Pain: LBO – what if leverage goes wrong?
A company approached us in relation to the leverage buyout (LBO) that they were about to execute.
The shareholders found the general idea of the LBO as very attractive and promising. However, their key concern was that managers are to push the company into too big risks. The managers prepared preliminary studies in-house and generally already agreed about the transaction conditions, while Consilue was engaged to give an independent third-party opinion about the deal.
Addressing the pain: Leverage buyout analysis
Consilue approach the case by studying in details both companies involved in the LBO. The main focus was given to:
- Detailed understanding of the environment, industry and business developments
- In-depth review of the past distressed performance of the target company
- Current indebtedness and determination of the maximum sustainable long-term debt levels
- Cyclicality of individual businesses and the effect on the repayments of financial obligations
- Analysis of the asset base and the market value volatility on the potential collateral reassurance
- Analysis of strength & stability of cash flows as well as the sensitivity effect under various scenarios
- The competences of the management (mainly in relation to the new challenges & capabilities required)
Results: Initial leverage buyout plan as too risky
The scenarios of leverage buyout prepared by the company management were carefully reviewed. After adjusting the sensitivity to more realistically reflect the underlying risks, the analysis showed that the target company dependency on clients in combinations with seasonality can have very risky outcomes and can be on the edge of the LBO survival ability. Consilue recommended the client to proceed with the leverage buyout deal, but update the financing structure to be less leveraged. The acquiring company should also immediately start with the measures to further diversify the sales structure and thus lower the dependency on clients.
Consilue also pointed out that the pessimistic scenarios of the leverage buyout all base on the cannibalistic financing effect of the acquiring company (decreasing the initially planned net investments), which is about to have a very negative impact on the development of the core business.
The consulting services proved that the LBO is too risky with the initially proposed financing structure. We are well aware that many LBOs are not well designed initially and this was one of our biggest fears as well. We are glad to realize that fact in the very first phase. Our management behavior is risk-loving due to their compensation scheme. Do not get me wrong, there is nothing wrong with high appetites of our managers, but they are simply forgetting about the risks involved in this leverage buyout case.
Decisions always need to be made in the context of risk-return scheme. With LBOs the acquired company helps to pay for itself. Since the process is often extended through-out a long period, the risks are multiplying and are of significant importance. It is of crucial to consider financing structure in the context of various (incl. extreme) scenarios and plan responses in advance.