By Edoardo Tosti (Boston University) and Carlo Leopardi.
Picture by Julian Santa Ana (Unsplash)
Walkthrough
Private Equity firms will use a mix of debt and equity as initial capital sources to finance a Leveraged Buyout (LBO) transaction. Traditionally, debt accounts for approximately 60-80% of the financing structure of LBOs, with the remaining contribution being equity. This capital mix is chosen by Private Equity funds as leveraging the majority of the transaction leads to higher returns, as debt is considered cheaper than equity. This is because debt is senior to equity, tax-deductible, and creditors’ expected returns is lower than equity investors.
Seniority
During a company’s bankruptcy filing, different capital sources have different priority tiers in case of liquidation. The higher a capital source ranks in the capital structure hierarchy, the lower its credit risk and, consequently, the lower its cost to the borrower. Generally, the capital structure hierarchy can be grouped as follow:
1) Secured Debt – Refers to debt instruments collateralized with an underlying asset.
2) Unsecured Debt – Refers to debt instruments which aren’t insured by an underlying asset in case of default
3) Mezzanine Financing – Layer of capital that lies between debt and equity, assuming properties from both
4) Preferred Equity – Type of non-voting equity whose dividends are prioritized over common equity
5) Common Equity – Type of voting equity representing ownership in a company
Risk vs. Return
By being at the bottom of the capital structure hierarchy, equity investors assume a higher risk as equity shareholder are residual claimants. Simultaneously, by representing ownership in the company, equity investments potentially bring a much higher upside compared to lower risk credit lending. Thus, the is risk-reward tradeoff.