This document provides a summary of a research report on leveraged buyout (LBO) transactions. It discusses the various players involved, including private equity funds, sellers of companies, lenders and debt investors. It also outlines the sources and uses of funds in an LBO deal structure. Additionally, the report examines tax shield strategies utilized in LBOs and different exit routes private equity firms may take, such as initial public offerings. In summary, the document analyzes the market mechanisms, tax advantages and typical exit processes associated with leveraged buyout deals.

1.
MARKET MECHANISM, TAX
SHIELD AND EXITING OF AN LBO
Research
report
drafted
by
Guillaume
ALLEGRE
Under
the
supervision
of
Jean-­‐François
Louit,
Partner
in
Scotto
&
Associés.

2. Acknowledgements
Before
beginning
this
research
report,
I
would
like
to
express
my
appreciation
and
thanks
to
my
supervisor,
Partner
Jean-­‐François
Louit
who
has
been
a
great
advisor
for
me.
You
encouraged
me
in
my
research
and
help
me
in
order
to
construct
the
best
plan
I
can
find.
I
would
also
like
to
thank
Laurent
Durieux
who
has
been
so
precious
to
explain
what
I
have
to
look
for
in
order
to
draft
this
research
report.
I
can’t
thank
you
enough
for
encouraging
me
throughout
this
experience.
Your
advices
on
my
research
as
well
as
on
my
career
have
been
invaluable.
I
would
like
to
take
this
opportunity
to
thank
Partner
Richard
Schepard
and
all
his
associates
of
Bredin
Prat
Paris
Office
who
have
devoted
few
time
in
order
to
help
me
in
my
research
about
LBO
transactions.
2

3. Table
of
Contents
PART
I
–
PLAYERS
AND
FUNDS
TO
BUILD
AN
LBO.
..............................................................................................
9
CHAPTER
I
–
PLAYERS.
................................................................................................................................................................
9
SECTION
I
–
Current
owners
and
investors.
.......................................................................................................................
9
I
–
The
investor
in
an
LBO
transaction.
.................................................................................................................................................................
9
A)
The
financial
impact
of
private
equity
funds.
.........................................................................................................................................
9
B)
Return
on
investor’s
investment.
..............................................................................................................................................................
11
II
–
The
seller
of
the
company.
................................................................................................................................................................................
12
A)
Different
alternatives
to
sell
a
company.
...............................................................................................................................................
12
B)
Selling
a
company
through
an
LBO
transaction.
................................................................................................................................
12
SECTION
II
–
Lenders,
debt
investors
and
existing
creditors.
..................................................................................
14
I
–
Banks,
the
major
lenders.
...................................................................................................................................................................................
14
II
–
The
unsecured
lenders.
......................................................................................................................................................................................
16
III
–
The
risky
situation
of
existing
lenders.
.....................................................................................................................................................
17
CHAPTER
II
–
SOURCES
AND
USES
OF
FUNDS.
..............................................................................................................
18
SECTION
I
–
Sources
of
funds.
................................................................................................................................................
18
I
–
Equity
capital.
..........................................................................................................................................................................................................
18
II
–
Tranches
of
debt.
..................................................................................................................................................................................................
19
A)
First
lien
debt.
...................................................................................................................................................................................................
20
B)
Second
lien
debt.
..............................................................................................................................................................................................
20
C)
High
yields
and
junk
bonds.
........................................................................................................................................................................
21
D)
Mezzanine
debt.
...............................................................................................................................................................................................
22
SECTION
II
–
Uses
of
funds.
.....................................................................................................................................................
23
I
–
Structuring
an
LBO
transaction.
......................................................................................................................................................................
23
II
–
Share
deal
and
purchase
agreement.
...........................................................................................................................................................
24
A)
Acquisition
equity.
...........................................................................................................................................................................................
24
B)
Target’s
net
debt.
.............................................................................................................................................................................................
25
PART
II
–
TAX
SHIELD
AND
STRATEGIES
FOR
EXITING
AN
LBO.
...................................................................
26
CHAPTER
I
–
TAX
SHIELD
IN
AN
ACQUISITION
BY
LBO.
............................................................................................
26
SECTION
I
–
Tax
aspects
in
the
world.
...............................................................................................................................
27
I
–
Deductibility
of
interest
expenses.
.................................................................................................................................................................
27
II
–
Parameters
existing
in
France
in
order
to
reduce
taxes.
.....................................................................................................................
30
SECTION
II
–
Limitation
of
tax
leverage:
example
in
France,
The
Netherlands.
.............................................
32
I
–
Example
in
France.
................................................................................................................................................................................................
32
A)
The
“Charasse
amendment”
followed
by
the
“Carrez
amendment”.
.........................................................................................
32
1
–
Charasse
amendment.
............................................................................................................................................................................
33
2
–
Carrez
amendment.
.................................................................................................................................................................................
34
B)
Parent-­‐subsidiary
regime:
a
new
French
tax
on
dividend
distributions.
................................................................................
35
II
–
The
Netherlands.
..................................................................................................................................................................................................
36
CHAPTER
II
–
EXIT
ROUTES
IN
LBO
TRANSACTIONS.
................................................................................................
37
SECTION
I
–
Exit
planning
considerations.
......................................................................................................................
37
I
–
Initial
public
offering;
“Reverse
LBO”.
..........................................................................................................................................................
37
II
–
Alternative
ways
for
exiting
an
LBO
.
..........................................................................................................................................................
39
SECTION
II
–
Capital
gain,
carried
interest
and
tax
aspects.
...................................................................................
40
I
–
Concept
of
carried
interest.
...............................................................................................................................................................................
40
II
–
Comparison
between
the
USA
and
in
France.
..........................................................................................................................................
41
3

4. List
of
abbreviations.
LPs:
Limited
Partnerships,
LLPs:
Limited
Liability
Partnerships
LLCs:
Limited
Liability
Companies
LBOs:
Leveraged
Buyouts
PEF:
Private
Equity
Funds
EBITDA:
Earnings
Before
Interest,
Taxes,
Depreciation
and
Amortization
LIBOR:
London
Interbank
Offered
Rate
ESOP:
Employee
Stock
Ownership
Plan
SPA:
Share
Purchase
Agreement
SEC:
U.S.
Securities
and
Exchange
Commission
TEV:
Transaction
Enterprise
Value
ETR:
Effective
Tax
Rate
GAAR:
General
Anti
Avoidance
Rule
SPV:
Special
Purpose
Vehicle
IPO:
Initial
Public
Offering
CFC:
Controlled
Foreign
Corporation
CBTD:
Cross
Border
Tax
Differential
CPS:
Cash
Pooling
Scheme
4

