steps in leading a management buyout:
Find the right financial partner. This is your first, and absolutely most important, task. Unless you have adequate capital and experience in buyouts, your most likely financial partner will be a private equity professional or fund. There are literally thousands of private equity funds. So a good place to start is a referral from a certified public accountant or lawyer whose practice includes buyouts.
Your financial partner must have sufficient capital as well as a track record of successfully closing transactions of similar size and type. Equally important, the right partner must be someone you trust and are comfortable working with. Unless you bring a majority of the capital to the transaction, it is likely your financial partner will have control. So spend time with your financial partner candidates. Call leaders of their current and prior investments. Ask how the partner keeps his or her word, how he or she works with leadership, how he or she adds value and how he or she responds when things don’t go as planned.
Our firm views investing as “betting on leaders” and treats our leaders accordingly. Find a firm that truly lives that philosophy, and it will serve you and your company well.
Structure both of your deals. Once you select your potential financial partner, you have two transactions to negotiate: one with your financial partner and one for the purchase of your company.
For the financial partner deal, your team’s invested dollars should be treated exactly the same as the financial partner’s investment — with the same rights, preferences and priorities. Second, you should clearly define how the board will be governed and under what circumstances the board could terminate you or a member of your team. This is typically done with performance hurdles, about which you must feel very comfortable. Third, there should be a significant additional financial incentive if you perform at or above expectation.
For the company deal, your financial partner should add a lot of value and your collective efforts should be well orchestrated. One of the most important decisions is who leads the negotiation with the seller. Whether your financial partner stays completely in the background or takes the lead depends on the type of seller and the relationship between the seller and your management team. Also important is how much debt will be used in the transaction. Some private equity firms will use as much debt as is available. Our firm only uses the amount of debt appropriate for the company. Typically, this will not exceed 2.5 times the trailing 12-month EBITDA.
Close and create a lot of personal wealth. If Steps 1 and 2 are completed properly, you will position your company to realize your vision. Equally important, you will position you and your team to create some well-deserved wealth.
Dan Lubeck is founder and managing director of Solis Capital Partners (www.soliscapital.com), a private equity firm headquartered in Newport Beach. Solis focuses on disciplined investment in lower middle-market companies. Lubeck was a transactional attorney and has lectured at prominent universities and business schools around the world. Reach him at Dan@SolisCapital.com.