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A Deep Dive into the Auction Process of Leveraged Buy Outs (LBOs)

I’ve been thinking…Just what is an LBO auction?

An LBO involves an M&A deal that is largely financed with debt.  If the target being acquired initiates the deal and is a large company, often an investment bank is engaged to conduct an auction of the target.  In general, interested buyers fall into two groups: (1) strategic buyers, who are companies interested in the target to help grow the buyers’ existing business or to diversify; or (2) financial buyers, who are specialized private equity firms, called buyout firms, seeking outsized investment returns for their associated buyout funds.

This blog’s focus is on the auction process in a typical LBO deal, which involves both a target using an auction procedure and a group of buyout firms participating in that auction.

In a companion blog, A Deep Dive into the M&A Process of LBO Deals, the focus is on the M&A process, after the target selects the winner of the auction.  The companion blog includes not only the target’s selection process of the auction winner but also the negotiations between the auction winner and the target regarding the terms and conditions of the definitive acquisition agreement.  The companion blog also deals with the typical actions of the buyout firm to secure the contemplated debt financing from the identified lenders and debt investors as well as the typical actions of the buyout firm (as owner) immediately after the LBO deal closes.


Buyout firms create and manage a series of buyout funds, which are the source of the equity that is used to partially fund an LBO deal.  A buyout fund is typically structured as a limited partnership, with the buyout firm acting as the general partner and the limited partners consisting mainly of institutional investors, such as pension funds.  The life of the limited partnership is generally 5-7 years.  Limited partners provide up to 99% of the buyout fund’s investment capital; the buyout firm supplies the rest and charges the buyout fund an annual management fee of 1 to 2% of the committed capital and a so-called carried interest of some 20% of the fund’s profits.  In return, the buyout firm’s executives handle the day-to-day management of the buyout fund, including the initial investigation of any so-called teaser letters, which is sent by a target’s financial advisor to solicit interest from potential buyers in acquiring their client’s business.

Anatomy of an LBO Deal Using an Auction

It all starts with the target’s decision to put itself up for sale to the highest bidder.  In my experience, the first move is to engage a set of qualified legal and financial advisors.  An investment bank is typically engaged as a financial advisor, and the choice is in part based on the investment bank’s experience with the company’s business and industry.  Moreover, often the decision on which investment bank to select not only considers prior deal experience using auctions but also experience in dealing with buyout firms and LBO transactions.

In my experience, the company’s Board interviews a handful of investment banks, and each bank’s M&A group makes a formal pitch for the business and details their relevant experience in such transactions.  Comprehensive pitches include not only a tentative timeline and initial thoughts on valuation but also a list of potential financial bidders and an outline of the proposed content of the so-called confidential information memo (CIM), which in part describes the target and the deal.

An engagement letter is then negotiated with the investment bank’s M&A group that the target’s Board has selected, and the final letter spells out the various duties and the basis for compensation.  Besides the M&A group, other areas of the investment bank are often involved in an LBO deal.  For example, the so-called capital markets group will use their market knowledge of recent similar deals to weigh in on relevant components of debt financing, such as interest rates, discounts and covenants.   Another area may be involved, the so-called leveraged finance group, if it is believed that providing seller financing would likely improve final bid prices and/or terms.  For instance, the deal could be structured to provide the successful bidder with so-called staple financing, including structuring the financing for the deal, securing the lenders and investors for the debt components of the successful deal’s financing.

Preparing the Teaser Letter and the CIM

Once the final engagement letter of the LBO advisor is signed, the focus turns to finalizing the list of buyout firms believed to be interested in the proposed deal.  Often contacting the identified buyout firms involves sending a teaser letter, which is 1-2 pages on the LBO advisor’s letterhead and has a firm deadline indicated.  In my experience, the teaser letter is crafted to contain just enough information for any contacted party to take the next steps of requesting the CIM and signing the required non-disclosure agreement (NDA).  For example, information that would be relevant to an interested buyout firm includes the target’s rationale for selling, the nature of the business and its size (measured by various financial and operating data).  At this stage, the name of the target is not disclosed, and the LBO advisor continues to be the sole contact with the buyout firms.

While awaiting responses to the teaser letter, the LBO advisor continues to confer with the company’s Board and executives about the auction process, the content of the virtual data room and the preparation of the CIM.  Moreover, the LBO advisor goes about completing its own reasonable due diligence investigation, which will serve as a reasonable basis believe in the accuracy and completeness of the material information in the CIM.

Invariably the company engages other advisors to render reports and/or opinions in connection with the LBO.  For example, accounting advisors are hired to prepare a report that contains historical balance sheet analyses, a run-rate analysis, tax due diligence and a so-called quality of earnings report, which includes an analysis of adjustments to reported EBITDA.  The final version of the accounting advisor’s report is often included in both the CIM and virtual data room.  Also, additional outside business advisors are sometimes engaged to prepare reports on other relevant matters on a case-by-case basis, such as insurance and human resources.

