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Leveraged buy-outs

Leveraged buy-outs may be becoming increasingly difficult to pull off in more mature private equity markets, but in Central and Eastern Europe they have become a hot topic. However, for many investors the LBO remains a confusing subject. Geoff Perry and Istvan Kovari of CMS Cameron McKenna describe the workings of an LBO transaction.

A current ‘hot topic' amongst private equity and venture capital firms across the Central and Eastern European region is the leveraged buy-out or ‘LBO'. The concept is well known in North America and Western Europe where venture capital buy-out transactions frequently include significant levels of debt financing to create leverage and to maximise equity returns. Although leveraged buy-outs are very rare in Hungary and the CEE region, an analysis of how a LBO is structured will reveal that all of the component parts will be familiar to investors currently doing business in the region. The three main elements in a typical leveraged buy-out are the equity financing, the bank financing and the acquisition itself. The art to carrying out a successful LBO is to run each element so that they combine simultaneously and smoothly.

In a typical LBO, the venture capital investor will use a new, special purpose vehicle (‘SPV'), incorporated locally or offshore (depending upon tax structuring and the requirements of the bank), through which to make the acquisition. The SPV will typically be founded with the minimum capital required in the relevant jurisdiction by either the venture capital firm (or by the lead investor if a syndicate is involved) or, if the buy-out is a management buy-out or buy-in, by the management team. Where a management team is involved or where there is a syndicate of investors, then a subscription and shareholders' agreement will be needed to regulate the amount and timing of the equity investment as well as how the SPV and the target will be managed. The key difference between funding the SPV for the buy-out and, for example, investing in a start up or providing expansion financing to an already existing company, is that you will need to ensure that the funds are only committed when the acquisition actually takes place.

As regards banking finance, this will take the form of an acquisition finance facility to part fund the purchase and may also include a working capital facility. In either case, the bank will insist on adequate security being provided. The SPV will have no assets unless or until the acquisition is completed. This means that the bank will expect the target company to grant security over its assets, typically real estate, operating assets and book debts, as well as the SPV granting a charge over the capital that it will hold in the target. It follows from this that the bank will wish to assess the adequacy of the security that can be provided by the target before they sign a facility agreement and sometimes even before they sign a term sheet. The involvement of the bank is crucial in any LBO and care must be taken to ensure that the bank is kept fully informed of how the transaction is progressing. For example, when undertaking due diligence on the target, you will need to ensure that any professional due diligence reports are addressed not just to the SPV and to the venture capital investors themselves but also to the bank. Any suggestion by the lending bank that its own professionals should carry out a separate due diligence should be strongly resisted as this would be a duplication of work which would increase costs and extend the timescale unnecessarily.

The timing of the granting of security to the bank needs to be managed and agreed with the bank. As mentioned, the SPV will have no assets until such time as the acquisition of the target is completed. Immediately following completion, the SPV can then grant security over the capital (shares or quota) of the target and can procure that the target itself grants charges over its assets. However, the bank will wish to structure the financing in such a way as to minimise its risk so that, effectively, the draw down of the facility and the granting of security happen at the same time. In practice, this means that the completion meeting (when all the funding is put in place and the acquisition is completed) should be carefully structured with a detailed agenda so that the funds are drawn down, the target is purchased and the security documents are executed in a pre-determined and irrevocable order so as to all happen virtually simultaneously. Otherwise, a complex formal escrow structure will be required.

The final element in a typical LBO will, of course, be the acquisition of the target itself. The usual sale and purchase agreement will need to be negotiated but, in view of the requirements of the financing bank, it will be essential that the seller understands the funding process and agrees to co-operate with the investors and the bank to ensure a smooth completion. Regardless of whether any regulatory or other approvals are required in order to complete the acquisition, it will frequently be advisable to negotiate with the seller either a conditional agreement or an agreement with a deferred closing date. If no approvals are required, then the period between signing and closing may be very short. However, the period is required because the equity investors will need to provide the equity to the SPV so that the SPV has cleared funds to transfer on to the seller. Arranging a gap between signing and closing ensures that the investors have time to commit the funds irrevocably to the SPV only after the seller has become bound to sell.

As regards the actual completion, the SPV will have been provided with funds (through the equity investments) to provide part of the purchase price and arrangements can be made for the financing bank to pay the balance direct to the seller by way of the first draw down. Immediately after the irrevocable payment instructions in favour of the seller have been given by the SPV and the bank, the seller can hand over the necessary documents to transfer title to the shares or quota in the target company and the target can then execute the necessary security documents in favour of the bank.

The above describes only a very simple leveraged buy-out structure and discusses it in only the most general of ways. There can be various other matters that influence the structure such as whether mezzanine finance is also being provided, whether the target is listed on any stock exchange and whether there is a syndicate of banks. However, this article should provide a good ‘flavour' as to how LBO's are put together.

Copyright © 2002 HVCA

Geoff Perry and Istvan Kovari are partners at CMS Cameron McKenna.

CMS Cameron McKenna is a major international law firm with offices in 21 jurisdictions including Hong Kong and Beijing.  The firm's website can be visited at www.cmck.com

Hungarian Venture Capital and Private Equity Association (HVCA) represents virtually all major sources of venture capital and private equity in Hungary and is dedicated to promoting the industry for the benefit of entrepreneurs, investors, its practitioners and the economy as a whole. For more information please visit www.hvca.hu