Investment Banking 101: Coverage, Products & Advisory – Part II (b): Products

Investment BankingIn this article, I run you through an investment banking process which involves both the coverage and product banking groups. I’ve chosen to describe this process using a transaction that I find very interesting – a Leveraged Buyout (LBO). There isn’t a lot of free material out there that describes an LBO in a simple manner. Hopefully, this article will change that.

Let’s study a generalized example of a Leveraged Buyout (LBO): An LBO is a takeover of a company (let’s call it a ‘Target’) by a Private Equity (PE) firm. This is always a friendly takeover. This takeover is assisted by a large amount of debt that the Target borrows itself.

The PE firm buys a small stake in the firm by buying some of its shares. The Target then takes on this debt to buy back its shares from the market, almost completely removing its shares from the market.

This decrease in number of shares available in the market causes the PE firm to be the majority and controlling shareholder of the firm. The PE firm “creates efficiencies” (cost-cutting, headcount reduction, as well as top line growth) in the firm while using its cash inflows to repay the debt.

The effective result of this is that the firm reduces its debt while simultaneously increasing the value of its equity. PE investors typically exit the investment after 5 years, making a tidy profit. Typical IRRs that PE firms look for are well above 20% (to give you a reference – most ‘regular’ companies that are doing well see an IRR of not much more than 15%).

So, now that we’ve got the basics of an LBO, let’s get back to our little ‘deal’ story. The bank’s Financial Sponsor’s Group (FSG) identifies a firm which has a steady cash flow as well as certain other characteristics that would make it the ideal candidate for an LBO.

This ‘identification’ would happen on one of their ‘pitch’ scans where they look for good deals in the market to pitch to prospective clients. The FSG is a coverage group that covers Financial Sponsors (or as we are accustomed to calling them – PE firms). The coverage group would typically pitch the idea to the PE firm or to the Target itself.

Once a suitable structure for the LBO has been arrived at and the Target and Sponsor (PE firm/s) are generally agreeable, the deal is brought to the capital markets origination desk. This is where the products groups are.

Since this is a LBO, the transaction will be funded by leveraged debt and / or high-yield bonds. The Leveraged Finance group then finalizes the structure of the transaction and prepares the marketing material for the transaction.

This marketing material consists of the Confidential Information Memorandum (CIM), various presentations on the transaction, etc. The group also assists on pricing (setting interest rates). The roadshow is held and then the loans / bonds are put out into the market for subscription.

Most PE firms insist on committed financing for their LBOs – which is a commitment from the issuer of the bonds / loans (the Lev-Fin group) that the money will come in, no matter what. This ‘no matter what’ phrase comprises all kinds of adverse conditions including harsh market conditions or poor liquidity situations.

Banks then ‘underwrite’ this commitment using their own funds. An underwriting is a commitment to pay, should the money not come in from the original source. Thus, an investment banking transaction is completed.

Read the other articles in the series: Introduction to Investment Banking

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