- LBO — Leveraged Buyout — Using Debt to Boost Equity Returns
- Why do PE firms use so much leverage?
- What type of company is a good candidate for an LBO?
- What are the steps in a Leveraged Buyout (LBO)?
- LBO financial modeling
- Additional information
- Leveraged Buyout: Definition, Examples and Uses
- How Is a Leveraged Buyout Different?
- Example of A Leveraged Buyout
- Advantages of a Leveraged Buyout
- 1. To Privatize a Public Company
- 2. To Break Up a Large Company
- 3. To Improve an Underperforming Company
- 4. To Enrich Shareholders and Owners
- Criticisms of the Leveraged Buyout
- What Is A Leveraged Buyout (LBO)?
- Leverage Buyout Definition
- What Companies Make Good LBO Targets?
- How Do PE Funds Increase the Value of the Target?
- What Happens to the Debt in the LBO?
- Leveraged Buyout (LBO)
- How Does a Leveraged Buyout (LBO) Work?
- Why Does a Leveraged Buyout (LBO) Matter?
- Leveraged Buyout (LBO) Analysis
- Transaction Structure
- Applications of the LBO Analysis
- Steps in the LBO Analysis
- Exit Strategies
- Exit Multiples
- Issues to Consider in an LBO Transaction
- Characteristics of a Good LBO Candidate
- Management Buyouts (MBOs)
- What is a Leveraged Buyout? Introduction to LBOs
- Leveraged Buyout Walkthrough
- Example Leverage Case Study Using Residential Real Estate
- Good Leveraged Buyout Candidates
- Sources and Uses: Modelling the LBO and IRR Triggers
LBO — Leveraged Buyout — Using Debt to Boost Equity Returns
In corporate finance, a leveraged buyout (LBO) is a transaction where a company is acquired using debt as the main source of consideration.
These transactions typically occur when a private equity (PE) firmWhy Private EquityWhy Private Equity is a common private equity interview question you’ll encounter if you’re going through the interview process at a PE firm borrows as much as they can from a variety of lenders (up to 70 or 80 percent of the purchase price) and funds the balance with their own equity.
Why do PE firms use so much leverage?
Simply put, the use of leverage (debt) enhances expected returns to the private equity firm. By putting in as little of their own money as possible, PE firmsTop 10 Private Equity FirmsWho are the top 10 private equity firms in the world? Our list of the top ten largest PE firms, sorted by total capital raised.
Common strategies within P.E. include leveraged buyouts (LBO), venture capital, growth capital, distressed investments and mezzanine capital.
can achieve a large return on equity (ROE) and internal rate of return (IRR)Internal Rate of Return (IRR)The Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a project zero. In other words, it is the expected compound annual rate of return that will be earned on a project or investment.
, assuming all goes according to plan. Since PE firms are compensated their financial returns, the use of leverage in an LBO is critical in achieving their targeted IRRs (typically 20-30% or higher).
While leverage increases equity returns, the drawback is that it also increases risk.
By strapping multiple tranches of debt onto an operating company the PE firm is significantly increasing the risk of the transaction (which is why LBOs typically pick stable companies).
If cash flow is tight and the economy of the company experiences a downturn they may not be able to service the debt and will have to restructure, most ly wiping out all returns to the equity sponsor.
What type of company is a good candidate for an LBO?
Generally speaking, companies that are mature, stable, non-cyclical, predictable, etc. are good candidates for a leveraged buyout.
Given the amount of debt that will be strapped onto the business, it’s important that cash flowsCash FlowCash Flow (CF) is the increase or decrease in the amount of money a business, institution, or individual has. In finance, the term is used to describe the amount of cash (currency) that is generated or consumed in a given time period.
There are many types of CF are predictable, with high margins and relatively low capital expenditures required. This steady cash flow is what enables the company to easily service its debt.
In the example below you can see in the charts how all available cash flow goes towards repaying debt and the total debt balance (far right chart) steadily decreases over time.
The above screenshot is from CFI’s LBO Model Training Course.
What are the steps in a Leveraged Buyout (LBO)?
The LBO analysis starts with building a financial model for the operating company on a standalone basis.