5. Today,
every
student
who
is
looking
for
a
job
in
investment
banking
law
or
corporate
finance
is
probably
going
to
have
to
know
one
thing
or
two
about
companies
buying
others.
There
are
many
types
of
transactions
to
buy
a
company
but
one
of
them
will
be
especially
studied
during
this
research
report,
the
LBO.
An
LBO
or
leveraged
buyout
is
simply
put,
one
company
buying
another
one
and
using
for
this
a
large
amount
of
debt.
That’s
it.
So
why
all
the
fuss
about
this
type
of
transaction?
Why
today
the
international
press
speak
about
the
LBO
and
his
bad
economics
consequences?
Why
does
this
type
of
transaction
is
preferred
from
other
types
of
mergers
and
acquisitions?
In
fact,
the
answer
rests
in
the
inherent
risks
that
go
with
a
transaction
that
financed
primarily
with
borrowed
money
that
is
to
say
with
debt.
By
way
of
introduction,
there
are
few
specifics
things
that
we
need
to
mention
about
the
debt
used
in
a
leveraged
buyout
transaction.
At
first,
the
assets
of
the
target
very
often
secure
the
debt
that
we
use
to
acquire
the
target
company.
That’s
an
essential
point
in
every
LBO.
Indeed,
the
potential
buyer,
namely,
the
person
who
would
like
to
acquire
the
target,
does
not
necessarily
need
to
possess
the
financial
amount
to
purchase
this
target.
Indeed,
the
target
just
needs
to
have
enough
available
collateral
(in
the
form
of
assets)
to
allow
an
outside
purchaser
to
have
bank
debt
financing
in
order
to
pay
for
the
transaction
and
the
cost
that
has
been
stipulated.
This
plan
supposes
the
target’s
assets
secure
the
bank
debt.
The
second
point
to
mention
about
the
nature
of
the
debt
is
that
it
can
come
from
either
bonds
or
bank
loans
(these
notions
will
be
detailed
after).
If
the
case
of
bonds,
this
means
that
it’s
issued
and
sold
to
investors
in
capital
markets.
As
we
study
it
later,
the
high
levels
of
debt
associated
in
LBO’s
transactions
very
often
results
in
the
bonds
being
rated
as
junk
or
below
investment
grade.
We
easily
understand
that
as
credit
ratings
are
used
to
appreciate
the
risk
of
default,
loading
up
a
target
with
debt
will
naturally
increase
this
risk.
Moreover
and
to
continue
in
this
idea,
the
higher
the
risk,
the
higher
the
interest
rate
the
bank
or
the
market
is
going
to
demand
for
lending
the
money.
In
the
case
of
the
debt
is
structured
by
bank
loans,
financing
means
come
directly
from
banks
rather
than
buyers
of
bonds
in
capital
markets.
That’s
an
advantage
for
the
purchaser
in
terms
of
security
of
the
debt.
Bank
loans
included
interest
expenses,
which
will
be
often
calculated
as
a
variable
rate.
It’s
common
for
the
lender
to
charge
5

6. the
borrower
an
interest
rate
of
LIBOR
and
an
additional
amount
of
money
which
is
called
“spread”.
The
LIBOR
is
the
short
term
for
London
Interbank
Offered
Rate.
Simply,
it’s
the
interest
rate
at
which
banks
offer
to
lend
funds
to
one
another
in
the
international
and
interbank
market.
It’s
set
every
day
approximately
at
11
AM,
by
a
certain
number
of
international
banks.
The
spread
is
an
indicator
of
the
risk
that
is
associated
with
the
borrower
and
the
seniority
of
the
loan
in
the
case
of
default.
Another
important
point
of
bank
loans
is
that
the
lending
is
often
syndicated
amongst
a
group
of
banks
in
order
to
decrease
the
amount
of
lending
exposure
to
any
borrower
that
is
to
say,
in
order
to
reduce
the
risk
of
bad
loans.
Indeed,
it’s
easily
to
understand
that
if
the
amount
of
loan
is
split
into
many
banks,
the
risk
of
a
default
scenario
is
consequently
reduced.
For
example,
if
a
bank
would
lend
an
amount
of
money
to
a
fund
in
order
to
buy
a
target
with
an
LBO
transaction,
this
bank
has
a
couple
of
choices.
On
the
one
hand,
the
bank
can
lend
$100
million
to
the
buyer
and
charge
an
interest
expense
of
LIBOR
plus
the
spread.
On
the
other
hand,
the
bank
can
lend
$10
million
to
the
investor
and
get
nine
other
banks
in
order
to
lend
the
remaining
amount
that
is
to
say
$90
million.
The
rate
of
interest
charged
will
still
be
LIBOR
and
the
same
spread.
Under
both
scenarios,
the
sum
of
money
that
the
bank
earned
from
interest
charged
is
the
same
but
there
is
a
reason
to
choose
the
second
possibility.
Indeed,
what
makes
this
option
the
better
is
about
a
default
scenario
namely
when
the
buyer
can’t
reimbursed
the
amount
granted.
If
the
bank
chooses
the
first
scenario
and
if
the
buyer
is
not
able
to
pay
back
its
loan,
the
bank
takes
on
solely
all
the
losses
associated
with
this
bad
loan.
By
contrast,
if
the
second
possibility
is
chosen,
the
losses
are
split
over
the
ten
lending
banks
and
interest
that
has
been
charged
is
still
coming
in
from
the
other
nine
banks
that
are
current
with
their
interest
payments.
In
general,
we
can’t
deny
the
fact
that
bank
loans
are
far
more
complicated
and
so,
multi
faceted
than
bonds.
There
are
many
different
types
of
loans,
including
term
loans,
revolving
credit
facilities,
but
the
most
important
thing
to
realize
is
that
these
banks
loans
can
have
floating
interest
rate
and
very
often
times,
these
loans
are
syndicated
amongst
several
lenders
as
we
said
it
above.
Contrary
to
banks
loans,
bonds
are
considered
as
fixe
rated
instruments
and
consequently,
sold
in
capital
markets.
6

7. Why
do
a
leveraged
buyout?
The
answer
is
quite
simple:
to
build
an
LBO
requires
a
very
close
cooperation
between
the
equity
and
debt
providers
but
the
purpose
in
the
end
is
to
make
money.
Indeed,
any
LBO
has
for
essential
goal
to
achieve
the
higher
return
on
the
initial
equity
investment
of
the
investor.
For
example,
we
can
imagine
a
company
purchased
for
an
amount
of
$100
million.
If
the
investor
acquires
this
company
with
100%
equity
capital
and
later,
sold
it
for
$110
million.
In
this
case,
the
investor
just
made
a
10%
return
on
his
initial
investment.
Alternatively,
if
the
investor
is
able
to
obtain
a
(secured)
loan
for
$90
million
and
made
an
initial
equity
capital
investment
of
$10
million.
He
has
to
pay
interest
expense
on
the
loan
contracted,
which
happens
approximately
to
be
7%
per
year.
After
one
year,
if
the
investor
is
able
to
sell
the
company
for
$110
million,
he
will
have
to
pay
down
the
$90
million
loan
and
pay
$6,3
million
for
interest
expense.
He
is
left
with
approximately
$14
million
for
himself,
so
a
gain
of
$4
million
compared
with
the
first
investment.
However,
if
it’s
true
to
say
that
a
leverage
transaction
present
several
advantages
to
investors,
we
can’t
forget
that
at
the
same
time,
an
LBO
bring
significant
risks.
It’s
principally
the
ability
of
corporations
to
execute
restructuring
plans
(steps
post
LBO),
which
will
determine
if
a
company
can
sufficiently
handle
the
interest
burden.
Where
come
from
the
leverage
in
an
LBO?
Classically,
the
leverage
comes
from
the
following
three
factors.
At
first,
a
financial
leverage
that
is
to
say,
an
optimisation
of
the
costs
of
funds.
Secondly,
a
legal
leverage
namely,
the
possibility
to
take
the
control
of
the
target
with
minimal
equity
capital.
In
the
end,
a
fiscal
leverage.
On
this
point,
we
will
study
later
that
tax
shield
results
on
the
debt
financing.
Financial
and
fiscal
leverage
are
of
course,
greatly
reliant
on
the
ability
of
the
target
group
to
service
the
acquisition
finance.
Legal
leverage
is
organized
around
mezzanine
finance
or
quasi-­‐equity
(it’s
subordinated
loans
or
convertible
loans),
one
or
more
acquisitions
vehicles
and
dynamic
equity
instruments
and
other
vehicles
such
as
securitisation
(all
these
points
will
be
developed
later
in
the
report).
What
about
the
history
of
leveraged
buyouts?
LBOs
reached
a
peak
approximately
in
2005
but
the
first
big
leveraged
buyout
took
place
in
1955
when
McLean
Industries
Incorporation
bought
two
companies 1 .
The
amount
of
money
that
has
been
borrowed
was
$42
million
and
this
transaction
raised
a
great
return
of
investment.
A
new
leveraged
buyout
boom
took
place
in
1980,
particularly
in
1976
with
the
formation
of
KKR
(Kohlberg,
Kravis
and
Roberts),
a
private
equity
fund
specialised
in
leveraged
buyouts.
One
of
the
largest
LBO
is
certainly
the
acquisition
by
KKR
and
Goldman
Sachs
of
Energy
Future
Holdings
for
$44
million
in
2007.
Since
our
currently
1
International
Chamber
of
Commerce
n°
MC-­‐F5876.
7

