I’ve been thinking…Just what is an Initial Public Offering (IPO)?

There are four principal methods for a private company’s equity shares to trade in the public markets: (1) sell shares to the public by undergoing an IPO, (2) sell shares to the public through a direct listing process, (3) be acquired by a SPAC, and (4) enter into a so-called reverse merger transaction with an already public company.   This blogs deals with IPOs.  Existing blogs dealt with direct listings and SPACs.  A future blog will cover reverse mergers.

Background

Some basic definitions are going to be helpful for this blog.  A direct listing is a formal process whereby a company facilitates the sale to new investors of registered shares of the company held by existing investors.  Such a sale of outstanding shares is also commonly called a secondary offering.  In a secondary offering, the company does not sell newly created shares and, therefore, does not raise capital for itself.  In contrast, when a company sells newly created registered shares into the market, this is called a primary offering.  In a primary offering, the company raises capital for itself.  An initial public offering, or IPO, refers to the first time a company issues newly created registered shares and sells those shares to a syndicate of underwriters, who in turn sell the same shares to pre-selected investors.  All subsequent offerings of newly created shares are called follow on offerings.

There are many similarities between the IPO process and the direct listing process.  The end result of each process is the creation of a public company with registered shares that are freely traded in the market.  However, becoming a public company also brings with it a host of responsibilities, including being subject to ongoing SEC regulations and reporting requirements.

The IPO Process from the Following Points of View: Issuers, Underwriters, Investors, Regulators and Markets

Issuers

It all starts with the decision at the board level of a private company to sell new shares in the public markets to, among other things, raise cash to facilitate faster organic growth, increase liquidity for either the firm and/or the original investors, and/or to use the marketable shares as a transaction vehicle for either growth by acquisitions or to diversify.

Among the first actions for a firm contemplating an IPO is to assemble the set of professional advisors needed, including the firm’s existing auditors and experienced legal counsel.  It is fact specific whether the firm’s existing law firm can act as so-called issuer’s counsel to guide the issuer through the legal aspects of an IPO, including the requirements of the Securities Act of 1933.  The key deliverable in an IPO is the issuer’s S-1 Registration Statement and Prospectus, which functions as both a disclosure and a marketing document.  By law, the content of the S-1 is required to be accurate and complete in all material respects, and the issuer is fully liable to IPO investors for material misstatements or omissions in the S-1, no matter what the reason.  It is customary for issuer’s counsel to tightly control the drafting process and content in the S-1, to coordinate the input of other professionals and to respond to SEC comments on the submitted S-1 drafts.

While issuer’s counsel can generally escape liability by reasonably relying on written assurances from the issuer’s executives that the final S-1 contains no material misrepresentations, the same issuer’s executives can only escape liability for material misstatements or omissions by having a reasonable basis to believe in the accuracy and completeness of material statements in the S-1.  However, from a practical standpoint, if material misstatements or omissions do exist in the S-1, it is a heavy lift for issuer’s executives to escape liability.

The issuer’s auditors are solely responsible for the accuracy of the audited financial statements contained in the S-1.  On the other hand, unaudited statements are often included in the S-1, and these financial statements are clearly marked as unaudited.  Special auditing procedures are used for disclosing unaudited data, and auditors can generally escape liability by, among other things, reasonably relying on written assurances from the issuer’s executives that the unaudited portions of the final S-1 contain no material misrepresentations.

In my experience, the issuer’s board interviews a small handful of investment banks and, based on their individual presentations to the board, selects the lead manager (or co-lead managers) as underwriters of the proposed IPO.  Among the key selection criteria are knowledge and experience with the issuer and/or the issuer’s business, relevant IPO underwriter experience and relevant industry research analyst experience.

While the issuer selects the investment bank as lead underwriter to manage the IPO, the interests of the underwriters are not totally aligned with the interests of the issuer.  To protect their interests, the underwriters not only engage so-called underwriters’ counsel to provide legal advice but also task a team of internal corporate finance professionals to perform a reasonable due diligence investigation to assure compliance with securities laws.  In addition, it is customary that written assurances are obtained by underwriters from issuer’s executives that the final S-1 contains no material misrepresentations.  Furthermore, the issuer’s auditors are often called on to provide underwriters so-called comfort letters on various financial matters.

