Private Equity: Episode 19 – The Financing Structure of an LBO
The LBO in PE
As we discussed in Episode 13, an LBO structure relies on borrowing in addition to capital contributions from investors. In an LBO, the equity contribution from investors is typically at least 30% of the total amount of the transaction. The remainder is completed by debt, which generally takes three main forms:
- Senior debt
- Junior debt
- Mezzanine debt
These debts are not necessarily all provided by banks but can also come from other investment funds specializing in these types of financings.
Senior Debt: This is a classic loan obtained from a bank. It is a first-ranking debt, meaning it is repaid before any other forms of debt. Depending on the amount borrowed, it may be arranged with one or more financial institutions. For larger amounts, the loan can be divided into several tranches, with deferred calls depending on the holding company’s needs. However, the constraints on this type of loan are quite stringent, with covenants that must be adhered to throughout the life of the loan.
Junior Debt: Also called subordinated debt, this is the second level of debt. It is conditional on the repayment of senior debt and is typically used to supplement mezzanine debt. It is often in the form of high-yield bonds (high yield bonds). The covenants associated with this type of financing are much less restrictive than those tied to senior debt.
Mezzanine Debt: This is a last-ranking claim, meaning it is subordinated to the repayment of all other debts. The principal repayment occurs only after all first-ranking claims have been settled, and the interest payment can be partially or fully deferred until maturity. This debt is typically in the form of convertible bonds or bonds with warrants, or it can be redeemable in equity to enhance return and minimize outgoing liquidity flows. Financing for this debt is provided by funds specializing in debt and helps bolster the holding company’s own resources in a bank loan transaction.
We will detail examples of LBO structures combining these various types of debt.