8. economic
slowdown,
the
number
of
LBO
has
decreased
and
today,
the
returns
of
investment
are
more
modest
than
the
last
10
years.
Indeed,
the
crisis
has
resulted
in
a
diminution
of
gains
for
the
investors
who
would
purchase
a
company
by
an
LBO
transaction.
It’s
easily
understandable
because
a
lot
of
company
are
today
in
financial
troubles
and
we
know
that
leveraged
buyouts
comes
with
risks.
When
times
are
good
that
is
to
say,
when
a
company
is
producing
enough
earnings
to
pay
its
suppliers,
employees
and
the
others,
LBO
is
a
beautiful
thing.
But
in
times
of
trouble,
as
today
with
the
crisis,
when
the
target
acquired
is
not
generating
profits,
LBO
can
be
a
deathblow.
The
principal
risk
is
the
risk
of
bankruptcy
if
the
company’s
returns
are
less
than
the
cost
of
the
debt
financing.
Moreover,
about
a
certain
number
of
situations,
it’s
possible
that
investors
are
not
able
to
respect
their
interest
expense
obligation.
In
good
times,
leverage
seems
as
a
wonderful
idea
but
in
bad
times,
the
interest
burden
can
weigh
on
the
company;
it
becomes
a
weight
and
can
sink
the
company
in
an
ocean
of
debt.
In
the
case
of
a
bleak
economic
horizon,
it’s
very
possible
that
the
company
has
to
file
for
bankruptcy
and
will
be
liquidated
by
the
sale
of
its
assets.
So
what
is
the
situation
of
the
players
who
participated
in
the
LBO
transaction?
Obviously,
the
lenders
are
first
in
line
to
obtain
any
proceeds
from
this
sale.
They
recoup
a
portion
of
the
debt
they
granted
in
the
leveraged
transaction
so
their
losses
may
be
limited.
What
about
the
equity
investor?
Unfortunately
for
him,
he’s
wiped
out
for
his
initial
10%
(or
more)
equity
investment.
During
this
research
report,
two
parts
will
be
successively
dedicated
to
leveraged
buyouts.
In
the
first
part,
it
will
be
important
to
define
the
general
structure
of
an
LBO.
In
other
words,
our
attention
must
be
focused
on
two
aspects
of
this
type
of
transaction.
On
the
one
hand,
the
different
players
who
decide
to
build
an
LBO.
On
the
other
hand,
sources
and
uses
of
funds
which
are
used
within
this
transaction.
8

9. PART
I
–
PLAYERS
AND
FUNDS
TO
BUILD
AN
LBO.
We
need
to
distinguish
between
two
types
of
issues.
Who
are
the
main
actors
and
what
is
their
role
in
the
transaction?
Secondly,
where
are
the
funds
come
from
and
how
can
players
use
of
it?
CHAPTER
I
–
PLAYERS.
All
players
have
a
decisive
role
in
an
LBO.
They
can
be
split
into
two
categories.
There
is
the
seller
who
manages
the
target
and
who
must
decide
to
accept
or
not
the
purchase
offer.
But
the
principal
actor
in
this
transaction
will
definitely
be
the
investor.
It
can
be
an
individual
or
a
private
equity
group.
SECTION
I
–
Current
owners
and
investors.
Every
LBO
starts
with
the
investor
who
has
the
central
role.
Everything
starts
when
the
individual
or
private
equity
group
sees
an
opportunity
and
sets
the
process
in
motion.
So,
what
is
a
private
equity
fund
and
how
the
investor
can
realize
the
greatest
return
possible
on
his
initial
equity
investment?
I
–
The
investor
in
an
LBO
transaction.
Leveraged
buyouts
are
the
most
common
investment
strategy
used
by
private
equity
firms.
A)
The
financial
impact
of
private
equity
funds.
A
private
equity
fund
is
often
used
to
making
investments
and
profits.
Classically,
in
a
private
equity
deal,
an
investor
or
a
group
of
investors
buys
a
stake
in
a
company
that
he
has
chosen
with
the
hope
of
ultimately,
making
an
increase
in
the
value
of
his
initial
investment.
Today,
we
can
say
that
it
exists
a
private
equity
industry2,
which
is
a
major
force
in
the
world.
When
funds
take
the
control
of
the
company,
they
will
usually
take
the
company
off
the
market
if
the
company
isn’t
private
already,
go
through
a
certain
period
of
restructuring
process
and
then,
relist
this
company
on
the
stock
market.
Private
equity
funds
are
typically
organized
as
limited
liability
partnerships
–
LLP,
where
institutional
investors
make
a
capital
commitment
to
fund
investments
over
2
“Valuation
;
measuring
and
managing
the
value
of
companies”,
written
by
McKinsey
and
Company
incorporation,
July
26,
2010.
9

