Mastering Complexity of Leveraged Buyouts: Check Cash Flow, Check Collateral, and Make Sure You Have a Good Lawyer
Diamond, Stephen C., American Banker
Mastering Complexity of Leveraged Buyouts
Check Cash Flow, Check Collateral, and Make Sure You Have a Good Lawyer
During the past several months leveraged buyouts (LBOs) have been both praised as a vehicle to promote the American entrepreneurial spirit and condemned as a misuse of this country's financial resources. Lenders have applauded them as a means of generating front-end fees and better-than-normal yields, while some financial columnists have denounced them as tomorrow's nonperforming loans and chargeoffs.
The fact is that LBOs, generically, are neither "good' nor "bad.' As with any other types of credit, their soundness depends on the intelligence with which they are structured. LBOs, however, in addition to bearing the usual credit risks, involve degrees of risk that only more knowledgeable lenders appreciate.
This article will highlight the primary areas of risk a lender faces in structuring and monitoring an LBO and make some admittedly simplistic observations that should assist lenders in managing the risk within acceptable levels.
Adequacy of Collateral
All secured LBOs should be predicated on the lender's maintaining a valid lien on collateral, which has sufficient liquidating value to cover the lender's exposure. Key check points to maintenance of collateral adequacy include:
Sufficiency of collateral. The test of collateral adequacy should be the value of that collateral in a forced liquidation. Going concern values are irrelevant if the LBO fails. Overadvances may be required to structure the deal, but they should be quantified.
Current asset valuation. This can best be determined in terms of downside liquidating value by professional asset-based lenders. No one can quantify what receivables and inventory are really worth in the event of liquidation as well as those who have had previous experience in liquidating collateral.
Fixed-asset loan valuations should be determined by outside appraisers who have been directed by the lender with respect to the basis on which the appraisal is to be made. Too many appraisals today are based on what values the lender needs to "do the deal,' not on what the property is really worth. If the appraisal was arranged by the borrower, the lender should talk to the appraiser to get behind the stated figures.
Collateral values vary and must be monitored after the closing. Receivables and inventories change daily in both quantity and quality. The value of fixed assets changes with the passage of time and changes in the business cycle. Poorly maintained fixed assets will lose value faster than will well-maintained assets. All of these variables should be closely tracked.
Sufficiency of legal position. Even if collateral can support the loan, the secured lender cannot rely on it if he cannot maintain a valid legal claim.
The legal risks of structuring an asset acquisition are always less than those involved in structuring a stock acquisition. The primary legal risk in a stock acquisition involves the violation of Section 548 of the Federal Bankruptcy Code, dealing with fraudulent conveyances.
Much has been written about this section and its application to LBOs, but even now it is not generally understood. If the fair market value of the assets at the time of acquisition is less than total liabilities, including contingent claims such as unfunded pension obligations, there is a significant legal risk of the secured lender's lien being set aside if the borrower fails within a one-year--and sometimes within a six-year--time frame.
Some convoluted legal opinions have been issued, occasionally by otherwise reputable firms, that clearly indicate a lack of understanding of how fair market asset valuation is determined under Section 548 of the Bankruptcy Code. It is safe to say this is clearly a most misunderstood area of risk in leveraged buyouts, even among counsel. …