Underwriters

It is fact specific as to what criteria the issuer uses to choose the lead underwriter, but the selected underwriter works off of a so-called IPO mandate versus a formal underwriter agreement.  It is customary that the binding underwriter agreement will only be signed by the issuer and the syndicate of underwriters on the eve of the actual IPO date.  However, once the IPO mandate is received from the issuer, the lead underwriter and underwriters’ counsel immediately convene the so-called all hands meeting, which in part includes finalizing the initial IPO timeline, including agreeing upon the required actions, due dates and the responsible parties for each required action in the IPO process.  It is fact specific as to the list of attendees in the all hands meeting, but the usual parties include the issuer’s executives (and often selected board members), issuer counsel, the issuer’s auditors and other advisors to the issuer as well as the lead underwriter, underwriter counsel and representatives of the other members of the underwriter syndicate.

The most important action of the lead underwriter, acting on behalf of the underwriter syndicate, is the performance of a reasonable due diligence investigation of the issuer and the securities being issued.  The Securities Act of 1933 requires IPO underwriters to act as gatekeepers for potential investors and to perform a reasonable due diligence investigation of material statements in the S-1.  Such a reasonable due diligence investigation would serve as a reasonable basis to believe in the accuracy and completeness of material statements in the S-1.  Legally, underwriters can only escape liability for material misstatements or omissions in the final S-1 by having a reasonable basis to believe in the accuracy and completeness of material statements in the S-1.  This is known as the due diligence defense and requires strict compliance with the underwriter standard of care and custom and practice for (i) accounting due diligence, (ii) financial due diligence, (iii) business due diligence, and (iv) legal due diligence.

Standard of Care and Custom and Practice in Underwriter Due Diligence

Standard of Care: The applicable standard of care in underwriter due diligence is the performance of a reasonable investigation of potentially material information to ensure there is a reasonable basis to believe in the accuracy and completeness of material information in the offering documents.  The reasonableness standard is that applied by the prudent person in the management of his/her affairs.  The materiality standard is that information is required to be reasonably investigated if there is a substantial likelihood that a reasonable investor would consider the information important in making an investment decision, or if the fact would meaningfully alter the total mix of information available.

Custom and Practice: The custom and practice performing a reasonable  due diligence investigation is as follows: (1) to make inquiries reflecting a reasonable level of skepticism (that is, acting as the devil’s advocate); (2) to follow up and reasonably understand and resolve material red flags (that is, information encountered in the course of a due diligence investigation that is inconsistent with the underwriter’s understanding of the issuer’s businesses, executives, operations, accounting or finances or that is potentially indicative of wrongdoing and, therefore, requires the underwriter to investigate further in order to arrive at a reasonably informed understanding or resolution) and to investigate and reasonably resolve issues encountered during due diligence that may not rise to the level of red flags but which warrant reasonable investigation under the circumstances; if the results of the follow up investigation are not satisfactory to the underwriter, the alternatives faced are either withdrawing from the offering transaction or accepting the risks of not conducting due diligence with reasonable care; and (3) to independently verify material information supplied by executives and advisors of the issuer (or other parties with potential conflicts of interest) on which the underwriter intends to rely.

Other services provided by the underwriters are, among other things, (i) arranging for a so-called teach-in by the research analyst of the lead investment bank (to an audience of sales executives from the lead underwriter) to present the research analyst’s opinion on the issuer, including the research analyst’s detailed financial model of the issuer; (ii) arranging for the issuer’s executives to present the preliminary road show slides (to an audience of sales executives from the lead underwriter) covering in part the issuer’s history and strengths but not the actual financial projections prepared by the issuer; (iii) conducting the road show, which is an orchestrated event in front of potential investors showcasing the issuer and its executive management in meetings (physical and/or virtual) with invited prospective investors; the road show takes place in a so-called quiet period, which prohibits the issuer from discussing its projected financial results; (iv) beginning the process of book building by tallying the so-called indications of interest from road show investors at various prices and quantities; (v) negotiating the over-allotment option (also called the green shoe), which is used for share price stabilization, if necessary, in the 30 day period immediately after the opening of share trading; (vi) committing to making a market in the issuer’s shares; (vii) negotiating and administrating the so-called lock-up of the shares of insiders and other investors owning large numbers of shares; a lock up for up to six months is often employed in order to modulate the supply of shares available for sale; (viii) conducting bring-down due diligence just before final pricing meeting to be assured that there are no recent developments that materially affect the accuracy and completeness of the offering documents; and (ix) agreeing on the final IPO share price and the number of IPO shares offered with the so-called pricing committee of the issuer, signing the underwriter agreement and requesting the SEC to accelerate its review process of the now final S-1.

