At Asperity, we have a monthly Lunchtime Learning session. 100-odd Asperity staffers in a room, bring your own lunch for a (hopefully interesting) talk about business. This Thursday, I’m doing the story of Asperity’s £25.5m sale to Inflexion Private equity. It’s called “Red Wine, Fancy Dinners & 680 signatures”. I wish it was as easy as that title suggests!
So with this very much on my mind, I thought I’d use my blog this week to establish some key concepts that will help everyone understand private equity. Probably the most important thing to understand is leverage, so here goes….
The leveraged buy out. As simple as I can do it!
Almost all deals done by private equity and venture capitalists (VC’s) are Levereged Buy Outs - so what does it mean and is it important?
Well a leveraged buy out is simply where you borrow money to buy something - a bit like buying a house or car. The loan is the leverage. And the loan is secured on the thing that you buy - the house or the company or the car. So if the loan isn’t paid back then the bank ends up owning the house, company or car.
A leveraged buy out is quite like a house mortgage. The difference just comes in the scale.
Valuation is key
When you buy a house, you have it independently valued and a professional valuer takes a sensible and cautious look at what the house is really worth. They look at other houses in the area, general trends in the local housing market and what the condition of the house is and then they settle on a sensible price. Then the bank lends you part of that money. So if your house is worth $250,000 the bank may lend you 90% of that, or $225,000 and you have to pay the rest in a deposit. This means if you don’t keep up the repayments the bank is pretty comfortable that they can get their money back on the house as the loan is for a maximum of $225,000 and the house at a sensible valuation is worth more than that. So far so good.
The bank also looks at your ability to repay the loan, and looks at your earnings to make sure you have enough money to pay the mortgage each month. Of course your circumstances may change - you or a partner may lose their job or work less hours and therefore earn less money. Or you may get into debt elsewhere and have less spare income so things can change. And all of this also happens in a levereged buy out. So lets map this onto a business.
Buying a business through a Leveraged Buy Out
Imagine you wanted to buy a business that is making £1 million profit each year. You might agree that you’ll pay the owner £7 million for it - which is 7 times the last year’s profits. A reasonable valuation for a growing business.
You could pay the whole £7 million yourself, but that might use up all of your cash. So instead, you go to the bank and ask if they would lend money on that business. You spend time showcasing the business to the bank, answering all of their questions and giving them all of the information on which they can evaluate the business - hopefully to see that it is a sound business with good prospects that is a good bet to lend money to.
In the end the bank agrees to lend £3 million, which you can now use as part of your £7 million to buy the business - so you only need £4 million of your own money.
You do all of this primarily because you believe that you can borrow money from the bank for a lower interest rate than your money is worth to you. So in our example above, rather than using £7m of your own money, you used £4m, leaving £3m of your money for other things. You’ll be paying interest on the £3m to the bank, but as long as the interest rate is lower than the return you think you can get on your £3m if you invested it elsewhere then you’re happy!
Who’s borrowing the money?
A Leveraged Buy Out is organised so the person doing the borrowing is actually the company being bought, not the buyer. It took me a little time to get my head around this at first, I have to be honest. I thought it was odd that the buyer didn’t borrow the money. It seemed odd that the company would borrow the money to then give it to the buyer who would then use it to buy the company. But then I realised that the buyer will own the company anyway, so it’s not that different really.
Think about it. If you want to buy the local dry cleaners for £250,000 and the dry cleaners is generating enough reliable profits for a bank to happily lend it £100,000, then you get the dry cleaning business to borrow that money at the exact same time that you buy the dry cleaners from its previous owners (the shareholders) for £250,000.
Then, when you write the check to the previous owners, you only need to write a cheque for £150,000 as the bank provides the other £100,000. And you now own a dry cleaners that has £100,000 of debt in it on day 1. This debt is called “senior debt” - because the company agrees to pay it back first, before any other loans it may have accumulated along the way. That’s one of the ways that banks try to improve their chances of getting their money back.
Now, think about liability
The good thing for you, as the buyer, is that if things go wrong the liability for the loan is with the company not with you. So in our example above it’s with the dry cleaning business rather than with you personally. So if the business falls on hard times and can’t make the loan repayments then the debt, the problems are between the bank and the business.
The bank can’t come chasing you for the money, because they lent it to the business. So if it really all goes wrong, the bank ends up foreclosing and owning the business. Quite a few large businesses that we all know are effectively owned by their banks right now.
To much leverage can make things go wrong.
One of the difficulties with leveraged buy outs is that businesses are harder to value than houses. House prices, despite recent troubles, are actually very stable over the long term. Unless the local area suddenly takes a real turn for the worst it’s very unusual for a house price to suddenly fall.
But even good businesses can be more fragile. A change to market conditions, fashion, consumer behavior, environment, competitors, or even just bad management can all change a company’s fortunes quite quickly.
If a bank has agreed to lend the company a lot of money compared to its profits, then a relatively small change in the company’s fortunes can make it unable to make it’s loan repayments. This happens more times than everyone would like and there are some high profile cases of this recently. The most newsworthy ones are often in retail.
Before a company becomes unable to make it’s loan repayments, it will normally “break it’s covenants”. You’ll have heard that term in the business press and tomorrow on my blog, we’ll talk about what covenants are and why they are important.