10. the
duration
of
the
fund.
Of
course,
private
equity
funds
have
a
large
variety
of
investment
strategies
but
they
tend
to
be
specialized
in
venture
capital
funds
and
as
far
as
we
are
concerned,
buyout
funds.
Buyout
funds
have
typically
sought
to
leverage
their
equity
investment
with
debt,
and
are
more
concerned
with
the
ability
of
a
company
to
generate
cash
flows
(which
will
be
used
to
reimbursed
the
debt)
than
are
a
venture
capital
fund.
At
its
most
basic
level,
a
private
equity
fund
is
a
large
sum
of
money
that
is
invested
in
a
public
(more
rarely
private…)
company.
The
fund
is
managed
by
a
team
of
skilled
investment
professionals
who
rapidly
identify
investment
opportunities,
make
transactions
and
provide
management.
Structuring
a
fund
requires
a
particularly
attention
about
state
regulations,
including
securities
law
issues,
tax
problems,
liability,
or
other
issues.
Generally,
funds
solve
these
issues
through
a
limited
partnership
model,
in
which
the
investors
hold
limited
partner’s
interests
and
the
management
team
holds
an
interest
in
an
entity
that
serves
as
the
general
partner
(refer
to
the
drawing
below).
For
example,
in
the
USA,
private
equity
funds
are
typically
organized
under
“Investment
Advisers
Act”3.
More
especially,
US
based
funds
are
often
organized
as
Delaware
limited
partnerships.
Indeed,
Delaware
law
is
used
because
of
its
familiarity
to
most
practitioners
and
investors.
Private
equity
funds
formed
to
invest
outside
of
the
US
are
often
formed
as
LPs
or
LLCs
in
offshore
jurisdictions
with
favourable
tax
regimes
like
the
Cayman
Islands,
the
Channel
Islands
or
Luxembourg.
The
purpose
of
the
fund
limited
partnership
is
to
eliminate
entity-­‐level
tax
and
protect
the
investors
in
the
fund
from
personal
liability
for
debts
and
obligations
of
the
fund.
As
we
have
said,
this
model
is
most
typically
implemented
through
a
limited
partnership,
but
benefits
can
be
achieved
through
a
limited
liability
company
–
LLC
–
in
jurisdictions
where
this
form
exists.
Private
equity
funds
are
managed
by
a
management
company
organized
by
the
3
Investment
Advisers
Act,
1940,
amended
and
approved
January
3,
2012.
10

11. sponsor,
which
may
act
as
the
“general
partner”
of
the
fund.
This
management
company
will
play
an
important
role
in
order
to
raise
investment
capital
and
execute
investment
transactions.
The
purpose
of
a
private
equity
fund
that
engage
in
LBO
transactions
is
to
achieve
the
most
significant
return
on
investment.
B)
Return
on
investor’s
investment.
Private
equity
funds
have
access
to
capital
for
investment
and
the
best
way
for
them
to
make
money
is
to
put
the
money
that
they
do
have
to
work,
in
the
form
of
investments.
They
look
for
a
strong
takeover
target
with
small
amounts
of
debt,
strong
cash
flow
and
assets
free
for
use
as
collateral.
The
investors
spend
lots
of
time
analysing
the
potential
returns
from
prospective
deals
and
eventually
choose
whether
to
move
on
a
company
or
not.
The
choice
of
the
target
is
so
very
important
for
any
LBO
transaction
because
the
amount
of
debt
will
be
reimbursed
by
dividends
from
the
target.
The
investor
is
so
the
“catalyst”
behind
the
transaction.
He
must
decide
how
aggressive
or
conservative
should
be
any
offer
that
is
put
forth
the
current
ownership.
To
a
certain
extent,
he
also
decides
how
much
leverage
to
use
in
the
transaction
and
more
exactly,
it’s
only
to
a
certain
extent
because
at
points
of
excessive
leverage
or
non-­‐creditworthy
deals
the
lenders
will
decline
to
award
credit.
The
investor
has
totally
discretion
over
the
multiple
of
earnings
it
is
wiling
to
assign
as
valuation
and
therefore
the
purchase
price
for
the
target
company.
It’s
up
to
the
investor
to
decide
what
is
a
reasonable
valuation
and
what
is
offer
price
for
a
company.
It’s
naturally
a
decision
that
must
take
multiple
factors
in
consideration.
Of
course,
the
investor
will
negotiate
with
the
seller
of
the
company
in
order
to
reduce
the
price
as
much
as
possible.
The
investor
is
motivated
to
ultimately
realize
the
greatest
return
possible
on
his
investment.
This
is
easier
said
than
done.
There
are
many
factors
that
can
affect
the
outcome
but
in
the
simplest
sense,
it
is
easier
to
realize
greater
returns
on
equity
capital
if
that
equity
is
a
small
number.
In
other
words,
the
greater
the
amount
of
capital
is
low
and
so,
the
greater
the
amount
of
money
borrowed
is
important,
the
greater
the
leverage
will
be
important
so
the
investor
has
to
play
as
much
as
possible
with
the
financial
leverage.
However,
the
investor
doesn’t
want
to
saddle
the
company
with
such
debt
that
he
risks
losing
his
entire
investment
because
of
a
possible
default.
So
for
this
reason,
the
investor
is
motivated
to
find
a
balance.
The
ideal
is
the
greatest
amount
of
debt
possible
that
will
not
also
sink
the
company
down
the
road,
leaving
it
able
to
pay
11

12. down
debt,
increase
earnings
and
eventually
be
sold
at
greater
multiple
of
earnings
than
it
was
purchased
for.
The
investor
has
so
a
primary
role
in
an
LBO
but
this
role
is
equally
risky.
To
a
certain
extent,
we
can
say
that
the
fate
of
the
transaction
is
already
known
when
the
amount
of
debt
and
equity
are
determined
after
negotiations
although
unpredictable
events
may
affect
the
transaction.
II
–
The
seller
of
the
company.
A)
Different
alternatives
to
sell
a
company.
Based
upon
the
attributes
of
the
business
and
the
overall
objectives
of
the
owners
of
the
target,
there
are
a
certain
number
of
alternatives
that
might
be
a
better
fit
in
order
to
sell
a
company.
These
alternatives,
including
for
example
dividend
recapitalization
and
leveraged
buyouts,
can
be
attractive
to
shareholders
from
both
a
valuation
and
great
outcome.
Dividend
recapitalization
is
a
process
that
provides
shareholders
with
the
ability
to
take
cash
out
of
the
company
by
raising
bank
debt
to
support
a
special
dividend.
This
strategy
was
particularly
popular,
for
example
in
the
USA
in
2010,
in
anticipation
of
expected
capital
gains
tax
increases
in
2011.
Another
alternative
would
be
to
adopt
an
employee
stock
ownership
plan,
a
widely
used
method
in
the
USA.
It
involves
the
creation
of
a
retirement
benefit
plan
that
borrows
money
in
order
to
acquire
stock
in
the
company.
Company
assets
must
guarantee
the
debt
and
the
proceeds
are
also
used
to
purchase
stock
from
existing
shareholders
and
from
the
company.
The
main
advantage
of
this
method
is
tax
issues.
But
today,
if
you
are
a
business
owner
looking
to
sell
your
company,
your
potential
buyer
will
most
likely
include
private
equity
funds
as
previously
said.
An
LBO
can
also
be
accomplished
through
a
private
equity
firm.
B)
Selling
a
company
through
an
LBO
transaction.
To
gauge
the
potential
interest
level
of
private
equity
funds,
a
business
owner
should
develop
an
understanding
of
what
this
fund
look
for
in
an
acquisition
and
why.
The
seller
also
has
an
important
role
in
the
transaction.
Indeed,
the
current
owners
of
the
company
are
the
people
who
should
know
the
most
about
the
target,
both
inside
and
out.
They
understand
the
history
and
development
of
the
company
as
well
as
the
operating
environment
in
which
they
do
business.
The
seller
and
investors
should
cooperate.
The
owner
of
the
target
is
more
likely
to
provide
information
about
income,
assets,
financial,
economic
and
social
organization
of
the
target.
12