Besides performing the reasonable due diligence investigation discussed above, other typical underwriter services include helping the issuer executives with (i) positioning the company’s story to new investors; (ii) drafting accurate and complete S-1 disclosures; (iii) educating company insiders and other advisors on the IPO process; (iv) outreaching to prospective investors, including orchestrating attendance at the IPO road show presentation; and (v) managing the liquidity of share trading post offering.

Investors

There are two types of investors in IPOs: institutional and retail.  It is fact specific as to (i) the percentage of new registered shares being sold compared to existing shares, and (i) the share allocation between institutional and retail investors.  In my experience, the issuer determines the specific number of shares for each specific retail investor in the so-called friends and family initial allocation.   For the balance of shares sold to investors, the issuer largely defers to the lead underwriter’s recommended allocation.   There are technical reasons these practices.  For example, the actual mechanics of an IPO are that the issuer sells the registered shares to the underwriter syndicate, who in turn resells the very same shares to the investors at a standard markup of 7%.  Further, it is customary that the underwriter has negotiated the so-called over allotment option totaling 15% of the shares, and that the full 15% is sold at the IPO date.   Moreover, during the road show, certain institutional investors have individually submitted so-called indications of interest for set numbers of shares at set prices.  This road show information is used by the syndicate manager to build the so-called book and, ultimately, to inform the setting of the recommended IPO share price to the pricing committee of the issuer.   The price discovery process is called the book building process.  In a typical IPO, the offering is oversubscribed, meaning that the number of shares sold in the IPO is less than the total indications of interest received.

Once the pricing committee of the issuer accepts the recommended final IPO share price and the number of shares to be issued, the SEC is asked to accelerate its review process of the now final S-1.  If the SEC complies, the registered IPO shares are sold to the pre-selected investors the next morning at the IPO price; and the new shareholders can immediately begin trading their shares at an opening price that is determined by supply and demand, which is almost always different from the set IPO price.

Regulators

The federal government dominates the regulation of the US public and private securities markets, with the states having minor roles in regulating the sale of securities to investors in the respective jurisdictions.  For firms contemplating an IPO, intimate knowledge of the following two federal laws is fundamental: (1) the Securities Act of 1933 (Securities Act), which deals with firms going public for the first time; and (2) the Securities Exchange Act of 1934 (Exchange Act), which established the SEC and deals with the continuing responsibilities of firms that are already public.

The Securities Act requires IPO candidate firms to file a registration statement on form S-1 before the registered shares can be sold to the investing public.  The requirements of the original Securities Act have morphed through amendments, case law interpretations and SEC directives.  In my experience, the SEC stands ready to timely review S-1 drafts submitted and to make comments consistent with the SEC’s goal of investor protection through full and fair disclosure.  Importantly, the SEC does not comment on the investment merits of a proposed offering.   Rather, the SEC’s review focuses on the accuracy and completeness of material information in the final S-1, which is fully consistent with the SEC’s mandate of investor protection.  Along with investor protection, another key goal of the SEC’s disclosure philosophy is market efficiency.  The SEC’s disclosure system is based on the notion that timely, accurate and complete disclosure of material information would not only help investors make informed investment decisions but also help inform independent investment analysis undertaken by key market participants, such as the sell-side investment banks and the so-called buy-side institutional investors, and thus help promote market efficiency.

Markets

As the principal regulator of the US public capital markets, the SEC’s unifying principle of regulation (to promote its mandates of investor protection and market efficiency) is through the requirement of full and fair disclosure.  To that end, so-called reporting companies are required to, among other things, (i) make accurate and complete disclosures of the SEC required information on a timely basis, and (ii) receive a clean audit opinion on an annual basis.  Domestic issuers, for example, are required by the Exchange Act to file with the SEC timely quarterly (10-Qs) and annual reports (10-Ks) as well as timely interim reports on material developments (8-Ks).   Each of the reports has proscribed content areas and is posted on the SEC’s public website, freely available to all market participants.

In my experience, investors and Issuers alike benefit from the SEC’s requirement of full and fair disclosure of material information.  For example, investors benefit by having access to timely, accurate and complete material information on which to base their investment decisions, including potential access to informed investment analysis and research from sell-side and/or buy-side analysts.  Issuers also benefit from receiving higher prices for their securities, resulting in less ownership dilution and lower cost of capital.  In addition, the policy of full and fair disclosure in the US securities markets has also attracted not only foreign investors but also foreign issuers.