While fact specific, the content of a 50-100 page CIM typically includes the following topics:

(1) history of business, challenges, competitive analysis, services provided, material third party relationships, information technology and regulatory matters

(2) growth strategy (de novo, M&A, organic)

(3) executive management summaries, company’s organizational structure

(4) overview and analysis of company’s industry

(5) summary of historical financial and operating data, including detail information on current years and recent quarters

(6) detail projections of financial and operating data

(7) reconciliation of reported EBITDA to adjusted EBITDA (from the accounting report)

In crafting the CIM, an evaluation is often made as to whether or not to reasonably disclose and explain any material ongoing and/or planned remedial work by the company and/or consultants.  In my experience, the target’s acknowledgement of an existing problem or opportunity, and the steps being taken or planned to be taken (including timelines and estimated costs), adds credibility to the accuracy and completeness of the CIM.

The CIM is accompanied by next steps instructions, which typically include the deadline by which a non-binding indication of interest must be submitted.  Often, a description of the valuation method used is also required.  Bidders submit a range of prices, with any limiting assumptions spelled out.

Buyout Firm’s Response to Teaser and CIM

Typically, the teaser letter sent by the target’s investment bank is unsolicited, but the target’s business is reasonably believed to be in each of the contacted buyout firm’s preferred investment space.  The deal described in the teaser letter is initially evaluated by the buyout firm’s designated screening committee to determine, among other things, (i) if the buyout firm has the necessary domain knowledge, (ii) if the necessary bandwidth is available to timely perform the required buyer due diligence, (iii) if no timing or other material conflicts exist, and (iv) most importantly, if on the surface the deal presents a compelling opportunity, which is reasonably capable of delivering the firm’s required minimum investment return.  If the screening committee’s evaluation is favorable, a request is made for the CIM and the NDA, and the NDA is timely executed by the buyout firm and returned to the target’s investment bank.

Upon receipt of the CIM, the buyout firm assigns a set of experienced executives, the so-called deal team, to conduct a preliminary investigation of the deal.  The first order of business is populating the so-called LBO financial model, which is a fixture in every LBO deal.  Although generic versions of LBO financial models exist, most buyout firms have their own tailor-made versions.  When initially populated, the LBO financial model is an integrated set of spreadsheets of not only the target’s historical financial and operating data, including historical balance sheets, income statements and cash flow statements, but also projected financial and operating data, based largely on the target’s projections in the CIM.  In my experience, the most important output of an LBO financial model is the expected internal rate of return (IRR), which is a straight-forward calculation based upon three inputs: the initial investment cost, the estimated final exit price and the estimated time period for effecting the exit transaction.  Among other important outputs, besides detailed balance sheets, income statements and cash flow statements, are detailed projections of EBITDA, capex, interest and principal repayments.

The LBO financial model, using in part the target’s projections as inputs, generates the outputs of the first iteration of the model.  The target’s projections will be subsequently replaced by the buyout firm’s own data.  In my experience, often many hundreds of iterations of the model are needed to build the requisite confidence that the deal is worth pursuing from an IRR standpoint and that the required debt levels would be reasonably available.  The key outputs from each iteration of the model are closely analyzed and then inputs are serially tweaked to move the key outputs of the next iterations of the model closer to the desired levels.

The basic business of a buyout firm is to leverage the equity raised in the associated buyout funds with debt provided by other investors to finance the buyout of a company that earns the minimum required IRR.  While a reasonable amount of leverage can be used to improve the IRR of an all equity deal, lenders have their own ideas of what is reasonable leverage.  Lenders have minimum underwriter standards, including credit metrics such 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).  In my experience, a successful LBO has a reasonable balance of both (i) financial engineering in the capital structure, including the mix of equity and various types of debt, and (ii) operating improvements to cash flows, based in part on the buyout firm’s deep domain knowledge and experience in the target’s business.

Buyout firms pay particular attention to the complicated interactions of key outputs of the financial model, including the amount of equity.  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’ expected underwriting standards and minimum credit metrics.  In addition, the buyout firm’s 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 portion 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.

Once the final iteration of the financial model is both feasible and favorable, the deal team then prepares a preliminary investment memo (30-50 pages) for its investment committee and seeks formal authorization to submit the recommended non-binding range of bid prices.

The content of the investment memo is of course fact specific and reflects not only the information in the CIM but also whatever unique knowledge and experience the deal team can bring to the proposed transaction. Often the preliminary investment memo contains the following information:

  • Executive Summary: summary of the deal, background, investment thesis, deal team recommendations
  • Company Overview: history, description, products and services, customers, suppliers, competitors, organizational structure, management team
  • Market and Industry Overview: growth rates in major market segments, market trends, innovation history and prospects
  • Financial and Operating Overview: analyses of historical and projected income statements, balance sheets, cash flow statements; analysis of key operating data
  • Due Diligence: summaries of deal team’s completed and on-going investigations regarding accounting, financial and business due diligence; current and potential material risks and mitigations to the company and/or industry; discussion of the scope of any required future due diligence by legal, accounting, financial or other professionals
  • Capital Structure: indicative amounts and costs of debt components, indicative amount of equity
  • Valuation: comparable company analysis, precedent transaction analysis, DCF analysis; latest iteration of LBO financial model
  • Exit: tentative conclusions regarding potential exits and timing as well as estimated IRRs for each exit scenario supported by LBO financial model and analysis; sensitivity analyses
  • Recommendations: the deal team recommends approval of a specific range of non-binding bid prices, and a list of qualifying terms and conditions. The deal team also outlines a proposed plan of action, if the target decides to accept the non-binding bid.  Among other things, the proposed action plan includes (i) contacting specifically identified professional advisors that will be engaged to help timely complete the required reasonable due diligence investigation, and (ii) contacting specifically identified lenders/debt investors regarding negotiating the required financing commitments (amounts, costs and minimum required credit metrics).

If the investment committee gives its approval, the contingent bid is submitted consistent with whatever constraints were attached to the investment committee’s approval.

Target’s LBO Advisor’s Response to Indications of Interest

The ultimate goal at this point is to cull the list of interested parties to a manageable number that will then be allowed access to the virtual data room and, ultimately, to the target’s executive management and advisors.  The LBO advisor receives the non-binding indications of interest of the buyout firms and shares the bids with the target’s board and executives.  The feasible non-binding bids are then ranked, and the field is narrowed to those believed to have a realistic chance of closing a deal with the target.  The LBO advisor formally notifies the handful of selected bidders.

In my experience, the virtual data room, which is a work in progress that is intended to house all of the deal information and documents deemed material, has been being assembled under the direction of the LBO advisor, including detailed access procedures.   Except for strictly confidential information, the virtual data room will include the final reports and opinions of all consultants and advisors used in connection with the LBO transaction.

The LBO advisor also works with the target’s board and key executive team to develop a presentation to be given individually to each qualified bidder.  Among other things, the presentation updates material information in the CIM and showcases the company’s executive team.  At the individual presentations, the LBO advisor will often discuss the data room procedures and stress the crucial nature of its middleman role so as not to unreasonably interfere with the target’s business operations once the qualified bidders are conducting their buyer due diligence investigations.

Buyout Firm’s Actions When Its Indication of Interest is Accepted

With few exceptions, only after notification that the non-binding offer was accepted will the buyout firm opt to engage the specific set of legal, financial and other advisors deemed necessary to perform a reasonable buyer due diligence investigation.  In my experience, the deal team itself has already conducted the bulk of the financial and business due diligence, whereas one or more law firms are engaged to conduct legal diligence.  An accounting firm is often engaged to conduct accounting due diligence, and an accounting report is created to document its findings.  Among other things, the accounting report addresses not only the work of the target’s auditor and financial statements but also a detailed analysis of the report(s) prepared by the target’s accounting advisor.

Depending on the specific background and/or bandwidth of the deal team, an outside financial advisor is often engaged to perform elements of financial and/or business due diligence.  The notion of “dueling experts” can be in evidence in LBO deals whenever advisors from both sides of the deal address the same topics.  In my experience, accounting advisors to individual buyout firms often take issue with content in the accounting report prepared by the target’s accounting advisor.

At this stage, qualified bidders (and their advisors) are given controlled access to the virtual data room and are able to schedule the individual presentation with the target’s executive team.  Moreover, a qualified bidder is able to request (through the LBO advisor) one-on-one meetings with the target’s executives and/or advisors to discuss relevant due diligence matters, including requests for additional information.  At the discretion of the LBO advisor, information that the target shares with one qualified bidder may be uploaded to the virtual data room to be accessible to all the qualified bidders.

In the end, the buyout firm’s goal is to perform as much due diligence as necessary to make a reasonable determination of the benefits and costs of the set of operating changes which, when timely implemented, will serve as reasonable justification for development of the parameters of a competitive bid at a valuation that would, among other things, reasonably allow the buyout fund to meet its required rate of return upon the planned exit of the investment.  In my experience, the preliminary investment memo is timely updated by the deal team to reflect the latest due diligence results.  Each of the updated investment memos is fact specific.  The final investment memo not only addresses any outstanding issues the investment committee had previously raised but also serves as a reasonable basis to believe in the accuracy and completeness of the material information relied on in deciding to recommend whether to abandon the auction or to proceed to preparing a final bid.

The Companion Blog on the M&A Process

The companion blog, A Deep Dive into the M&A Process of LBO Deals, picks up where this blog, A Deep Dive into the Auction Process of LBOs, left off.  That is, the companion blog begins with the notion that the final investment memo gave rise to a formal bid from the buyout firm for the target.  In turn, the target effectively ends the auction process by accepting a formal buyout offer and immediately commencing exclusive negotiations of the terms and conditions of a definitive acquisition agreement, including any agreed upon closing conditions.  The companion blog also deals with, among other things, the typical actions of the buyout firm to secure the contemplated debt financing from the identified lenders and debt investors as well as the typical actions of the buyout firm (as owner) immediately after the LBO deal closes.