13. The
current
owners
should
also
have
a
keen
sense
of
where
the
market
for
their
product
is
heading.
It
would
be
wrong
to
say
that
the
seller
has
a
passive
role
in
the
LBO,
he
has
a
really
interest
in
working
hand
in
hand
with
investor.
It’s
up
to
the
owners
of
the
company
to
consider
and
ultimately
accept
or
decline
offers
to
sell
their
ownership
in
the
company.
As
part
of
the
process,
the
owners
will
most
likely
try
to
negotiate
a
larger
multiple
of
earnings
into
the
purchase
price.
It
is
the
job
of
the
owners
to
test
the
upper
limits
of
what
the
purchasers
are
willing
to
pay
for
the
target
and
then,
try
to
take
that
offer
price
a
little
further.
Business
owners
will
find
all
sorts
of
justification
for
deserving
a
large
multiple
for
their
earnings;
after
all,
that
is
what
they
are
supposed
to
do…
When
a
business
owner
arrives
at
the
decision
to
sell,
there
are
few
greater
motivations
than
money.
Although,
some
business
owners
may
also
consider
such
things
as
the
identity
of
the
purchaser,
the
future
of
the
company
post-­‐sale,
and
the
likelihood
and
degree
of
cost
cutting
after
sale,
rarely
do
any
of
these
considerations
trump
monetary
pay-­‐off.
It
is
safe
to
say
that
the
primary
motivation
of
the
business
owner
is
to
get
the
greatest
valuation
and
sale
price
possible
for
the
business.
If
the
company
has
a
bright
future
en
growth
potential
is
still
relatively
high,
a
savvy
owner
will
logically
demand
a
greater
multiple
of
earnings
for
a
purchase
price
before
agreeing
to
sell.
Today,
business
sellers,
buyers
and
advisors
of
them
are
facing
many
problems
with
respect
to
bringing
a
transaction
with
a
successful
conclusion.
The
values
are
down,
financing
is
tough
even
non-­‐existent,
liquidations
are
increasing,
and
sellers
and
buyers
are
also
giving
up.
Buyers’
advisors
say
that
the
valuation
is
too
high
based
on
financing;
the
sellers’
advisors
say
the
price
is
too
low
and
the
sellers
need
in
a
certain
extent
an
all
cash
sale
to
avoid
risk.
While
the
economy
has
made
it
more
difficult
for
buyers
to
obtain
the
optimal
amount
of
financing
required
for
leveraged
buyouts,
those
buyers
can
attempt
to
bridge
this
financing
gap
by
having
sellers
provide
seller
financing,
for
example
in
the
form
of
seller
notes
or
earn
out
payments.
We
can
define
seller
notes
as
a
common
means
used
to
bridge
the
financing
gap
also
it
consists
in
asking
the
seller
of
a
business
to
provide
seller
financing
by
taking
a
portion
of
the
purchase
price
in
the
form
of
a
“note”
issued
by
the
target.
So
more
simply,
it’s
a
form
of
debt
financing
used
generally
in
small
business
acquisitions
in
which
the
seller
agrees
to
receive
a
portion
of
the
purchase
price
as
a
series
of
instalment
payments.
In
some
LBOs,
the
business
buyer
and
seller
may
agree
on
deferred
or
interest
only
payments
initially
in
order
to
reduce
the
cash
flow
pressure
on
the
buyer
during
the
business
ownership
transaction
period.
13

14. Concerning
earn
out
payments
in
an
LBO
transaction,
it
is
a
contractual
agreement
by
the
investor
of
the
target
to
pay
to
the
seller
of
this
company
an
additional
value
or
compensation
in
the
future
depending
upon
how
the
target
performs.
There
are
a
lot
of
ways
to
calculate
and
pay
the
compensation,
but
in
general,
it
as
a
bonus
that
is
paid
based
upon
future
performance.
The
measure
used
to
calculate
an
earn
out
is
generally
based
upon
a
percentage
of
the
revenue.
An
earn
out
is
usually
used
to
close
the
value
gap
between
the
asking
price
of
the
seller
and
the
purchase
price
which
the
buyer
is
willing
to
pay.
An
earn
out
structure
can
take
on
many
forms
and
the
earn
out
amount
is
usually
paid
in
either
cash
or
equity.
For
buyers,
to
set
up
an
earn
out
clause
reduces
the
risks
of
the
purchase.
By
establishing
a
payment
plan
based
on
target
performances
in
the
future,
investors
can
protect
themselves
from
unwise
purchasing
decisions
that
have
been
made.
Sellers,
on
the
other
hand,
can
benefit
from
an
earn
out
agreement
because
they
can
earn
more
over
time
from
the
sale
if
the
clause
is
structured
correctly
and
the
company's
performance
is
great.
However,
sellers
also
run
a
risk
and
could
not
obtain
the
full
purchase
price
if
the
target
performs
poorly.
When
the
buyer
has
identified
the
target
company
and
the
seller
is
willing
to
sell,
it
is
necessary
to
associate
moneylenders.
Without
them,
a
leverage
buyout
can’t
be
realized
because
the
financial
and
so,
tax
leverage
depends
on
the
amount
of
debt
used
to
acquire
the
target.
SECTION
II
–
Lenders,
debt
investors
and
existing
creditors.
A
leveraged
buyout
is
a
type
of
takeover
where
a
substantial
proportion
of
the
acquisition
price
is
financed
by
borrowings,
using
the
target
company's
assets
to
reimburse
the
amount
of
debt.
In
other
words,
in
an
LBO
transaction,
the
debt-­‐equity
level
is
very
high.
Multiple
tranches
of
debt
are
commonly
used
to
finance
LBOs,
so
there
is
no
only
one
type
of
lender.
Lenders
are
often
classified
into
several
categories
according
to
the
priority
of
debt
reimbursement.
I
–
Banks,
the
major
lenders.
The
banks
are
without
doubt
one
of
the
major
lenders
in
every
leveraged
buyout
transaction.
Typically,
banks
extend
loans
that
are
senior
in
the
credit
pecking
order
and
secured
by
the
assets
of
the
target
that
is
to
say,
company
being
acquired,
and
sometimes,
by
the
assets
of
the
investing
company
(hereafter,
the
“Newco”).
This
fact
raises
this
following
question;
how
would
the
lenders
protect
themselves?
14