This means building a forecast five years into the future (on average) and calculating a terminal valueKnowledgeCFI self-study guides are a great way to improve technical knowledge of finance, accounting, financial modeling, valuation, trading, economics, and more. for the final period.
The analysis will be taken to banks and other lenders in order to try and secure as much debt as possible to maximize the returns on equity. Once the amount and rate of debt financing are determined, then the model is updated and final terms of the deal are put into place.
After the transaction closes, the work has just begun, as the PE firm and management have to add value to the business by growing the top line, reducing costs, paying down debt, and finally realizing their return.
Summary of Steps in a Leveraged Buyout:
- Build a financial forecast for the target company
- Link the three financial statements and calculate the free cash flow of the business
- Create the interest and debt schedulesDebt ScheduleA debt schedule lays out all of the debt a business has in a schedule its maturity and interest rate. In financial modeling, interest expense flows
- Model the credit metrics to see how much leverage the transaction can handle
- Calculate the free cash flow to the Sponsor (typically a private equity firm)
- Determine the Internal Rate of Return (IRR) for the Sponsor
- Perform sensitivity analysisWhat is Sensitivity Analysis?Sensitivity Analysis is a tool used in financial modeling to analyze how the different values for a set of independent variables affect a dependent variable
Image Source: CFI’s Leveraged Buyout Course.
LBO financial modeling
When it comes to a leveraged buyout transaction, the financial modelingWhat is Financial ModelingFinancial modeling is performed in Excel to forecast a company's financial performance. Overview of what is financial modeling, how & why to build a model. that’s required can get quite complicated. The added complexity arises from the following unique elements of a leveraged buyout:
- A high degree of leverage
- Multiple tranches of debt financing
- Complex bank covenants
- Issuing of Preferred shares
- Management equity compensation
- Operational improvements targeted in the business
Below is a screenshot of an LBO model in Excel. This is one of many financial modeling templates offered in CFI courses.
To learn more about the above model with step-by-step instruction, launch CFI’s LBO financial modeling course now!
Read more about a specific type of LBO called a management buyout (MBO). Check out our resources section to learn more about corporate finance, and explore CFI’s career map to find the path that’s right for you. Make yourself stand out from the crowd with financial modeling courses and finance certifications.
Other relevant CFI resources:
- Free guide to financial modeling best practicesFree Financial Modeling GuideThis financial modeling guide covers Excel tips and best practices on assumptions, drivers, forecasting, linking the three statements, DCF analysis, more
- DCF modeling guideDCF Model Training Free GuideA DCF model is a specific type of financial model used to value a business. The model is simply a forecast of a company’s unlevered free cash flow
- How to link the 3 financial statementsHow the 3 Financial Statements are LinkedHow are the 3 financial statements linked together? We explain how to link the 3 financial statements together for financial modeling and
- Corporate finance career map
Leveraged Buyout: Definition, Examples and Uses
A leveraged buyout (LBO) occurs when someone purchases a company using almost entirely debt. The purchaser secures that debt with the assets of the company they're acquiring and it (the company being acquired) assumes that debt.
The purchaser puts up a very small amount of equity as part of their purchase. Typically, the ratio of an LBO purchase is 90% debt to 10% equity. That is, if the purchaser is buying a company for $100 million, they will borrow $90 million and pay $10 million from their own cash.
The purchaser can be any entity with access to the right banks and capital, but usually leveraged buyouts are conducted by other companies or investors.
How Is a Leveraged Buyout Different?
Almost any major corporate purchase involves significant debt. This is true even if the purchaser actually has enough cash on hand for the entire transaction. Among other benefits, using debt for a corporate acquisition has tax advantages and allows a purchaser to potentially write off bad loans if the acquired company does poorly.
However, a leveraged buyout differs from a typical corporate purchase in two primary ways.
• An LBO involves a higher debt-to-equity ratio than most ordinary corporate acquisitions.
• An LBO secures the acquisition debt with the acquired company. This is the defining feature of an LBO.
Example of A Leveraged Buyout
David owns an investment firm. He would to purchase StoreCo, a retail chain. He intends to reform the company into a more cost-effective operation then sell it.