Since its establishment in 1934, the SEC has continued to introduce new regulations to help meet its mandates of investor protection and market efficiency.  For example, in 1980, the SEC addressed the disclosure burden on issuers by adopting integration of the 1933 Securities Act disclosures with the 1934 Securities and Exchange Act disclosures and allowing previously filed information to be incorporated by reference in new filings.  In 1981, the SEC adopted the Management’s Discussion and Analysis (MD&A), which provides securities holders and the market a narrative discussion and analysis of the financial condition and results of operations of the issuer, from management’s point of view.  Beginning in 1984, the SEC sought to make access to disclosed information easier with the development of the Electronic Data Gathering, Analysis and Retrieval system (“EDGAR”), an online system that provides digital access to the filings of issuers.  In 1998, the SEC sought to make disclosures more comprehensible with its Plain English Disclosure rules.

I’ve been thinking…Just what is the M&A Process in an LBO deal?

This blog is a follow on to a companion blog, A Deep Dive into the Auction Process of LBOs, which explored the typical actions of both the target that put itself up for sale through an auction process and the buyout firms who participated in that auction.  In contrast, this blog’s focus is on the M&A process in an LBO deal, which includes not only the target’s selection process of the auction winner but also the negotiation process between the auction winner and the target regarding the terms and conditions of the definitive acquisition agreement.  This blog also deals with (i) the winning buyout firm’s finalization of the contemplated debt financing supplied by the lenders and debt investors, (ii) financial engineering in the LBO capital structure, and (iii) the typical actions the buyout firm takes (as the new owner) immediately after the LBO deal closes.

Selecting the Winning Bidder and Negotiating the Acquisition Agreement

Once the LBO advisor receives the final offers from those buyout firms willing to go forward with the transaction, those offers are shared with the target’s board and executives.  A decision process must be established in which the target decides which buyout firm is most likely to close the deal, assuming the offer is acceptable to the target.  In my experience, this decision requires that all of the acceptable final offers be individually analyzed, compared and ranked.  This is a fact specific exercise, requiring a comparative evaluation of, among other things, the different prices offered, the sets of accompanying terms and conditions, the arrangements of the unique debt financing proposals of each offer and any requests for additional time to complete outstanding due diligence items, including outstanding legal matters.  Often there is room for counter offers.

In the end, only one buyout firm is selected to enter into exclusive negotiations with the target regarding the terms and conditions of the definitive acquisition agreement.  In the negotiations, each party is represented by their own team of legal advisors.  Often, representatives of the LBO firm’s investment committee join the deal team in concluding the negotiations. The time required to reach agreement is fact specific, but the end result is the so-called merger agreement, which will guide the M&A process through the agreed upon closing date of the LBO deal.

After the merger agreement is signed, and until the LBO closes, the target is still owned by the target’s existing shareholders.  It is fact specific as to whether the target’s shareholders must vote to approve the merger agreement.  In any case, the target’s executives work closely with the winning buyout firm to effect a timely closing, including ensuring the debt portions of the LBO are successfully funded on the timely basis.

The Decision to Submit a Final Bid

The decision to submit a final bid is invariably backed up by the final draft of the investment memo, which is authored by the deal team and discussed thoroughly at the investment committee level.  Already familiar with the material details of the LBO deal from earlier investment memo drafts, the investment committee’s attention is focused on the final iteration of the LBO model and, among other things, the reasonableness of the projections that support the proposed offer.  In my experience, the investment committee approval process of buyout firms can vary between requiring a simple majority of committee members to unanimity.

Private equity firms owe a fiduciary duty to the investors in their associated private equity funds.  This means that the investment committee must be reasonably convinced that the buyer due diligence investigation performed on the deal was reasonable and met the standard of care and custom and practice required of fiduciaries.

Standard of Care and Custom and Practice in Buyer Due Diligence

Standard of Care: The applicable standard of care in buyer due diligence is the performance of a reasonable investigation of potentially material information to ensure there is a reasonable basis to believe in the accuracy and completeness of material information relied on by the buyer.  The reasonableness standard is that applied by the prudent person in the management of his/her affairs.  The materiality standard is that information is required to be reasonably investigated if there is a substantial likelihood that a reasonable investor would consider the information important in making an investment decision, or if the fact would meaningfully alter the total mix of information available.

