3 ms·

Because it doesn't work that way? The banks that fund the "giant loan" in #1 put in covenants preventing any payments to the equity investor (who has to put in

Because it doesn't work that way? The banks that fund the "giant loan" in #1 put in covenants preventing any payments to the equity investor (who has to put in their own money) from paying out on the equity until all the debt has been paid off. This is not their first rodeo. The nature of the covenants varies a lot between industries, but the general rule is that the banks won't lend into the deal unless they are guaranteed to get their money back out first (maybe the CEO gets a salary, but it's all specified in the debt documents upfront). That's almost the definition of leveraged finance. If you want to criticize the leveraged buyout model, a stronger critique is whether the equity investor is putting 10 bets down, where each has a 10% chance of a >10x return, which puts 9 companies at risk.

mediaman 9y ago
The covenants still typically allow the private equity investor to do a 'recap' (i.e., issues themselves a dividend) while still having the debt outstanding. This would come with restrictions, such as balance sheet ratios and interest coverage ratios. What the PE player would want to do is do the leveraged buyout, cut expenses to boost EBITDA, reduce working capital demand (create cash) by lengthening payables, collecting extended debts, and cutting inventory or selling off excess assets, and then once interest coverage is up from the EBITDA boost, issue a recap as big as the covenants allow to get much of the original equity risk off the table. Then they see if they can grow it, or sell it off, to get their multiple. Sometimes it works, sometimes the company goes through bankruptcy (ch 11) instead. It's not whether it always works, it's whether it works on average. The results have higher variance due to the higher leverage but it doesn't make it wrong.
ComputerGuru 9y ago
You’re not wrong, but neither is the parent. The way LBO works is you pick a juicy target with a lot of cash. Then you raise equity from others in your still-worthless company. Then you take out a loan for up to said company’s cash reserves plus the cash you’ve raised. Guaranteed win for sleazy VC and bank. Company is screwed, but their CEO probably got a nice bonus for negotiating the buyout plus a hefty separation package.

mediaman 9y ago

The covenants still typically allow the private equity investor to do a 'recap' (i.e., issues themselves a dividend) while still having the debt outstanding. This would come with restrictions, such as balance sheet ratios and interest coverage ratios. What the PE player would want to do is do the leveraged buyout, cut expenses to boost EBITDA, reduce working capital demand (create cash) by lengthening payables, collecting extended debts, and cutting inventory or selling off excess assets, and then once interest coverage is up from the EBITDA boost, issue a recap as big as the covenants allow to get much of the original equity risk off the table. Then they see if they can grow it, or sell it off, to get their multiple. Sometimes it works, sometimes the company goes through bankruptcy (ch 11) instead. It's not whether it always works, it's whether it works on average. The results have higher variance due to the higher leverage but it doesn't make it wrong.

ComputerGuru 9y ago

You’re not wrong, but neither is the parent. The way LBO works is you pick a juicy target with a lot of cash. Then you raise equity from others in your still-worthless company. Then you take out a loan for up to said company’s cash reserves plus the cash you’ve raised. Guaranteed win for sleazy VC and bank. Company is screwed, but their CEO probably got a nice bonus for negotiating the buyout plus a hefty separation package.