Secured LBO Financing or Asset-Based Lending

Under asset-based lending, the borrower pledges certain assets as collateral. Asset-based lenders look at the borrower's assets as their primary protection against the borrower's failure to repay. Such loans are often short-term, i.e., around 1-5 years in maturity and secured by assets that can be easily liquidated such as accounts receivable and inventory. Secured debt also called the asset-based lending contains two sub-categories: senior debt and intermediate-term debt. In some small buyouts, these two categories are considered one. In larger deals, there may be several layers of secured debt, which vary according to the term of the debt and the types of assets used as security.

Senior Debt

Senior debt consists of loans secured by liens on particular assets of the company. The collateral that provides the risk protection required by lenders includes physical assets such as land, plant and equipment, accounts receivable and inventories. The level of the accounts receivable that the firm averages during the period of the loan is assessed, based on which the amount of loan to be lent is determined. Lenders usually will give 85% of the value of the accounts receivable and 50% of the value of the target inventories (excluding the work-in-progress).

The process of determining the collateral value of the LBO candidate's assets is sometimes called qualifying the assets. Assets that do not have collateral value such as accounts receivable that are unlikely to be collected are called the unqualified assets.

Intermediate-term Debt

The intermediate-term debt is usually subordinate to senior debt. The loan is often backed by the fixed assets such as land and plant and equipment. The collateral value of these assets is usually based on their liquidation value. A debt backed up by equipment usually has a term of six months to one year and a debt backed by real estate will have a one to two year term. Usually, the loan amount will be equal to 80% of the appraised value of equipment and 50% of the value of real estate. However, these percentages may vary depending on the area of the country and conditions of the market. The collateral value depends not on the book value of the asset, but on its auction value. If the auction value i.e., the liquidation value is greater than the book value of assets, the firm's borrowing capacity is greater than what is reflected in the balance sheet.

Costs of Secured Debt

The costs of senior debt vary depending on the market conditions. Senior debt rates are often quoted in relation to other interest rates such as the prime lending rate. The prime rate is the rate, which the bank charges for its best customers. It often ranges between 2 and 5 points higher than the prime rate for a quality borrower with quality assets.

Unsecured LBO Financing

Leveraged buyouts are typically financed by a combination of secured and unsecured debt. The unsecured debt also referred to as subordinated and junior subordinated debt has a secondary claim on the assets of the LBO target. Unsecured financing often consists of several layers of debt each secondary (subordinate) in liquidation to the next most senior issue. Those with the lowest level of security normally get the highest yields to compensate for their higher level of risk.

It is also often called mezzanine financing, because it has both equity and debt characteristics. It has more characteristics of a debt, but it is also like equity because lenders receive warrants that may be converted into equity in the target. The warrant allows the holder to buy stock in the firm at a pre-determined price within a defined time period. When the warrant is exercised the share of ownership of the previous equity holders is diluted. Hence, this form of LBO financing is often used when there is no collateral. The main advantage of the mezzanine layer financing is the profit potential that is provided by either the direct equity interest or warrants or warrants convertible into equity. The added return potential offsets the lack of security that the secured debt has.

Unsecured LBOs are sometimes called cash flow LBOs because stable cash flows can also act as an important source of protection. The more regular the cash flows, the more assurance the lender has that the loan payments will be made. These deals have a more long-term focus with a maturity of around 10-15 years. On the contrary, secured LBOs might have a financing maturity of only around 1-5 years. The cash flow LBOs allow the firms that are not in capital-intensive industries like the service industries to be LBO candidates. Usually, lenders of an unsecured financing require a higher interest rate as well as an equity interest. The equity interest may be as low as 10% or as high as 80% of the company's shares. If the risk is higher this percentage will be even more.