Custom and Practice: The custom and practice in performing a reasonable  due diligence investigation is as follows: (1) to make inquiries reflecting a reasonable level of skepticism (that is, acting as the devil’s advocate); (2) to follow up and reasonably understand and resolve material red flags (that is, information encountered in the course of a due diligence investigation that is inconsistent with the buyer’s understanding of the target’s businesses, executives, operations, accounting or finances or that is potentially indicative of wrongdoing and, therefore, requires the buyer to investigate further in order to arrive at a reasonably informed understanding or resolution) and to investigate and reasonably resolve issues encountered during due diligence that may not rise to the level of red flags but which warrant reasonable investigation under the circumstances; if the results of the follow up investigation are not satisfactory to the buyer, the alternatives faced are either withdrawing from the transaction or accepting the risks of not conducting due diligence with reasonable care; and (3) to independently verify material information supplied by executives and advisors of the target (or other parties with potential conflicts of interest) on which the buyer intends to rely.

 The Due Diligence Supporting the Winning Bid

Support for the buyout firm’s final offer is contained in the final investment memo, which is largely based on the buyer due diligence performed on the LBO deal.  In my experience, the LBO financial model plays an outsized role in the decision to make a final offer.  The LBO financial model starts with key input assumptions for, among other things, the entry purchase multiple and price, relevant underwriting standards and minimum credit metrics from both lenders and debt investors, the debt funding mix and the equity-debt split.  These assumptions help form the backbone of the initial output of the financial model, which in part includes detailed projections of EBITDA and free cash flow, debt repayments, capital expenditures (capex), source and use of funds, estimated deal expenses, exit multiple range, IRR calculations and sensitivity analyses.

Not every target is a good candidate for a successful LBO transaction. In my experience, a successful LBO has a reasonable balance of both (i) financial engineering in the capital structure, including the mix of equity securities and various types of debt, and (ii) operating improvements, which refers to, among other things, projected improvements to cash flows that are deemed reasonable in part because of the results of the buyout firm’s due diligence investigation as well as its domain knowledge and experience in the target’s business.  While the benefits of the financial engineering techniques are built into the final offer, the projected benefits of the identified operating improvements can only be fully realized after the LBO closes and the buyout firm is in complete control.

Buyout firms pay particular attention to the complicated interactions of key outputs of the financial model, including the amount of equity required.  For example, not only is the sufficiency of the amounts and timing of free cash flows and EBITDA closely scrutinized, but also the nature, amounts and timing of debt being sought from outside lenders and debt investors are analyzed for internal consistency with the creditors’ reasonably expected underwriting standards and minimum credit metrics.  In addition, the revenue and expense projections must be feasible and able to reasonably generate sufficient cash flows to satisfy the estimated financial and non-financial constraints that the individual creditors will insist upon when negotiating the debt portions of the deal.   Finally, the projected IRR from the financial model must be sufficient to justify the risks of moving forward with the LBO deal.

The Winning Bidder Negotiates the Debt Components of the LBO Deal

While the details are fact specific, the deal team had already predicated its final offer on a specific level of financial engineering in the capital structure, including the mix of equity securities and various types, amounts and costs of debt.  In my experience, the typical LBO deal projects not only a set amount of senior debt supplied by a group of lenders but also a set amount of a so-called revolver loan, which is funded by the same lenders.  In addition, the typical LBO taps the debt capital markets for a set amount of subordinated debt (high yield debt or junk bonds) and often a set amount of so-called mezzanine securities.  While fact specific, the deal team typically relies on its financial advisor’s so-called capital markets group to sign off on the reasonableness of the estimates used in the debt components of the LBO financial model.

After the terms and conditions of the merger agreement have been negotiated, but before the scheduled closing date, the funding of the LBO debt must be finalized not only with the selected lenders but also with the targeted debt investors.  Any material differences from the amounts and costs estimated in the final LBO financial model will change the final IRR calculation and/or the final debt-equity funding mix.

Not surprisingly, lenders not only demand up-to-date data on both the target’s recent financial and operating performance and its projections, but lenders also want a clear demonstration that such data meet the lenders’ credit underwriting standards and minimum credit metrics for the nature of the lending commitments sought.  In my experience, the deal team and its financial advisors help the target’s financial executives prepare the required financial and operating submissions to the lenders and participate in any direct follow up and/or Q&A by the lenders.

It is customary that the borrower in the case of loans, or the issuer in the case of debt securities, is a newly-formed firm owned and controlled by the buyout firm and/or its affiliates, which will be merged into the target at the time of closing.

