Who are the lenders in an LBO

by definition every LBO transaction uses
a high amount of leverage typically at least 70 to 75 percent of the
acquisition price is financed with debt so undoubtedly lenders are an important
stakeholder and we need to be familiar with their role all transactions that
involve a high amount of leverage organized debt into several tranches
let’s provide an example financial debt can be structured in three tranches term
a term B and term C term a would be the most senior type of debt issued it will
cover 50% of the transaction price and will have a spread of 200 basis points
above LIBOR term B would be jr. regarding term a this means lenders who
participated in term a will be reimbursed before the ones who
participated in term B term a lenders have an advantage in terms of access to
collateral assets and this renders term B riskier the spread of term B reflects
this riskiness and it is priced at 250 basis points above LIBOR and finally we
will have term C which is the last layer of senior debt issued term a and term B
lenders will be reimbursed before term C lenders
hence it is riskier than both of them and not surprisingly it is priced at 300
basis points above LIBOR so these are the three tranches of senior debt
lenders can choose which one corresponds to their risk return appetite financial
sponsors the equity holders of the target are interested in gearing as much
debt as possible that is why sometimes they use paid in-kind instruments the
most common pick instrument is a mezzanine loan as you can sense from its
name this isn’t a pure debt instrument it is 50/50 half debt half equity a
mezzanine loan is typically composed of two parts a loan that must be
similarly to the three tranches we discussed before and an option which can
be converted into shares of the target upon completion of its sale this
provides a great upside to the owners of them as an enol own at the same time
they will be the first ones who will sustain losses if things go wrong with
the target so yes a mezzanine loan is another popular instrument used in most
LBOs it is significantly riskier than the other debt tranches but provides a
great upside if everything goes as planned
lb o–‘s are a risky business and lenders expect a good IRR senior lenders
remuneration will come from the spread on money market rates net of taxes they
will consider the initial debt drawdown amount the holding period of the deal
the periodic interest rates they will receive and the principal repayment they
will get at closing mezzanine investors have a different risk profile they make
an initial contribution receive periodic interest rates a principal repayment at
the closing of the deal and an equity kicker the equity kicker allows
mezzanine investors to acquire shares of the target at a predetermined price upon
closing which ensures they participate in the upside from the deal so this
covers it in terms of describing the debt structure in a leveraged buyout
starting from the next lesson we will build an LBO model in practice it would
allow you to see how the concepts we’ve seen so far can be applied in practice

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