15. The
transaction
between
a
lender
and
Newco
would
generally
involve
the
negotiation
of
a
loan
agreement
where
the
lender
would
want
various
representations
and
warranties
to
be
inserted.
In
particular,
the
lender
would
want
to
accelerate
the
repayment
of
the
loan
in
case
of
major
breaches
of
the
“entrenched
covenants”
and
the
specified
“events
of
default”.
Also,
the
lender
may
want
to
impose
restrictions
on
the
creation
of
further
charges
on
the
security,
or
the
disposal
of
the
assets,
investments
in
business
or
shares,
issuance
of
new
shares,
etc.
While
negotiating,
these
requirements
may
conflict
with
Newco's
desire
to
maintain
flexibility
as
regards
its
business
operations.
This
problem
may
be
reduced
if
banks
participate
as
syndicated
lenders
as
said
in
the
introduction
of
this
report.
Under
this
scenario,
several
banks
will
come
together
to
lend
a
portion
of
the
total
amount
of
debt.
This
reduces
consequently
the
credit
exposure
each
bank
has
to
regarding
to
the
borrower,
while
still
allowing
them
to
participate
as
a
lender.
An
investment
bank
often
arranges
the
syndication,
while
commercial
banks
makeup
a
large
number
of
the
lenders,
along
with
other
investment
banks
participating
in
the
syndication
as
lenders
in
the
deal.
Commercial
banks
have
traditionally
played
an
important
role
in
leveraged
buyout
financing,
as
provide
the
majority
of
buyout
debt,
typically
in
the
form
of
short-­‐term
and
covenant-­‐heavy
term
loans
and
revolving
lines
of
credit.
Plainly,
banks
play
an
important
role
in
takeover
finance
in
general
and
more
particularly
in
LBO
transactions.
Commercial
bank
lending
facilitates
LBO
deals.
Consequently
to
the
extent
that
they
exercise
their
authority,
banks
have
placed
themselves
in
a
position
to
control
the
borrowing
firm’s
capital.
Indeed,
the
lending
bank
can
design
a
loan
contract
to
protect
its
interests
against
substantive
changes
in
the
borrowing
firm’s
operating
and
financial
condition.
Without
diminishing
their
function
of
resource
allocation,
banks
also
contribute
importantly
to
the
borrowing
firm’s
operational
and
financial
decisions.
Along
with
the
credit
supplied
to
the
borrowing
firm
are
explicit
conditions
that
restrain
management’s
actions
regarding
the
firm’s
operations,
asset
disposition
and
executive
changes;
It’s
the
role
of
the
bank
to
evaluate
the
projected
credit
situation
of
the
company
post-­‐transaction
and
to
offer
or
decline
lending
terms
based
on
the
creditworthiness
of
the
company
under
the
proposed
capital
structure
(capital
structure
will
be
detailed
later
in
this
report).
15

16. The
banks
are
motivated
to
assess
the
risk
of
lending
correctly
and
set
interest
rates
that
are
an
appropriate
reflection
of
that
risk.
If
a
bank
does
lend,
it
wants
to
make
sure
it
is
receiving
adequate
payment
for
the
risks
involved.
II
–
The
unsecured
lenders.
Debt
investors
are
oftentimes
the
unsecured
creditors
in
the
deal
and,
as
a
matter
of
course,
command
a
higher
fixed
rate
of
interest,
often
referred
to
as
high
yield,
which
is
compensation
for
firstly,
being
unsecured
and
secondly,
being
junior
in
the
credit
pecking
order
to
the
senior
secured
bank
debt.
Indeed,
these
creditors
find
their
place
in
the
deal
through
the
purchase
of
high
yield
bonds,
which
are
underwritten
and
arranged
by
an
investment
bank.
Unsecured
lenders
are
often
professional
fixed-­‐income
investors
that
understand
the
risks
associated
with
high-­‐yield
corporate
bonds.
As
the
senior
secured
lenders,
the
unsecured
lender’s
role
is
to
evaluate
the
credit
quality
of
the
company
post-­‐leveraged
buyout
and
determine
the
risk
of
the
company
not
being
to
pay
back
its
loan.
The
unsecured
lender
must
consider
the
fact
that
it
will
only
receive
its
money
after
the
senior
secured
lender
gets
paid.
In
the
end,
the
amount
granted
of
unsecured
debt
that
is
issued
can
make
a
significant
difference
in
the
amount
of
leverage
available
in
a
deal.
Moreover,
unsecured
creditors
are
motivated
by
the
large
interest
payments
that
are
associated
with
high-­‐yield
bonds.
Although
unsecured
loans
used
to
finance
leveraged
buyout
carry
significant
risks,
ultimately
it
is
the
large
coupon
payments
that
bring
investors
forward
to
purchase
the
securities
once
the
investment
bank
issues
the
bonds.
Once
again
the
motivation
is
a
balance
between
the
greed
and
fear
of
the
creditor,
the
same
two
things
that
run
the
entire
credit
markets.
In
return
for
the
burden
of
assuming
this
high
risk,
unsecured
lenders
typically
require
a
higher
interest
rate
often
called
“equity
kicker”,
also
known
as
equity
sweetener.
It’s
a
warrant
or
an
option
to
buy
equity,
attached
to
debt
that
is
used
to
finance
leveraged
buyouts.
The
percentage
of
ownership
can
be
as
little
as
9%
or
as
high
as
80%
of
the
target’s
shares.
The
percentage
is
higher
when
the
lender
perceives
the
greater
risk.
It’s
very
often
used
in
mezzanine
financing
where
the
lender
receives
equity
interests
from
the
borrower,
regarding
as
an
additional
financial
reward
for
according
loans.
Equity
kickers
are
generally
structured
as
conditional
rewards,
so
that
the
lender
only
16

17. receives
its
equity
if
the
borrower's
business
meets
certain
specified
performance
goals.
Unsecured
lenders
are
entitled
to
receive
the
proceeds
of
the
sale
of
the
secured
assets
after
full
payment
has
been
made
to
the
secured
lenders
so
it
can
explain
what
unsecured
component
receive
a
higher
return
to
compensate
for
assuming
the
greater
risk
in
the
LBO
transaction.
III
–
The
risky
situation
of
existing
lenders.
This
category
of
lenders
is
made
up
of
creditors
that
issued
debt
to
the
company
before
there
was
any
talk
of
a
leveraged
buyout.
The
existing
lenders
presumably
lent
money
to
the
company
to
help
them
expand
operations
or
meet
liquidity
needs
or
both.
Most
likely,
existing
lenders
are
traditional
creditors,
such
as
a
commercial
bank
specializing
in
making
traditional
commercial
loans.
This
group
likely
has
a
relationship
with
the
company
and
has
a
reasonable
understanding
of
the
company’s
credit
situation.
The
existing
lenders
doesn’t
play
a
major
role
in
an
LBO
transaction.
Classically,
they
receive
the
loan
principal
and
any
interest
due
and
pre-­‐payment
fees
once
the
LBO
transaction
goes
through.
In
a
situation
such
as
the
pre-­‐payment
of
a
bank
loan
there
is
typically
a
pre-­‐payment
fee
between
1%
and
1,5%
that
is
agreed
at
the
initial
extending
of
the
loan.
The
fee
is
paid
to
the
lender
at
the
time
of
pre-­‐payment.
Once
a
borrower
decides
to
pre-­‐pay
a
loan,
the
existing
creditors
then
becomes
focused
on
seeing
that
its
extended
loans
and
other
monies
due
and
receivable
are
paid
back.
In
the
event
that
a
lender
is
large
enough,
it
may
be
motivated
to
seek
participation
as
one
of
the
lenders
in
the
leveraged
buyout
transaction.
This
would
present
an
opportunity
for
the
lender
to
extended
additional
loans.
But
undeniably,
the
biggest
losers
in
an
LBO
transaction
are
the
firm's
existing
creditors
because
the
buyout
is
financed
primarily
with
debt
so
existing
creditors
become
creditors
of
a
much
riskier
firm.
After
listing
the
main
actors
involved
in
an
LBO
transaction,
focus
should
be
sources
of
funds
and
uses
of
them
in
the
buyout.
Indeed,
we
must
study
what
are
the
various
tranches
of
debt
which
are
the
main
part
of
financing
in
an
LBO
transaction
and
more
particularly,
how
can
investors
use
the
funds
they
have.
17