They agree to a purchase price of $100 million. To conduct a leveraged buyout, David first commits $10 million of his firm's money. He then finds a bank to extend a loan for the remaining $90 million.
David's firm is negotiating this loan, but it will soon own StoreCo. So the loan is structured such that StoreCo will assume this debt. The bank will secure its $90 million with StoreCo's assets.
This means that StoreCo will be responsible for making all payments on the debt that David used to buy it, and that if StoreCo defaults on these obligations the bank will seize its land, inventory and other assets in lieu of payment.
Advantages of a Leveraged Buyout
Leveraged buyouts have become increasingly popular because they require very little upfront capital and can insulate a purchasing company from a financial setback. If a deal doesn't work out, the acquired company is saddled with bad debt, not the purchaser.
In our example above, let's say that David can't make StoreCo as profitable as he'd . The $90 million loan now looks a money loser, but it is StoreCo which must continue to make payments on that bad deal and which (in the worst case scenario) faces insolvency. David's firm won't lose any money on this loan.
This doesn't mean that a purchasing company is completely insulated from loss. In addition to the up-front capital, purchasers can face potentially significant liability in the form of shareholder lawsuits if they use an LBO to saddle an otherwise-healthy company with untenable payments. However, the purchasing company is protected against direct loss on the underlying debt.
It is not uncommon for otherwise profitable firms to face financial difficulties and even bankruptcy following a leveraged buyout, as they must subsequently pay a debt worth almost the entire value of the company.
1. To Privatize a Public Company
Taking a publicly traded company private means consolidating its public shares in the hands of private investors who take those shares off the market. Those investors will now own either all or a majority of the target company. This requires enough capital to purchase all or most of the company's net value.
Since these investors will now own the company, they can have the company assume the debt liability for this transaction.
2. To Break Up a Large Company
Sometimes a company may grow large and inefficient, such that the whole is worth less than the sum of its parts.
In this case an investor may purchase the company and split it off, selling it as a series of smaller companies.
For example, a company that manufactures cars, airplanes and tanks might get split up into an automotive, an aerospace and a defense firm, each of which would get sold to larger companies in the relevant industries.
In this case the investor would buy the company through a leveraged buyout in the belief that these individual sales will more than pay off that loan.
3. To Improve an Underperforming Company
Finally, an investor might believe that a firm is significantly underperforming its potential. In this case the purchase price of the company would be worth much less than what the company could eventually be worth, making a leveraged buyout a good option.
This is the case with our example above. David believes that ShopCo could be worth substantially more than it currently is.
He will have it assume $100 million in debt because he believes that in five years the company will be worth $200 million or more.
Another investor might purchase ShopCo with the intention of holding and operating the company, believing that he can improve the company and generate profits worth considerably more than the debt payments.
There is a fourth, less valuable, use for the leveraged buyout.
4. To Enrich Shareholders and Owners
When a company is purchased, the purchase price flows to all owners and the stock price generally surges. For a privately held firm the individual owner(s) collect that money directly minus any partnerships or other liabilities.
For a publicly held firm the purchase capital accrues to shareholders. This typically enriches executives and members of the board of directors. The former group will often have their compensation tied to stock performance, while the latter group typically comprises some of the company's largest shareholders.
However, this means that a leveraged buyout comes with a significant conflict of interest.
The decision makers in charge of approving any acquisition stand to personally make a lot of money off the resulting deal, even if it means saddling the company with unsustainable debt obligations. In fact, in cases where an investor is purchasing the firm, often that investor will already own significant holdings in the target firm, giving them a a stake in this personal enrichment.
This is not dissimilar from the practice of leveraged buybacks, in which shareholders will have a company assume significant debt in order to buy back its own stock on the open market. In both cases the company takes on a significant financial liability in a transaction that directly enriches the individuals making that decision.
Criticisms of the Leveraged Buyout
This leads directly to the main criticism of the leveraged buyout: That it is a predatory tactic.
A leveraged buyout has potentially significant value when used properly. It can allow an investor or business leader with good ideas to reform a company even if he or she doesn't have access to substantial capital.
In our example above, David might be exactly the right person to make ShopCo a thriving 21st century concern. A leveraged buyout allows him to try without risking the utter ruin of his investment firm if the project fails.
