Design and impacts of securitized leveraged buyouts

Abstract

Private equity investors have traditionally used innovative financial methods in structuring their leveraged buyouts (LBO) deals. In recent years, they have frequently employed securitization to raise funds on the back of their acquisitions’ operating assets. A distinctive feature of these transactions is that they aim to enhance the securitizing LBO’s debt pay capacity through a set of structural enhancements including operating debt covenants. Operating covenants—supported by legal security arrangements—mitigate an LBO’s financial and operating risks and improve its cash generation potential. We test this hypothesis by examining changes in the operating income of Hertz LBO. The results show that, within the operating framework adopted by Hertz LBO, securitization improved the transaction’s debt service capacity.

Keywords:

• leveraged buyouts
• securitization
• operating management covenants
• Hertz

JEL classifications:

• G32
• G34
• L20

Public Interest Statement

Asset-based securitization first became prevalent in the 1980s. It creates special security mechanisms that enable the creditors to gain control of the securitized assets in the event of a default. However, in a securitized LBO transaction, full isolation of the cash-generating assets from the originator’s credit risk via SPV is not achievable, because of the operating nature of the securitized assets. As a consequence, operating covenants are introduced to monitor and control the operating performance of these assets. The method does not materially alter the core business model of the securitizing firm. Rather, the goal is to enhance the firm’s debt service capacity. The paper explores the design and impacts of these financial methods using the experience of a securitized LBO transaction. It fully sheds light on the nature of these regulatory processes and considers their effectiveness in LBO-related financial markets.

Notes

1. For example, Guo et al. (2011) in their study of the recent wave of LBOs suggest: “Firms with greater increases in leverage as a result of the buyout consistently show better cash flow performance. These results are consistent with the disciplining effect of higher debt for the post-buyout firm.” For a discussion of the other so-called LBO hypotheses such as interest tax benefits or deal value discrepancy, see Cumming, Siegel, and Wright (2007).

2. Domino Pizza’s securitization, for example, specifies a normalized cap-ex in the $20–30 million range annually. Minimum cap-ex requirements are designed to ensure the competitive position of the business remains at least as good as at closing. Like Domino’s, the emphasis in a securitized LBO is on increasing the securitized assets’ inherent resilience by making investments in capital replacement projects, along with creating new growth opportunities.

Additional information

Funding

Funding. The authors received no direct funding for this research.

Notes on contributors

Laurent Bouvier

Laurent Bouvier is a structured credit analyst at BNP Paribas. He obtained his master’s degree from Birkbeck College, London. His area of expertise includes credit control and securitization.

Tahir M. Nisar

Tahir M. Nisar is an associate professor at the Southampton Business School, University of Southampton. He completed his PhD degree at the London School of Economics. He specializes in leveraged buyouts, entrepreneurial finance, and corporate governance.