18.
CHAPTER
II
–
SOURCES
AND
USES
OF
FUNDS.
Building
a
leveraged
buyout
is
about
organization
and
capital
structure.
The
first
step
in
building
is
preparing
the
sources
and
uses
of
funds
for
the
LBO.
In
other
words,
you
have
to
know
how
much
a
buyout
will
cost
for
the
investor
this
is
the
question
of
uses
of
funds,
but
before,
where
the
money
to
pay
for
this
might
come
from
and
this
is
the
question
of
sources
of
funds.
SECTION
I
–
Sources
of
funds.
We
need
to
figure
out
how
we
are
going
to
get
the
money.
Sources
of
funds
are
made
up
of
the
various
types
of
capital
used
to
complete
the
transaction.
One
part
of
the
price
of
an
LBO
transaction
comes
from
equity
but
this
part
is
minor.
Indeed,
the
major
part
of
the
price
comes
from
debt
in
order
to
maximize
tax
leverage
(PART
II)
and
financial
leverage.
I
–
Equity
capital.
One
part
of
funds
must
be
provided
by
the
investors.
The
common
equity/equity
capital
comes
from
a
private
equity
fund
(CHAPTER
I)
that
pools
capital
raised
from
various
sources.
These
sources
might
include
pensions,
insurance
companies,
wealthy
individuals.
The
objective
is
to
rely
on
this
equity
capital
to
build
a
Newco
that
is
large
enough
to
be
leveraged
later
with
senior
and
subordinated
debt
and
to
use
leverage
with
an
important
degree
in
order
to
realize
future
acquisitions.
The
level
of
equity
capital
provides
more
flexibility
to
the
Newco
in
making
acquisitions.
The
buyer
also
can
obtain
more
attractive
financing
in
terms
of
structure
and
pricing
because,
the
total
amount
of
equity
represents
the
sum
that
the
investors
so
generally,
private
equity
funds,
are
willing
to
put
at
risk
in
the
LBO
deal.
In
other
words,
equity
capital
represents
invested
money
that,
in
contrast
to
debt
capital,
will
be
not
repaid
to
the
investors
in
the
course
of
transaction.
It
represents
the
risk
staked
by
the
buyers.
For
the
bank,
the
equity
capital
represents
the
sum
that
could
be
seized
so,
this
amount
represents
a
guarantee
for
lenders.
With
the
equity
capital,
a
larger
pool
of
lenders
will
be
probably
available
to
provide
funding.
Lenders
know
that
all
or
an
important
amount
of
the
investor’s
funds
has
been
invested
in
the
plan
before
the
bank
lends
its
money.
What
are
different
possibilities
to
invest
equity
capital
in
the
Newco
structure?
18

19. Equity
capital
give
legally
the
property
of
the
holding
to
investors.
This
capital
contribution
may
be
in
cash,
but
can
also
be
realized
in
the
form
of
a
transfer
of
assets.
The
seller
may
also
bring
part
of
its
securities
within
the
target
company
into
the
acquiring
holding
company.
This
method
enables
the
seller
to
remain
involved
in
the
transaction
once
the
LBO
has
been
set
up,
keeping
in
mind
that
the
value
of
the
share
contribution
will
have
to
be
assessed
by
a
statutory
registrar.
This
method
can
be
advantageous
in
a
certain
number
of
States
like
France.
Indeed,
when
the
seller
is
located
in
France,
a
transfer
of
assets
allows
him
to
differ
taxation
in
accordance
with
the
150-­‐OB
article
of
the
“CGI”4.
Although,
generally,
the
majority
of
the
equity
capital
represents
cash.
Typically,
the
common
equity
represents
25-­‐35%
of
capital
structure
but
it’s
a
question
of
financial
analysis.
Indeed,
in
every
LBO
transaction,
investors
must
see
how
returns
are
affected
with
changes
in
the
amount
of
equity
capital
that
bas
been
invested
in
this
transaction.
II
–
Tranches
of
debt.
Multiple
tranches
of
debt
are
used
to
finance
an
LBO
transaction,
and
may
including
any
of
the
following
tranches
of
capital
listed
in
descending
order
of
seniority.
Firstly,
the
Newco
can
obtain
a
revolving
credit
facility
also
called
revolver.
A
revolver
is
a
form
of
senior
bank
debt
that
we
can
compare
as
a
credit
card
and
that
is
generally
used
to
help
fund
a
company's
working
capital.
The
Newco
can
use
the
revolving
credit
up
to
the
credit
limit
when
it
needs
cash
in
the
LBO
transaction,
but
must
repay
the
amount
when
an
excess
of
cash
is
available.
What
is
very
advantageous
is
there
is
generally
no
repayment
penalty
for
using
revolver.
The
revolver
offers
Newco
a
lot
of
flexibility
according
to
its
capital
needs
and
allowing
access
to
cash
without
having
to
obtain
additional
either
debt
or
equity
financing
as
seen
before
(§
I).
Although,
there
are
two
different
costs
associated
with
revolving
credit.
On
the
one
hand,
the
interest
rate.
On
the
other
hand,
an
undrawn
commitment
fee.
The
interest
rate
that
is
charged
on
the
revolver
balance
is
usually
LIBOR,
which
must
be
added
a
premium
that
depends
on
the
credit
conditions
obtained
by
the
Newco.
4
CGI
:
the
french
«
Code
général
des
impôts
»
that
contains
tax
law.
19

20. The
undrawn
commitment
fee
is
usually
a
fixed
rate
that
is
multiplied
by
the
difference
between
the
revolver's
limit
and
any
drawn
amount.
A)
First
lien
debt.
The
senior
bank
debt
is
a
lower
cost-­‐of-­‐capital
and
more
exactly,
lower
interest
rates
than
subordinated
debt
but
there
are
typically
more
restrictive
provisions
and
limitations
than
mezzanine
debt
for
example.
Bank
debt
generally
needs
a
fully
amortization
over
a
5
to
8
year-­‐period.
Provisions
typically
restrict
the
Newco’s
flexibility
either
to
make
further
acquisitions
or
raise
additional
debt
holders.
Senior
bank
debt
also
contains
financial
maintenance
clauses
that
are
generally
secured
by
the
assets
of
the
borrower.
Senior
bank
debt
can
take
two
forms.
On
the
one
hand,
a
term
loan
A.
This
tranche
of
debt
is
generally
amortized
evenly
over
5
to
7
years.
In
other
words,
loan
tranche
A
characterised
by
a
fixed
amortisation
schedule
with
maturity
reached
after
seven
years.
On
the
other
hand,
a
term
loan
B
that
usually
involves
a
repayment
over
5
to
8
years,
with
a
large
payment
in
the
last
year.
In
other
words,
the
latter
allows
borrowers
to
defer
reimbursement
of
a
large
amount
of
the
loan
but
it’s
more
costly
for
the
Newco
than
term
loan
A.
However,
at
present,
tranche
A
debt,
amortised
over
its
maturity,
is
shrinking
while
tranche
B,
which
carry
no
periodic
capital
repayment,
is
preferred
by
banks
to
improve
the
leverage
degree.
The
interest
rate
charged
on
senior
bank
debt
is
often
a
floating
rate
that
is
approximately
equal
to
the
LIBOR
and
a
premium,
depending
on
the
credit
conditions
of
the
borrower.
If
the
borrower
has
negotiated
a
great
credit
terms,
bank
debt
may
be
repaid
early
without
penalty.
B)
Second
lien
debt.
In
a
second
lien
debt
or
second
lien
loan
transaction,
the
second
lien
lenders
hold
a
second
priority
security
interest
about
the
borrower’s
assets.
Second
lien
financing
continue
to
be
popular,
particularly
in
the
USA,
with
deal
volumes
reaching
approximately
$27.8
billions
during
2008,
but
have
also
gained
a
large
growth
in
Europe,
with
approximately
3
billions
raised
in
20075.
Second
lien
debt
is
simply,
as
this
name
suggests,
debt
which
benefits
principally
from
the
same
security
as
secured
senior
debt
as
we
have
seen
previously,
on
a
second
ranking
basis.
5
According
to
18th
annual
Thomson
Reuters
LPC
loan
market
conference.
20