However, leveraged buyouts can destroy otherwise healthy businesses.
It is not uncommon for companies targeted by a leveraged buyout to eventually file for bankruptcy due to unsustainable debt payments imposed by this tactic.
In recent years the average leveraged buyout has imposed debt almost seven times the target company's EBITDA (essentially, the company's earnings before expenses).
This is what happened, for example, when investor Sam Zell purchased the Tribune Company. In 2007 he used a leveraged buyout to take over the media company, which at the time of purchase was profitable.
This imposed $13 billion in debt on the company, which severely disrupted its cash flow.
The Tribune Company struggled to meet the obligations imposed by Zell's buyout, and by 2008 it had filed for bankruptcy as a direct result of the debt payments.
The leveraged buyout also has received significant criticism from financial regulators and market watchers.
An LBO is a highly leveraged transaction, as noted above. This means, however, that the lending institution is far more exposed than it would be in an ordinary transaction. The threat of default is higher, because the larger debt leads to higher payments.
The consequences of default are also more severe. The bank risks losing far more money in a transaction this highly leveraged, and the underlying firm risks bankruptcy and (potentially) liquidation if it can't make its payments on time.
In this context, regulators have grown increasingly concerned over a boom in leveraged buyout loans in the past several years. As Reuters has reported, «the volume of leveraged loans in particular reached $1.
3 trillion in the U.S. and Europe in 2018, versus $734 billion in 2007.
» This amount of debt means that even a small number of defaults could suck capital lending institutions and collapse firms, leading to a cascade reaction of losses.
What Is A Leveraged Buyout (LBO)?
LBO stands for Leveraged Buyout and refers to the purchase of a company while using mainly debt to finance the transaction. Leveraged Buyouts are usually done by private equity firms and rose to prominence in the 1980s.
The company performing the LBO or takeover only has to provide a portion of the financing yet is able to make a large purchase through the use of debt, hence the name 'Leveraged'. During the 1980s — 1990s when LBOs were hot, debt could make up as much as 90% of the purchase of a business.
However, now investors and private equity firms are a bit more risk adverse and therefore may use closer to 50% debt and 50% equity to purchase a business.
The expectation with leveraged buyouts is that the return generated on the acquisition will more than outweigh the interest paid on the debt, hence making it a very good way to experience high returns whilst only risking a small amount of capital.
Leverage Buyout Definition
You can learn more about LBOs in the video below.
What Companies Make Good LBO Targets?
Considering that the buyer will put a large amount of debt on the company, it is critical that the company be stable and able to pay off its future debts otherwise it will ly default and go into bankruptcy. With that in mind, below are some types of companies that make good targets:
- Stable, strong cash flow business
- Company with low debt levels
- Non-cyclical businesses
- Companies with large economic moats
- Companies with good existing management teams
- Companies with a large asset base that can be used for collateral
- Distressed companies in good industries
Some private equity firms look to «turn around» troubled assets or may just look to buy an asset with the hopes of selling it for a better price in the future.
How Do PE Funds Increase the Value of the Target?
When a PE fund purchases a business, it either plans to hold the company and let it continue operating the same way or it may look to undergo operational improvements.
These operational improvements may involve changing the management team of the business, selling off assets to unlock value, purchasing additional assets to make the core business more efficient, among a variety of different options.
This is all done in the hopes of either increasing the profitability of the business or expanding the multiple that the business is valued at.
What Happens to the Debt in the LBO?
The PE firm will then either sell off parts or all of the target company or use its future cash flows to pay off the debt and then exit at a profit. Since the debt that is used to purchase the business is put on the books of the target company and not the PE firm (sponsor), when the company is sold any amount of debt that is paid down becomes equity.
Once the target company is on stable footing, the sponsor may use the internal cash flows of the business to pay off the debt that was used in the buyout transaction. By doing this, they increase the return that they achieve when they sell the business either through an IPO or by selling the business to financial or strategic buyer.
You can see a visual example below.
After year 4, if we assume that the business has not been operationally improved and that the multiple assigned to the firm's EBITDA has not expanded, the business could be sold today for $100 million and the financial sponsor would receive $90 million dollars on their initial $40 million investment. In a span of 4 years, the company made $50 million dollars not including performance fees that they are being paid by their clients.
