PE LBO

Debt Restructuring

• Debt restructuring involves renegotiating existing debt contracts to change characteristics (e.g., interest rate, maturity) or converting debt into equity.

Default and Financial Distress

• Default occurs when a firm fails to make scheduled payments or violates debt covenants.
• Direct costs of financial distress include lawyers' fees, consultant fees, and transaction costs to liquidate assets.
• Indirect costs involve reluctance from non-financial stakeholders to do business with the distressed firm.

Applicability and Procedures

• Debt restructuring is suitable for firms facing pure financial distress (temporary payment issues), but not for those in economic distress (negative NPV projects or declining performance).
• Two main procedures for debt restructuring: private workout and formal bankruptcy (Chapter 7 or Chapter 11).

Private Workout vs. Formal Bankruptcy

• Private workouts have lower legal and professional fees, shorter duration, no information leakage, and no judge intervention.

Chapter 11 Bankruptcy

• Under Chapter 11, debt and equity holders receive new financial claims, and a reorganization plan is proposed by management and approved by creditors and a judge.

Lender Behavior and Coordination Problems

• Lenders can be "tough" by increasing interest payments or collateral or "soft" by reducing interest or principal amounts and extending maturity.
• Coordination problems in debt restructuring include bank runs and holdout problems, where creditors might not cooperate or rush to claim their share.

Case Study: Eurotunnel

• Despite multiple restructurings, Eurotunnel remained over-indebted, leading to a significant debt buy-back strategy and eventual placement under judicial protection in 2006.

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Leveraged Buyouts (LBOs)

• An LBO is the acquisition of a controlling interest in a company using a significant amount of borrowed money (debt) along with equity from the sponsor.

Financing and Characteristics

• Financing typically includes equity from the sponsor and a significant amount of debt raised from banks.
• LBOs are considered high-risk but potentially high-reward investments, with the high level of debt creating a risk of bankruptcy.

Target Characteristics and Exit Strategies

• Good LBO targets have resilient cash flows, strong earnings history, market-leading position, growth potential, and strong management.
• Exits can be through an IPO, sale to another LBO fund, or a trade sale.

LBO Principles and Leverage

• Sponsors aim to achieve high returns on equity by acquiring a target with significant leverage, paying back debt using the target’s dividends, and exiting at a higher value.
• Leverage increases ROE by magnifying returns from equity investment, but it also increases the risk of financial distress.

Examples and Holding Period

• Famous examples of LBOs include KKR's buyout of RJR Nabisco and Blackstone's acquisition of Hilton Hotels.
• The typical holding period for an LBO investment ranges from 5 to 7 years, during which the debt is paid back and the target is prepared for exit.

Private Equity Fund Management

• General Partners charge 1.5%-2% management fees on funds under management and 20% carried interest, provided the hurdle return (often 8% per annum) is exceeded.