Leveraged Buyout (LBO) Definition
LBO (Leveraged Buyout) analysis helps in determining the maximum value that a financial buyer could pay for the target company and the amount of debt that needs to be raised along with financial considerations like the present and future free cash flows of the target company, equity investors required hurdle rates and interest rates, financing structure and banking agreements that lenders require.
Heard about Coca Cola LBO? There are a lot of Speculations about it. Will it take place? Will it not? The estimated deal is about $50 billion. Such is the hype of Leveraged Buyouts today. $50 Billion is a huge amount, and it explains the density and Volume of LBO’s that are taking place.
LBO sounds like a dense word, and indeed it is. The billion-dollar deals which are taking place each year have made LBO’s quite fascinating.
StatisticsStatisticsStatistics is the science behind identifying, collecting, organizing and summarizing, analyzing, interpreting, and finally, presenting such data, either qualitative or quantitative, which helps make better and effective decisions with relevance. have found that 25+ big and small Leveraged Buyout deals have taken place until the first half of the year 2014, valuing over billions of dollars. That’s quite a lot of money!
So why exactly is the hustle and bustle about the word LBO? Let’s understand how Leveraged Buyout works!
- How does it work?
- Steps in LBO Analysis
- Sources of funds
- Sources of Revenue
- Key characteristics
- Exit Strategies
- Exit Multiples
- Issues to Consider
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How does LBO analysis work?
- Leveraged Buyout analysis is similar to a DCF analysisDCF AnalysisDiscounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company's future performance.. The common calculation includes the use of cash flows, terminal valueTerminal ValueTerminal Value is the value of a project at a stage beyond which it's present value cannot be calculated. This value is the permanent value from there onwards. , present value, and discount rate.
- However, the difference is that in DCF analysis, we look at the present value of the company (enterprise value), whereas in LBO analysis, we are actually looking for the internal rate of return (IRR).
- LBO analysis also focuses on whether there is enough projected cash flow to operate the company and also pay debt principal and interest payments.
- The concept of a leveraged buyoutBuyoutA buyout is a process of acquiring a controlling interest in a company, either via out-and-out purchase or through the purchase of controlling equity interest. The underlying principle is that the acquirer believes that the target company’s assets are undervalued. is very simple: Buy a company –> Fix it up –> Sell it.
- Usually, the entire plan is, a private equity firm targets a company, buys it, fixes it up, pays down the debt, and then sells it for large profits.
Let’s consider a more precise example to understand the concept better.
Suppose you buy a company for $100 using 100% of the cash. You then sell it 5 years later for $200.
In this case, the return multiple comes to 2x. The internal rate of return for you, in this case, will be 15%
Let’s compare that to what happens when you buy the same company for $100, but use only 50% cash and sell it 5 years later, still for $200 (shown as $161 here because the $50 in debt must be repaid)
In this case, the return multiple comes to 3x, and the internal rate of return for you will be 21%. The reason for this is as follows.
You had taken 50% debt and paid 50% cash. So you had paid $50 from your pocket and taken a loan of $50 for the remaining payment.
During the course of 5 years, you pay the loan of $50 step by step.
At the end of the five years, you sell the company for $200. Now taking out the outstanding loan of $39 of debt from this, the amount that remains with you comes to $161 ($200-$50).
The rate of return is higher in this case, as you had initially invested $50 of your cash and got $161 in return.
One thing that you may want to remember is that, in order to have a good buyout, the predictable cash flows are essential. And this is the reason why target companies are usually a mature business that has proven themselves over the years.
Leveraged Buyout Analysis Steps
Follow the steps for Leveraged Buyout Analysis
- Assumptions of Purchase Price
The first step is making assumptions on the purchase price, debt interest rate, etc.
- Creating Sources and Uses of Funds
With the information of purchase price, interest, etc., then a table of Sources and Uses can be created. Uses reflect the amount of money required to effectuate the transaction. Sources tell us where the money is coming.
- Financial Projections
In this step, we project financial statements, i.e., Income Statement, Balance Sheet, Cash flow StatementCash Flow StatementStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities., usually for the period of 5 years
- Balance SheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. Adjustments
Here, we adjust the Balance Sheet for the new Debt and Equity.
Once the Financial ProjectionsThe Financial ProjectionsFinancial projection is a statistical forecast of a company's future revenue and expenditure based on historical market patterns, internal factors, data interpretation, anticipated market developments, and experiences. To meet production or sales targets, both short-term and long-term financial estimates are sometimes evaluated. and adjustments are made, assumptions about the private equity firm’s exit from its investment can be made.
A general assumption is that the company will be sold after five years at the same implied EBITDA multiple at which the company was purchased (Not necessary)
- Calculating Internal Rate of Return (IRR) on the Initial Investment
There is a reason why we calculate the sale value of the company. It allows us to also calculate the value of the private equity firm’s equity stake, which we can then use to analyze its internal rate of return (IRR).
IRR is used to determine; how much you are going to get back on your initial investment.
Leveraged Buyout (LBO) Example
So now, we have understood what are the steps involved in LBO analysis. But, just reading the theory does not give us the whole picture. So let’s try to jam with some numbers to get clear insights into an LBO.
Let’s get you into a role play now. Yes, you have to think that you are a successful businessman.