**To learn more about this concept and become a master at LBO modeling, you should check out our LBO Modeling Course. Learn more here.**
Module 1: Introduction
Module 2: LBO The Big Picture
Module 3: Valuation and Transaction Assumptions
Module 4: Sources and Uses: The Theory
Module 5: Sources and Uses: Application to Nike Case
Module 6: P&L Projections & LBO Adjustments
Module 7: Debt Schedule
Module 8: Balance Sheet and Adjustments
Module 9: Taxes
Module 10: Exit, Returns, & Sensitivity Analysis
Bonus Module A) Purchase Price Accounting
Bonus Module B) Dividend Recap
Bonus Module C) Add-on Acquisition Build
Learn More Here
Return to the Finance Dictionary
Read Forum Topics About Leveraged Buyout (LBO)
Leveraged Buyout (LBO)
A leveraged buyout (LBO) is a method of acquiring a company with money that is nearly all borrowed.
How Does a Leveraged Buyout (LBO) Work?
The basic idea behind an LBO is that the acquirer purchases the target with a loan collateralized by the target's own assets. In hostile takeover situations, the use of the target's assets to secure credit for the acquirer is one reason the LBO has a predatory reputation.
Private equity firms often raise money specifically to conduct LBOs.
These LBO funds are often hundreds of millions of dollars strong, which goes a long way considering that these acquirers will borrow most of the money they'll need to purchase their targets.
Many LBO funds are divisions of major banks J.P. Morgan or divisions of private equity firms such as Carlyle Partners or Blackstone Capital Partners.
To conduct an LBO, the acquirer ensures that the target's assets are adequate as collateral for the loan needed to purchase the target.
The acquirer must also create and study financial forecasts of the combined entities to make sure that they generate enough cash to cover the principal and interest payments.
In some cases, maintaining optimal cash flow could be a challenge if the target's management team leaves after the acquisition.
Once the buyer has determined that the LBO is financially feasible, it works on acquiring enough cash for the acquisition by incurring debt. In some cases, the ensuing liability comes directly from one or more banks.
In other cases, the acquirer issues bonds in the open market.
Because the combined entity often has a high debt/equity ratio (near 90% debt, 10% equity), the bonds are usually not investment grade (that is, they are junk bonds).
Doing an LBO is expensive and the process can be complex. When a particular deal is especially large, there is often more than one acquirer which allows for sharing of the risks, costs, and rewards of the deal.
Often the acquirer must hire an intermediary to negotiate the emotional matters of severance, union contracts, reorganization plans, and other major post-acquisition issues with management, shareholders, and directors.
In addition, the use of an investment bank, a law firm, and third-party consultants is often necessary to correctly structure the transaction.
Generally, acquirers sell or take their LBO targets public five or ten years after their purchase and make what are hopefully large profits, often 15% to 25% compounded annually.
A sale doesn't always mean the debt is paid off, however.
The act of offering new shares to the public is frequently an attempt to obtain cash to pay down the debt to a feasible level (this is called a reverse LBO).
LBO activity usually increases when interest rates are low (which reduces the cost of borrowing) and/or when the economy or a particular industry is underperforming (and thus undervaluing the target firm's equity). However, increased LBO activity also means more competition for deals, which tends to bid up the premiums paid for targets. Expensive acquisitions increase the debt needed to acquire targets and increase the risk that a newly combined entity won't be able to support its larger debt obligations.
Why Does a Leveraged Buyout (LBO) Matter?
The purpose of an LBO is to make a large acquisition without having to commit a lot of capital. The acquirers also want to maximize shareholder value by attempting to create a stronger and more profitable combined entity. The buyer needs to ensure that the expected synergies materialize in order to realize financial returns.
The risks associated with a LBO deal are why share prices often fall when a company announces news of a LBO. However, such a price fall can be a buying opportunity if investors think the company will be able to pay down the debt, which increases the value of the shares.
The world's most famous LBO is the approximately $25 billion takeover of RJR Nabisco by private equity firm Kohlberg Kravis Roberts in 1989. The deal was so famous (and so brazen) that it was immortalized by the book and movie Barbarians at the Gate.
