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The capital structure of a typical PE portfolio company may be made up by a combination of:
Senior debt - this is the debt financing supplied by a bank or other institution that is secured by the company's assets. It is the first capital to be repaid if a company fails. Junior debt - this debt financing often is not secured and as a result is a more expensive source of capital than senior debt, and as such, it is subordinated to the senior lender. Mezzanine capital - this type of capital can be in the form of subordinated debt or as preferred shares. Often warrants are associated with this type of financing. Preferred shares - this type of capital has characteristics of both debt and equity. Preferred shares may pay dividends and are senior to common equity, but subordinated to debt financing. Normally, preferred shares have no voting rights. Common shares - this is the riskiest type of capital and these shareholders control the company. The way a deal is structured is critical to the success of a portfolio company. When cash flows are relatively predictable and regular, more debt is typically used. When cash flows are uncertain and irregular, too much debt can cripple a company's ability to operate normally and may place the shareholders at great risk if it were to experience a downturn. Financial engineering uses leverage to multiply the rate of return on a PE Firm's equity investment. Most PE Firms use some degree of financial engineering to ensure that their minimum rates of return are realized. Operational improvement strategies are a much more important component of modern PE Firms' strategies than they were a few short years ago. These strategies can include add-on acquisitions, core competence in a specific industry, technical or business support, synergies with other portfolio companies, training programs, HR support and many others. Today's modern PE Firm brings a lot more to the table than capital and operate more like industry players than financial services companies. Next... Key criteria for an LBO |