Are you considering an LBO operation but feeling perplexed about the financing? Discover the types of debt available, identify the key players involved in an LBO operation, and learn how to select the financing structure best suited to your needs and profile. By mastering these essential financial aspects, you will be able to understand how to structure financing tailored to your operation.

Financing actors or "lenders"

Financing an LBO operation is key to its realization, which is why it is essential to involve the appropriate actors based on the size of the target, its profitability, and the structuring of the operation:

• Commercial Banks

Commercial banks are often the main providers of debt in LBOs, particularly for small and medium-sized operations. They generally provide senior debt, which is the most secure and benefits from specific guarantees. For small operations (less than €10 million), a single bank, often the target company's bank, may be sufficient to provide the necessary financing.

• Private Debt Funds

Private debt funds are increasingly present in the LBO market, particularly for medium to large-sized operations. These funds offer financing in the form of mezzanine debt or unitranche debt, thus providing flexible solutions tailored to the specific needs of companies. They are attractive due to their ability to provide significant amounts and to accept higher levels of risk in exchange for superior returns.

• Specialized Banks

Some specialized banks, often smaller in size, also primarily operate in market niches such as mezzanine financing or unitranche financing. They are particularly active in medium-sized operations where they can offer tailored solutions. Their expertise allows them to structure innovative financing that meets the specific needs of companies and LBO funds.

• Banking Syndicates

For large-scale operations, it is common to see banking syndicates form. A group of banks, often orchestrated by an investment bank, comes together to share risks and financing amounts. This syndication model allows for raising significant funds while diversifying financing sources and spreading risks across multiple financial institutions.

What debt to finance the operation?

Senior debt

Senior debt, commonly used in LBO operations, generally represents an amount of 3 to 5 times the gross operating surplus of the target company. This debt is structured in several tranches, ranked from least risky to most risky:

• The tranche A, repaid linearly over a period of 6 to 7 years;
• The tranches B and C, which are repaid at the loan's maturity, respectively from 7 to 9 years. However, tranche C tends to disappear. Note that in the case of secondary LBO operations taking place before the repayment of these tranches, they are refinanced.

Each tranche has a specific interest rate, often high, potentially reaching several hundred basis points above Euribor. Moreover, senior debt benefits (with few exceptions) from guarantees on the target's securities and financial covenants. For significant amounts, it is generally guaranteed by a banking syndicate, while for small LBOs, financing is often provided by a small group of local banks, known as "club deals".

The advantages of senior debt include its high level of security and interest rates generally lower than those of other types of debt (between 3% and 7%). However, in most cases, it imposes strict repayment conditions and rigorous financial covenants. This type of financing is particularly suitable for companies with good profitability and stable cash flows, and is often provided by commercial banks or banking syndicates for large operations.

Main subordinated debts

Mezzanine Debt

Mezzanine debt is a form of financing that sits between senior debt and equity in terms of risk and return. It is often used to finance LBO operations when senior debt is not sufficient to cover the financing needs and is provided by specialized debt funds (mezzanine lenders). Generally, mezzanine debts have a duration between 7 and 10 years and are typically repayable at maturity (bullet). Due to its subordinated position to senior debt (in case of bankruptcy, mezzanine debt is repaid after senior debt, making it riskier for lenders), lenders require higher interest rates ranging between 10% and 15%, often accompanied by a participation in the company's capital gains (via warrants or conversion options) to compensate for this risk.

Moreover, mezzanine debt offersgreater flexibility in terms of repayment conditions and guarantees, compared to senior debt.A portion of the interest (PIK) can be capitalized rather than paid in cash, which can help the company preserve liquidity.