In those days, many companies used LBOs to purchase undervalued companies only to turn around and sell off the assets (these acquirers were called corporate raiders).
Today, however, LBOs are increasingly used as a way to make an average company become a great company.
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Leveraged Buyout (LBO) Analysis
A leveraged buyout (LBO) is an acquisition of a company or a segment of a company funded mostly with debt. A financial buyer (e.g.
private equity fund) invests a small amount of equity (relative to the total purchase price) and uses leverage (debt or other non-equity sources of financing) to fund the remainder of the consideration paid to the seller.
The LBO analysis generally provides a «floor» valuation for the company, and is useful in determining what a financial sponsor can afford to pay for the target and still realize an adequate return on its investment.
Below is a simple diagram of an LBO structure. The new investors (e.g. and LBO firm or management of the target) form a new corporation for the purpose of acquiring the target. The target becomes a subsidiary of NewCo, or NewCo and the target can merge.
Applications of the LBO Analysis
- Determine the maximum purchase price for a business that can be paid certain leverage (debt) levels and equity return parameters.
- Develop a view of the leverage and equity characteristics of a leveraged transaction at a given price.
- Calculate the minimum valuation for a company since, in the absence of strategic buyers, an LBO firm should be a willing buyer at a price that delivers an expected equity return that meets the firm's hurdle rate.
Steps in the LBO Analysis
- Develop operating assumptions and projections for the standalone company to arrive at EBITDA and cash flow available for debt repayment over the investment horizon (typically 3 to 7 years).
- Determine key leverage levels and capital structure (senior and subordinated debt, mezzanine financing, etc.) that result in realistic financial coverage and credit statistics.
- Estimate the multiple at which the sponsor is expected to exit the investment (should generally be similar to the entry multiple).
- Calculate equity returns (IRRs) to the financial sponsor and sensitize the results to a range of leverage and exit multiples, as well as investment horizons.
- Solve for the price that can be paid to meet the above parameters (alternatively, if the price is fixed, solve for achievable returns).
In LBO transactions, financial buyers seek to generate high returns on the equity investments and use financial leverage (debt) to increase these potential returns. Financial buyers evaluate investment opportunities with by analyzing expected internal rates of return (IRRs), which measure returns on invested equity.
IRRs represent the discount rate at which the net present value of cash flows equals zero. Historically, financial sponsors' hurdle rates (minimum required IRRs) have been in excess of 30%, but may be as low as 15-20% for particular deals under adverse economic conditions.
Hurdle rates for larger deals tend to be a bit lower than hurdle rates for smaller deals.
Sponsors also measure the success of an LBO investment using a metric called «cash-on-cash» (CoC).
CoC is calculated as the final value of the equity investment at exit divided by the initial equity investment, and is expressed as a multiple. Typical LBO investments return 2.0x — 5.0x cash-on-cash.
If an investment returns 2.0x CoC, for example, the sponsor is said to have «doubled its money».
The returns in an LBO are driven by three factors, which we demonstrate in our topic on creating value in LBOs:
- De-levering (paying down debt)
- Operational improvement (e.g. margin expansion, revenue growth)
- Multiple expansion (buying low and selling high)
Equity holders – In addition to the operating risk assumed risk arises due to significant financial leverage.
Interest costs resulting from substantial amounts of debt are «fixed costs» that can force a company into default if not paid.
Furthermore, small changes in the enterprise value (EV) of a company can have a magnified effect on the equity value when the company is highly levered and the value of the debt remains constant.
Debt holders – The debt holders bear the risk of default equated with higher leverage as well, but since they have the most senior claims on the assets of the company, they are ly to realize a partial, if not full, return on their investments, even in bankruptcy.
Ideally, an exit strategy enables financial buyers to realize gains on their investments. Exit strategies most commonly include an outright sale of the company to a strategic buyer or another financial sponsor, an IPO, or a recapitalization. A financial buyer typically expects to realize a return on its LBO investment within 3 to 7 years via one of these strategies.
The value of a company acquired in an LBO transaction is often value at the time of acquisition using valuation multiples (e.g. EV/EBITDA).
