Special purpose acquisition vehicle

A leveraged buyout has a problem of plumbing. Several banks and bond investors are lending most of the purchase price. Private equity funds are putting up the rest. Somebody has to hold the money, and somebody has to own the company that gets bought.

The answer is to incorporate a company for the purpose. The workbook calls it a special purpose acquisition vehicle, or simply an acquisition company.

It does two jobs.

First, it pools the capital. The debt and the equity both come into one entity, on agreed terms and in an agreed order of priority.

Second, it gives the lenders a ring-fenced secured structure. Their claim sits in a company that holds nothing except the target. Nothing else of the funds is exposed, and nothing else gets in the way of their security.

The vehicle then acquires control of the target. The target services the debt and the equity above it, by pledging its assets and passing cash up as dividends.

Be careful with the initials. This is not the blank-cheque listed shell that people call a SPAC. It is a private holding company built for one deal.

Section 8.3.1.2 introduces the vehicle as part of the LBO structure: LBO financing falls under the category of special situation financing and is therefore a form of structured financing. In order to enable the pooling of the debt and equity capital and to provide a ring fenced secured structure for the providers of the debt capital, a special purpose acquisition vehicle (an acquisition company) is usually incorporated for the LBO.

The workbook's basic LBO structure, read top to bottom.

The financing split. A classic LBO is financed 70% debt and 30% equity, and the workbook notes some LBOs may stretch it even beyond that.

Why the structure is worth the trouble. An LBO is resorted to when the target has a large acquisition price and substantial potential for free cash flow generation. Because such companies are usually less levered to begin with, the new leverage can be serviced comfortably, which produces an upside in return on equity for the buyout investors. Buyouts also usually involve tax arbitrage, by bringing significant debt into the deal structure to avail a tax set-off and increase ROE.

Why the ring fence matters both ways. The workbook is blunt about the downside: LBO structures have a huge embedded risk of default and bankruptcy, which may crystallise if the future performance of the target does not pan out as envisaged. The vehicle contains that risk. Lenders look to the vehicle and the target, not to the fund's other holdings.

How complex it gets. In practice, the workbook says, LBO structures can be quite complex to provide for debt tranching, tax deductibility or cross border financing.

Konkan Capital Partners, a Category II AIF, agrees to buy 70% of Sabarmati Packaging Ltd for Rs 2,000 crore. Sabarmati generates Rs 260 crore a year of free cash flow and carries almost no debt.

Step 1 — incorporate the vehicle. Konkan sets up Sabarmati Acquisition Co Pvt Ltd. Its only asset will be the Sabarmati shares.

Step 2 — fund it on the classic 70:30 split.

Step 3 — acquire and service. The acquisition company buys the 70% stake. Sabarmati collateralises its assets for the lenders and upstreams cash as dividends. At a blended interest cost of 11%, the annual debt service is Rs 154 crore against Rs 260 crore of free cash flow — covered about 1.7 times.

Why the ROE improves. Compare the two ways of owning the same stake.

Less than a third of the money, and a higher return on it. That is the arbitrage the structure exists for, and the workbook's tax point sharpens it further because the interest is deductible where a dividend is not.

Now the warning. Suppose free cash flow falls to Rs 140 crore in a bad year. Debt service of Rs 154 crore is no longer covered. The equity return is negative and the lenders can enforce against the ring-fenced vehicle and the pledged assets of Sabarmati. Konkan loses its Rs 600 crore; it does not lose the rest of its portfolio. That is what ring-fenced means — protection for the lenders inside the structure, and containment for the fund outside it.

Chapter 8 (Alternative Investment Fund Structuring), section 8.3.1.2 on the Leveraged Buy-Out, introduces the vehicle and prints the basic LBO structure diagram immediately after.

The examinable points are why it is incorporated — to pool the debt and equity capital and to provide a ring-fenced secured structure for the providers of the debt capital — and the classic 70% debt, 30% equity split. Expect a question on who owns the acquisition company (the private equity investors), what it acquires (control of the target), and how the debt is serviced (by the investee company collateralising its assets and upstreaming cash flows through dividends). The three named debt layers — senior, sub-ordinate and mezzanine — are also worth memorising in that order.

• This is not a SPAC. A US-style special purpose acquisition company is a listed blank-cheque shell that raises money from the public first and finds a target later. The workbook's special purpose acquisition vehicle is a private company incorporated for one identified LBO.
• Nor is it the special purpose vehicle of a REIT or an infrastructure fund, which holds and develops assets rather than acquiring control of a company.
• The private equity investors own the vehicle; the vehicle owns the target. Two levels, and questions swap them.
• The target services the debt, not the fund. Cash comes up from the investee company as dividends against collateralised assets.
• 70% debt and 30% equity is the classic split, and it is a maximum only by convention — the workbook says some LBOs stretch beyond it.
• Ring-fencing protects the lenders' security and contains the fund's loss. It does not reduce the risk of default; the workbook calls that risk huge and embedded.
• Senior, sub-ordinate and mezzanine are three tranches inside the debt, not three alternatives to it.