Unitranche Debt

Unitranche debt is a financing solution that merges elements of senior debt and mezzanine debt into a single tranche. This type of financing is frequently used in LBO operations to simplify the debt structure. By integrating senior debt and mezzanine debt into a single tranche, it becomes easier to negotiate and manage loan agreements, allowing for faster implementation compared to traditional financing structures. Moreover, due to the reduction in the number of stakeholders involved (vs. a transaction with senior and mezzanine debt), its transaction costs are reduced. Unitranche financing is generally a senior bullet financing, meaning repayable at maturity, with quarterly cash remuneration (Euribor + 6-10%) and, potentially, capitalized interest.

However, this type of financing also has drawbacks: interest costs are higher than those of senior debt, due to the increased risk for lenders. Moreover, unitranche debt may include more restrictive covenants, thus limiting the borrower's operational flexibility. Companies must therefore carefully evaluate these constraints before opting for this type of financing and ensure they are able to comply with the established contractual conditions.

This financing is particularly suited to companies seeking flexible financing solutions, especially for external growth operations such as mergers and acquisitions, where speed of execution and customization of loan terms are crucial.

Anticipating needs and negotiating complementary financing

LBO operations are also an opportunity for the company to anticipate financing needs for the day-to-day management of its operations as well as for its future M&A operations and investments.

Revolving credit facility (RCF)

The revolving credit facility represents a form of senior bank debt functioning similarly to a credit card for businesses. It is primarily intended to finance working capital needs and is particularly suitable when the latter experiences strong seasonality. When a company uses this type of credit, it "draws" on the credit line up to the authorized limit in case of liquidity needs. The company then commits to repay the amount used as soon as it has surplus funds, without any prepayment penalty.

This type of financing offers great flexibility, allowing companies to quickly access liquidity without requiring additional financing through loans or equity. It involves two main costs: the interest rate applied to the amount of credit used and a commitment fee on the unused portion, compensating the bank for its commitment to lend up to the credit limit.

CAPEX and acquisition lines (capex and acquisition facilities)

By opening a CAPEX line for financing future investments or an acquisition line to finance build-ups, companies can anticipate their needs from the LBO operation and thus gain in execution speed when they need it. Anticipating these points also has the advantage of avoiding having to renegotiate with banks when the company needs to finance its development and be competitive in a potential M&A process.

What support is available for setting up financing?

In the context of an LBO process, some investment banks offer "Bank Advisory" services. They implement a "lender education" process which aims to inform and educate future lenders about the particularities of the LBO operation and the target company. This approach has several advantages:

1. Competition among lenders: By informing multiple potential lenders, banks can create competition between financial institutions to obtain the best financing conditions. This competition can often result in more advantageous terms than those offered by the historical banks.
2. Optimization of financing conditions: Competition pushes historical banks to improve their offers if they wish to retain the business. This can translate into lower interest rates, more flexible guarantees, and other financial benefits.
3. Clarity and understanding of the issues by financiers: The "lender education" process ensures that all potential lenders fully understand the risks and opportunities associated with the operation. This understanding facilitates negotiation and obtaining financing.
4. Respect for management preferences: This process also allows the management of the target company to express their preferences regarding financial partners, thus reducing the risk of having unwanted partners imposed on them.

In summary, the "lender education" process in an LBO allows for optimal structuring of financing, ensures a good understanding of the issues by all lenders, and maximizes financial conditions for the success of the operation. Unlike the staple, funds retain control over the final negotiation of terms (leverage level, conditions, etc.) with financiers. Nevertheless, it is important to note that while "Bank Advisory" services provide comfort to the seller, it remains the responsibility of the acquirer to provide the financing.

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In conclusion, financing an LBO operation relies on a thorough understanding of the various financing options available and on the ability to structure these options optimally. The "lender education" process plays a crucial role in ensuring that all potential lenders understand the risks and opportunities of the operation, thus allowing for the maximization of financial conditions. The different types of debt, whether senior debt, mezzanine debt, unitranche debt, or convertible bonds, offer a range of solutions tailored to the specific needs of companies and investors. By combining these solutions and anticipating future financing needs, companies can ensure the success of their LBO operation while maintaining their financial flexibility to support long-term growth.