While exiting the investment at a multiple higher than the acquisition multiple will help boost a sponsor's IRR, it is difficult to justify a prediction that the exit multiple will be higher than the entry multiple (known as «multiple expansion»).
It is important that exit assumptions reflect realistic approaches and multiples (exit multiples should generally equal acquisition multiples) for analytical purposes, and multiple expansion is usually an unjustifiable assumption.
Issues to Consider in an LBO Transaction
- Type of industry
- Competitive landscape
- Major industry drivers
- Potential outside factors (politics, changing laws and regulations, etc.)
- Strategic positioning within the industry (market share)
- Growth opportunity
- Operating leverage
- Sustainability of operating margins
- Potential for margin improvement
- Level of maintenance CapEx vs. growth CapEx
- Working capital requirements
- Minimum cash required to run the business
- Ability of management to operate effectively in a highly levered situation
- Accessibility and cost of bank and high yield debt
- Expected equity returns
Characteristics of a Good LBO Candidate
The following characteristics define the ideal candidate for a leveraged buyout. While is it very unly that any one company will meet all these criteria, some combination thereof is need to successfully execute an LBO.
- Strong, predictable operating cash flows with which the leveraged company can service and pay down acquisition debt
- Mature, steady (non-cyclical), and perhaps even boring
- Well-established business and products and leading industry position
- Moderate CapEx and product development (R&D) requirements so that cash flows are not diverted from the principle goal of debt repayment
- Limited working capital requirements
- Strong tangible asset coverage
- Undervalued or out-of-favor
- Seller is motivated to cash his/her investment or divest non-core subsidiaries, perhaps under pressure to maximize shareholder value
- Strong management team
- Viable exit strategy
Management Buyouts (MBOs)
Management buyouts are similar to LBO, except that the management team of the target company acquires the company rather than a financial sponsor.
For example, the sole owner of a private company might be nearing his twilight years and wishes to exit the business he started years ago.
The management team might believe strongly in the prospects of the company and agree to buy out the owner's equity interest and assume control of the company.
What is a Leveraged Buyout? Introduction to LBOs
When someone brings up an LBO, people immediately associate this with investment banking and private equity.
LBOs are associated with very advanced financial modelling and students sometimes get scared when the concept comes up.
In reality, while investment bankers do run LBO models on a very regular basis, it is one of the simplest concepts and easiest things to model in high finance.(1)
Leveraged Buyout Walkthrough
A leveraged buyout means that you are using leverage to buy out a company. In simpler terms, it means you are purchasing a company partially funded with debt. In a private equity context, the company will start to pay down debt using free cash flows before being sold in a reasonable time horizon (the base case is 5 years, this is called the “exit”).
The idea is that due to the lower cost of capital of debt (especially on an after-tax basis owing to interest deductibility), you will elect to use debt as much as you can as long as it is below your cost of equity. That is one way to look at it.(2)
The simpler way to look at it is that you reap the rewards of ownership despite using Other People’s Money – a very powerful financial concept.
Example Leverage Case Study Using Residential Real Estate
For the layman, let’s look at a house.
You put $100,000 down on a $400,000 condo. It goes up 10% to $440,000 in one year. The asset is up 10%.
If you bought the condo with all cash, your return on investment and return on equity is 10%.
Now if you bought the condo only putting down a $100,000 down payment and covering the rest with mortgage (75% loan-to-value or LTV), you owe the bank $300,000 but you own the property.
If the condo goes up 10% in one year, the property is worth $440,000. What you owe the bank remains the same $300,000 (ignoring principal repayments and assuming that your rent just covers your interest and principal). So your equity value is now worth $440,000 – $300,000 = $140,000.
Your return on equity is $40,000/$100,000 or 40%. Same asset, markedly different returns on the money you invested. This is how leverage works.
Leverage juices returns. Leverage is how people get rich – whether financial or operational. However, leverage is a knife that cuts both ways.
If your house was purchased for $1 million and your down payment was $200,000 before the housing market crashes, devaluing your house that now trades at $800,000, your equity has been wiped out to zero.
