Equity can come from two primary sources in LBO financing.
- PE firm
- Management
The amount of sponsor equity that is usually invested is the difference between the total uses and the maximum amount of debt capital the firm was able to access.
Total Uses – Debt = Equity
The private equity firms invested capital is called sponsor equity.
The management’s invested capital is called rollover equity.
So, if the private equity firm needs $100M in capital to close the deal (fees included) and has $60M in debt capital, then the equity invested must equate to $40M ($100 – $60).
The private equity firm ideally wants to put up as little capital as possible, so they will go to the firm’s current management and ask them to invest in the post-LBO company.
The value is two fold. Not only can the private equity firm contribute less of their own capital, but management also becomes aligned with the post-LBO company because they have “skin-in-the-game” aka they are invested in the success of the company post transaction.
If management rolls over 20% of their existing equity, this means that they are in essence contributing 20% of the equity difference, $40M.
So management brings in $8M.
These funds are raised when the company is bought out and existing shareholders are paid out and then simultaneously reinvested into the new company.
This means that the private equity firm must commit $36M ($40 – $8) difference.
Bottom-line? There are two sources of equity in an LBO, the private equity firm and existing management.