Debt investors require a different approach from lenders because the sale of debt securities must comply with applicable securities laws.  It is customary for the deal team to engage its financial advisor in an underwriter capacity and to prepare offering documents to solicit potential debt investors on behalf of the issuer.  If the LBO debt financing will use both subordinated debt and mezzanine securities, then depending on the specific facts, separate offering documents from the issuer may be required.

The preparation and distribution of securities offering documents is exacting and time-consuming work that carries with it due diligence responsibilities for both the issuer and the underwriter.  The individual due diligence investigations of the issuer and underwriter serve as the reasonable bases for both parties to believe that material information disclosed in the offering documents is accurate and complete in all material respects.  It is customary that potential debt investors are invited to attend a so-called roadshow covering, among other things, the LBO transaction, the issuer and the debt securities being offered.

It is fact specific just how much of a role the target’s existing executives will play in the company post-closing operations.  Often, key executives of the target are singled out and offered significant roles after the close, including rolling over of their existing equity ownership in the target and participation in other financial incentives tied to the successful performance of the post-LBO company.

Financial Engineering in the LBO Capital Structure

In my experience, a key goal of an LBO is to maximize the IRR on exit.  One key strategy consists of financial engineering in the capital structure, not only in the debt portion but also in the equity portion.  The other key strategy is operating improvements, which is discussed in the next section and refers to projected improvements to cash flows implemented by the buyout firm after closing.

Financial engineering of the debt portion of the capital structure involves layering in the maximum amounts of low-cost senior debt (and revolver debt) with the maximum amount of higher cost subordinated debt.  If applicable, mezzanine debt is added.  The balance of each type of debt must be consistent with applicable debt capital market underwriting standards and minimum credit metrics.

While a reasonable amount of leverage can be used to improve the IRR of a deal financed by 100% equity, creditors have their own ideas of what is reasonable leverage.  For example, lenders have minimum underwriter standards, including minimum credit metrics, regarding such ratio measures as (i) leverage ratio (debt/EBITDA), (ii) interest coverage ratio (EBIT/interest), (iii) debt service coverage ratio (EBITDA – capex)/(interest + principal), and (iv) fixed charge coverage ratio (EBITDA – capex – taxes)/(interest + principal).

Financial engineering of the equity portion of the capital structure involves designing a limited array of equity securities with different rights and issuing those securities with preferred rights to the buyout funds that will own the target post closing.  An example of such a preferred security is one with cumulative dividend rights.  On exit, investors owning equity securities with cumulative dividend rights have preference to the exit proceeds over other investors owning non-preference equity securities.

Typical Actions of New Owners After the Closing Date

For the closing to occur, a number of customary actions must take place simultaneously, including in part the following: (1) distributing cash in accordance with the agreed upon cash distribution schedule, including paying the agreed upon offer price to the target’s shareholders by drawing funds from (a) identified lenders and debt investors (in return for the associated loans and debt securities in the new firm), and (b) identified buyout funds (in return for the associated equity shares in the new firm); (2) attending to administrative matters, such as the completion of the reverse merger and any required name changes or share trading symbol changes; and (3) attending to corporate governance matters, such as holding the required organization board meeting, adopting the agreed upon Articles and By-laws, electing new board members to assure control by the new owners, adopting new incentive compensation plans, and approving the board’s new meeting schedule and agenda format.

Implementing Operating Improvements After the Close

Once the buyout is completed, the buyout firm’s executives set about to timely orchestrate a set of value-added operating improvements, which were identified in the final investment memo.  More particularly, such operating improvements are based on projected improvements to cash flows that are deemed reasonable in part because of the results of the buyout firm’s due diligence investigation as well as its domain knowledge and experience in the target’s business.

In my experience, as the new owner, the buyout firm seeks to realize the identified operating improvements by, among other things, controlling the company’s board membership and working through a new or existing team of company executives who are financially motivated to timely achieve the value-added changes.  By continuously monitoring progress against plan on the value drivers of the company, the board will have the opportunity to decide on a timely exit transaction, which maximizes the LBO transaction’s internal rate of return.

Final Notes on the Buyout Business

The 5-7 year life of the typical buyout fund reflects the belief that a portfolio of LBO investments can be sourced, diligenced, negotiated, closed, restructured/repositioned, and successfully exited within the life of the limited partnership.  In addition, the buyout business model charges its portfolio companies (i) a monthly management fee, (ii) a deal origination fee for arranging the buyout, and (iii) financing fees on future fundraising by the company.  It is customary for these fees, which are paid to the buyout firm, to offset the management fees charged by the buyout firm to the buyout fund.