Good Leveraged Buyout Candidates
Moving on from a simple house to a business that generates cash flows, the old LBO model (and the one that is easy to put down on paper) is for a private equity firm/corporate raider to find a company that has strong, stable cash flows, low capital expenditure requirments, with a decent return on equity and low levels of debt. Basically, an underlevered cash cow.(3)
Then you secure financing from banks for a loan, a bridge loan for high yield bond takeout and provide some of your own equity from a fund that you just raised, pay a large premium for the stock if it is publicly traded and then boost the return on your equity via cheap debt.
The stable cash flows make sure that you will comfortably service your lofty interest payments after relevering the company and the equity cheque you have to cut is low because the debt as a % of the LBO in terms of a funding source is huge.
Unfortunately, LBOs have become commoditized now and do not return the same as they used to. Banks and debt investors do not allow the same level of leverage (debt as a number of turns of EBITDA) anymore and also require a larger equity cheque (think of this as the down payment on the house – instead of a 10% down payment they may expect 25 or 50%). A higher equity cheque means a lower IRR.
Sources and Uses: Modelling the LBO and IRR Triggers
First, the private equity firm will purchase a company at a valuation that can also be communicated as a purchase multiple of EBITDA (a crude proxy for cash flow). For example, if EBITDA is $100 million and the multiple contemplated is 7x, the purchase price will be $700 million.
Next, the sources and uses for funding have to be determined. On the uses side, we look at the $700 million value of the contemplated transaction and see whether that means just the equity or the assumption of some outstanding debt on that balance sheet.
You also need to set aside 1 or 2% of the purchase price to pay investment banking fees, lawyer fees, debt issuance fees and accounting fees. (in buying a house – same thing, the house sells for $1 million, you need to pay real estate agent fees of 3% so the uses are $1.
03 million – the sources are the mortgage and your equity cheque).
On the sources side, you are raising debt from a variety of stakeholders, from the banks (the most senior) to the subordinated debtholders. Then you will have preferred shares and equity.
Assuming that you have EBITDA and capex lines, the LBO really just takes a stream of levered free cash flows before an exit – LBOs and private equity firms generally will see a sale of the business in the end.
Every year, operating cash flows will be reduced by capital expenditures (the CFO line in the statement of cash flows already accounts for changes in net working capital and interest) to get to a levered free cash flow number. This levered free cash flow number will either be used to pay down debt or be kicked out to the financial sponsor/private equity firm via a dividend.
Usually, the EBITDA is expected to grow while debt is paid down. Inflation works well for LBOs because cash flows will rise while the cost of debt is eroded owing to the time value of money (a dollar today is worth more than a dollar tomorrow).
During the exit year, we again assume an exit multiple where the company is sold off.
So what affects your return on equity or IRR? If you lower the purchase multiple, you will increase your IRR and vice versa. If you lower the exit multiple, you will lower your IRR and vice versa. If you increase the amount of debt as part of the uses, you increase your IRR. If you lower the interest rates, you will increase your IRR.
1. Operational modeling and three statement modelling are actually more difficult and require better accounting and algebra skills – an LBO is a simple IRR formula that you can build easily with an EBITDA line and a few debt tranches.
2. Theoretically, the more debt you layer on, the more expensive the incremental debt costs. This is because as the risk of default increases (as meeting interest obligations becomes more difficult), debtholders must be compensated for the additional risk with a higher promised return (higher interest).
Also, different debt investors will have different risk profiles – banks need to be paid back and are the most senior, secured debt. High yield bonds and subordinated debt rank lower in the capital structure and must be compensated for their subordinated claims.
Bank debt might fund 30% of a transaction where junior debt may make up an incremental 40%, all of which demands a higher coupon than the bank debt.
3. Following this logic, companies with unstable cash flows, such as cyclical stocks or commodity producers (oil and gas companies are at the mercy of macroeconomics and regional egress dynamics) will not be able to lever as much as an infrastructure asset with secure cash flows.
An oil and gas LBO may only be levered up to 2x or 3x, accordingly. The more utility the cash flows, the higher the leverage it can support.
A telecommunications company with a steady customer base has historically been able to hold plenty of debt on the balance sheet, although this is slowly changing if you look at firms such as Frontier Communications.