Leveraged Buy-Outs – How are Financial Instruments Designed?

The outline structure of a leveraged buy-out may be depicted as follows:

  

Figure 1:  Outline structure of a leveraged buy-out

To make an offer for a target company, a new company is established (Newco) to raise necessary funds for the acquisition from investors and banks.

In a large buy-out it is usual to see several buyers of debt, mezzanine and equity that carry different risks and rewards (Figure 2).

Figure 2: Types of financial instruments risk and reward

  

In principle creating financial instruments is similar to painting – there are a fixed number of primary colours and a fixed variety of financial characteristics. However, there are two basic sources of financial returns – yield (or income) and capital gains (or wealth creation).

Table 1: Creating a hierarchy of financial instruments by varying risk and reward

Financial engineering blends together a series of rights and obligations to create a mix of risk, reward and control. The “best” instrument is one that ticks all the boxes in Table 1 above – secured, interest, dividend and share of capital gain. But some are mutually exclusive. In the end, negotiation skills determine instruments that are best subscribed for a buy-out. 

Source: Private Equity Demystified – An Explanatory Guide by John Gilligan and Mike Wright