21. The
senior
lenders
(so
who
can
called
first
lien
lenders)
and
second
lien
lenders
agree
that
on
respect
of
the
security,
the
senior
lenders
will
be
fully
paid
before
the
second
lien
lenders.
The
second
lien
debt
can
have
the
form
of
a
loan
or
bonds
and
is
typically
lent
at
the
same
level
as
the
senior
debt.
Second
lien
debt
is
not
new
in
Europe
and
differs
from
mezzanine
debt
in
that
the
repayment
right
of
the
second
lien
lender
isn’t
normally
subordinated
to
those
of
the
senior
lender.
The
price
and
flexibility
are
the
two
factors
that
attract
borrowers
to
second
lien
deals.
It’s
more
expensive
than
senior
bank
debt
but
second
lien
debt
in
the
USA
and
Europe
is
significantly
less
expensive
than
mezzanine
loans
as
we’ll
see
just
after.
The
price
depends
on
risk
profile
and
more
particularly
in
Europe,
second
lien
is
generally
priced
between
400
and
700
basis
points6,
against
11.000
basis
points
or
more
for
certain
mezzanine
vehicles.
To
conclude,
the
second
lien
loan
is
situated
between
senior
debt
and
mezzanine
senior
debt.
It
offers
larger
repayment
duration
than
the
senior
debt
and
its
remuneration
is
higher.
Since
the
second-­‐lien
is
second
in
ranking
behind
the
traditional
senior
credit
facility,
its
repayment
will
be
made
in
full,
at
maturity,
once
the
first
lien
senior
debt
has
been
fully
repaid.
C)
High
yields
and
junk
bonds.
This
tranche
of
debt
is
typically
very
unsecured.
High
yield
debt
is
often
referred
to
as
“junk
bonds,”
but
this
term
is
past.
Today,
high
yield
bonds
are
a
mature
asset
can
provide
a
number
of
advantages
to
investors
who
understand
and
accept
the
risks.
Companies
with
credit
ratings
that
are
beneath
investment-­‐grade
offer
those
bonds7.
Investment
grade
companies
are
large
multinational
firms
with
massive
recurring
revenues
and
a
lot
of
cash
on
their
balance
sheets.
In
other
words,
there
is
no
chance
that
they
will
default,
or
fail
to
make
their
interest
and
principal
payments
on
time.
Companies
with
outlooks
that
are
questionable
enough
and
also,
could
default,
have
lower
credit
ratings
and
investors
demand
higher
yields
to
own
their
bonds.
High-­‐yield
debt
characteristic
is
very
high
interest
rates,
which
compensate
investors
for
their
risk
as
we
said
previously.
This
tranche
of
debt
is
often
used
to
increase
leverage
levels.
High-­‐yield
bonds
don’t
offer
any
access
to
capital.
6
Basis
point;
unit
of
measure
using
to
describe
the
percentage
change
in
the
value
or
rate
of
a
financial
instrument
;
one
basis
point
is
equivalent
to
0,01%.
7
Investment
grade;
for
example,
Microsoft
or
Apple.
21

22. D)
Mezzanine
debt.
One
reason
why
the
second
lien
concept
is
difficult
to
settle
down
in
Europe
is
the
presence
of
a
healthy
junior
debt
market.
The
mezzanine
ranks
last
in
the
hierarchy
of
tranches
of
debt.
Private
equity
investors
and
hedge
funds8
often
finance
this
type
of
debt.
Mezzanine
financing
is
an
intermediate
step
between
equity
capital
and
debt.
It’s
a
hybrid-­‐financing
instrument
that
can
be
used
to
improve
creditworthiness,
to
optimise
tax
structures,
and
to
achieve
a
better
rating
of
the
company.
The
mezzanine
capital
that
can
be
provided
has
a
lower
ranking
than
senior
debt
but
a
higher
ranking
than
shareholders'
equity.
In
the
USA,
a
company
doesn’t
grant
security
to
mezzanine
investors,
and
so
the
market
for
second
lien
debt
was
untapped
until
recent
years.
On
insolvency,
the
USA
second
lien
lenders
now
fit
into
the
debt
structure,
ranking
just
behind
senior
secured
debt,
but
just
ahead
of
the
unsecured
subordinated
mezzanine
lenders
and
high
yield
bondholders.
The
USA
senior
lenders
have
become
more
comfortable
with
the
reduced
exposure
that
has
been
offered
by
a
new
class
of
second
ranking
debt.
On
the
other
hand,
European
mezzanine
debt,
although
usually
contractually
subordinated
through
an
intercreditor
agreement,
benefits
from
second
lien
debt
over
the
assets
of
the
borrower’s
company.
European
senior
banks
often
already
have
the
reduced
exposure
offered
by
a
second
ranking
secured
debt,
but
that
debt
is
also
usually
contractually
or
structurally
subordinated.
In
other
words,
the
mezzanine
debt
is
a
hybrid
component
of
the
financing
in
an
LBO
transaction,
between
senior
debt
and
equity
capital.
It
incorporates
convertible
bonds
or
bonds
attached
to
subscription
warrants,
and
it
gives
the
bond
lenders
the
rights
to
convert
to
an
ownership
or
equity
interest
in
the
Newco
if
the
loan
is
not
paid
back
in
time
and
fully.
The
reimbursement,
generally
made
in
full
at
maturity,
is
subordinated
to
the
repayment
of
senior
debt.
It
provides
flexibility
for
setting-­‐up
and,
by
diversifying
the
financing
sources,
its
fulfils
the
needs
of
senior
lenders
and
those
of
equity
investors.
There
are
other
sources
of
funds
equally
important
like
seller
credit.
It
meets
the
concern
of
the
buyer.
Part
of
the
target
company's
price
is
materialized
through
a
loan
granted
by
the
seller.
By
getting
involved
in
this
financing
scheme,
the
seller
8
It’s
an
aggressively
structure,
different
to
a
private
equity
fund,
which
managed
portfolio
of
investments
in
order
to
maximize
the
return
of
investment;
22