The financing consideration process. In this section, we will look at the financing consideration process, including addressing existing debt, evaluating debt capacity, analyzing the collateral base, considering the minimum equity contribution, simulating the expected ratings outcome and analyzing financial ratios.

When deciding on a leverage finance structure, you will consider the following. First, you should thoroughly analyze the target company's existing debt provisions and consider all financing alternatives, before formulating a leverage view. Then you will evaluate the debt capacity by using EBITDA multiples and other methodologies.

As a next step, it is essential to analyze the target company's collateral base as some assets might contribute to other forms of financing such as asset-based lending. Then you'll consider a minimum equity contribution, based on the expected sources and uses analysis. Next, it will simulate the expected credit ratings outcome which is important because it will decide the spreads on the debt and therefore the institutional investors' appetite. Lastly, you'll analyze key financial ratios to make sure that the expected capital structure works from the sponsor and lender's perspective. Keep in mind that the steps described are just guidance and in reality, you will need to revisit each step several times as all the components are closely connected. When you start considering a leverage buyout capital structure, you might ask how important is the existing debt structure of the target company? For the most part, it does not matter. Of course, there are some exceptions and this chapter will tell you what aspects you should look into in terms of the analysis of existing debt. In a leverage buyout in most cases, existing debt that resides in the balance sheet of the target company is retired or refinanced, because debt provisions are critical in a leverage buyout and sponsor companies, should have full control over it. Otherwise, existing covenants will prohibit, post-acquisition debt levels. You will need to analyze the pre-payability, covenants, lender relationship and breakage costs by looking into contracts of the existing loans and bonds. In terms of pre-payability, bank debt is typically prepayable at par, but bonds are typically un-prepayable, so debt retirement often entails some breakage costs. These costs should be calculated, before formulating the capital structure. For example, there may be a call premium, which is the amount above par value a debt security owner receives if the security is called or redeemed earlier than its maturity, it makes repayment of debt more expensive. Companies are often restricted from repaying debt early. If they want to repay early, they have to pay a call premium. Also covenants are specified in the existing debt, which includes limitations on mergers, additional debt, et cetera. Therefore, in the case of a new acquisition, debt retirement is necessary. The lender relationship should be revisited as the existing lenders are very close with the target company's management, business and credit profile and possibly they will want to help finance the company post-acquisition or post buyout. Debt capacity is determined considering the market lender and in institutional investors' appetite as well as the expected credit metrics. However, there's a rule of thumb, about what level of debt is acceptable at each tier of the capital structure, so here is an example of a capital structure. The debt capacity is evaluated based on proforma EBITDA, so we need an estimate of EBITDA here. Typically, on balance sheet bank leverage, which does not include a revolving credit facility is three to 3.5 times. Though we might be able to stretch this four times for asset-rich companies. Bond multiples are typically two to two and a half times. You can build a debt structure with these debt multiples and then create several financing scenarios with different multiples. In the same capital structure, we would start with 3x for the term loan A and 2x for the term loan B and one and a half for the subordinated notes. Of course, you will want to consult with banks to make sure that the debt composition and levels are reasonable given the market conditions at that point and we will also need to make sure that the debt level makes sense financially by analyzing the credit metrics, which will be explained later in the module. The next step is analyzing a collateral base. Collateral works as a backstop, in other words insurance to support leverage financing. In addition, collateral will allow lenders to find and diversify funding, because some types of assets can be a base for other kinds of loans. For example, suppose a company has a lot of real estate. In that case, there is a potential opportunity for significant real estate financing. For example, a collateralized mortgage backed security or sale leaseback of key real estate holdings. Also, if a company has a lot of receivables, such as accounts receivable and financial receivables, as well as inventories, asset-based lending, also known as ABL is an option. Let's suppose a company has many securities or investments, such as loans receivable. Loan securitization is a viable financing option here. Of course, these assets are utilized as a collateral base for a blanket lien. That is one of the most popular collaterals, you'll see in leverage finance. These facilities have many advantages, over conventional credit facilities. The merits of these financing methods are, additional liquidity and cheaper costs and those financing methods can be paired with other forms of capital, including private credit term loans, institutional term loans, high yield debt and traditional mezzanine financing. Over the years, ABL and securitization have evolved and they provide a financing solution that private equity sponsors should consider. The next step would be considering the equity contribution and there is no perfect answer in terms of how much equity is required. Generally, it is around 20 to 30%. Here's a simple example we will go through now on how to determine the equity contribution. This transaction assumes an EBITDA of a hundred million, an entry multiple of 9x, total debt multiple of six and a half times and transaction expenses of about 20 million. In practice, you will first decide the debt amount as explained on a previous page by inputting a certain debt multiple allowed in the market. In this example, a total debt multiple is 6.5x. You can get the total amount of debt of 650 million by multiplying the expected EBITDA and the debt multiple. Now, we can estimate the total uses of funds that will be needed to close the transaction, which includes the equity value of the target company, the repaid existing debt and transaction related fees, such as the advisory fee and debt issuance fee. Here, the total uses is 920 million. Then we can get the equity amount needed by subtracting the total debt from the total uses and that would be $270 million. The equity percentage of the capital structure is calculated by sponsor equity, divided by total capitalization and you get an equity percentage of about 29%. This is in line with typical range of equity contribution. This is simple math and the higher the leverage, the smaller the equity contribution. When deciding a reasonable amount of equity contribution, you need to be sure to factor how much rolled equity from the management stake will be a part of the transaction. When deciding the capital structure, it is important to consider ratings. If you want to have a higher IRR theoretically, you will leverage more and have less equity contribution. This will result in a higher rate of return, but as a hindsight, generally the expected credit ratings will fall. Lower ratings cause higher financing costs. For example, a yield that is mainly comprised of credit spread and a risk-free rate matched to its maturity is significantly different, among credit ratings. Here is a yield chart by different rating and tenor. As you can see, the difference is huge between triple C and B and B versus double B at five-year tenor. So, ideally structuring to double B or above and trying to avoid B or below on the bonds is preferable where possible. You would need to talk to the ratings advisory team, within the investment bank or commercial bank, about the expected ratings outcome. Also, if the company has an existing credit rating, it is always possible to have a conversation with the credit rating agencies about the transaction. When considering an appropriate capital structure for an LBO it is essential to target realistic credit statistics. There are typical credit statistics used in analysis for leverage buyouts; the leverage ratio, the coverage ratio, also called the debt service coverage ratio and the debt repayment rate. These ratios are often included in debt covenants and therefore useful parameters to analyze to make sure that a proforma capital structure is adequate or appropriate. Let's look at the leverage ratios. There are three main leverage ratios here. Total debt to EBITDA, senior secured debt to EBITDA and net debt to EBITDA. Leverage ratios help make sure that debt multiples make sense in the context of the overall purchase price multiple. As a rule of thumb, total debt leverage rarely exceeds six times EBITDA, but this depends on the market situation and the credit. If debt market is booming, financial sponsors may be able to leverage more. Next is the coverage ratio. Our coverage ratio is adequate. As a rule of thumb, the interest coverage ratio, should be at least two times the earnings metric. Of course, the higher the interest coverage, the better. Keep in mind that a denominator of coverage ratios, should be cash interest and that does not include any PIK or pay in kind interest. Lastly, evaluate the percentage of debt repayment. In reality you would just adjust the outstanding debt amount as well as the interest rate, while analyzing the equity returns such as IRR in tandem.