- Suppose you are on the verge of acquiring a company. So your first step would be making some assumptions with respect to sources and uses of funds. It is important for you to determine how much you will pay for the company.
- You can do this with the help of EBITDA multiple. Assume that you are paying 8 times the current EBITDA.
- The current sales (Revenue) of the company is $500, and the EBITDA margin is 20%, then the EBITDA comes to $100.
- It means that you may have to pay 8*$100= $800
Then you need to determine how much of the purchase price will be paid in equity and how much in debt. Let’s assume that we use 50% equity and 50% debt. So it means that you will use $400 of equity and $400 of debt.
- Now, think that you are planning to sell that company after 5 years at the same EBITDA multiple of 8.
- The next step is to do some financial forecastingFinancial ForecastingFinancial Forecasting is the process of predicting or estimating future stats of an organization i.e. how business will perform in the future based on historical data like by analyzing the income statement, position statement, current conditions, past trends of the financial, future internal and external environment which is usually undertaken with the objective of preparing and developing budget and allocating available resources to ensure best possible utilization. to see how the future cash flows of the company will look like.
- You can calculate the cash flows before the debt repayment using the following formula: (EBITDA- changes in working capital – Capex – Interest after-tax).
- Initially, we have found out the EBITDA for the company to be $100. Now we will assume that the EBITDA of the company grows from $100 to $200 over 5 years.
Let’s say that you are able to pay $40 as a yearly installment. Below is the schedule of interest payments and ending debt after each year. Please note that at the end of the fourth year, the total outstanding debt is $313.80
Assuming that EBITDA is $200 after 5 years and with the valuation of 8x EBITDA multiple, you will get 200*8=$1600 as the total valuation of the firm.
Out of $1600, you need to repay the outstanding debt of $313.80. That leaves you with 1600-313.80= $1,286 of equity
- Therefore your overall return will be 1,286/400= 3.2x returns over 5 years or incorporating the cash flows; we get 21% IRR.
Sources of Funds in a Leveraged Buyout
The following are the sources of funds to finance the transaction.
Revolving credit facility
A revolving credit facilityRevolving Credit FacilityA revolving credit facility refers to a pre-approved loan facility provided by banks to their corporate clients. It states that the companies are free to borrow funds from these financial institutions to fulfill their cash flow needs by paying off the underlying commitment fees. is a form of senior bank debt. It acts like a credit card for companies. A revolving credit facility is used to help fund a company’s working capital needs. A company in need generally will “drawdown” the revolver up to the credit limit when it needs cash, and repays the revolver when excess cash is available.
Bank debt is the security of a low-interest rate than subordinated debt. But it has more heavy covenantsCovenantsCovenant refers to the borrower's promise to the lender, quoted on a formal debt agreement stating the former's obligations and limitations. It is a standard clause of the bond contracts and loan agreements. and limitations. Bank debt typically requires full payback over a 5- to 8-year period.
Bank debt generally is of two types:
- Term Loan A
Here the debt amount is evenly paid back over a period of 5 to 7 years.
- Term Loan B
This layer of debt usually involves minimal repayment over 5 to 8 years, with a large payment in the last year.
It is a form of the hybrid debt issue. The reason behind that is, it generally has equity instruments (usually warrants) attached to it. It increases the value of the subordinated debt and allows for greater flexibility when dealing with bondholders.
Subordinated or High-Yield Notes
They are commonly referred to as junk bonds. These are usually sold to the public and command the highest interest rates to compensate holders for their increased risk exposureRisk ExposureRisk Exposure refers to predicting possible future loss incurred due to a particular business activity or event. You can calculate it by, Risk Exposure = Event Occurrence Probability x Potential Loss. Subordinated debt may be raised in the public bond market or the private institutional market and usually has a maturity of 8 to 10 years. It may have different maturities and repayment terms.
Seller notes can be used to finance a portion of the purchase price in a Leveraged Buyout. In the case of seller notes, a buyer issues a promissory notePromissory NoteA promissory note is a negotiable instrument that represents the debtor's or the writer's (the maker's) written consent to pay a promised sum to the creditor (the payee) on a specified date. to the seller wherein he agrees to repay over a fixed period of time. Seller notes are attractive sources of finance because it is generally cheaper than other forms of junior debt. Also, at the same time, it is easier to negotiate terms with the seller than a bank or other investors.
Equity capital is contributed through a private equity fund. The fund pools the capital, which is raised from various sources. These sources include pensions, endowments, insurance companies, and HNI’s.
Leveraged Buyout – Sources of Revenue
Carried interestCarried InterestCarried interest, often known as "carry," is the portion of profit earned by a private equity firm or fund manager upon the fund's exit from an investment. This is the most important part of the Fund manager's total remuneration. is a share of the profit that is generated by the acquisitions made by the fund. Once all the partners have received an amount equal to their contributed capitalContributed CapitalContributed capital is the amount that shareholders have given to the company for buying their stake and is recorded in the books of accounts as the common stock and additional paid-in capital under the equity section of the company’s balance sheet., the remaining profit is split between the general partner and the limited partners. Typically, the general partner’s carried interest is 20% of any profits remaining once all the partners’ capital has been returned.
LBO firms charge a management fee associated with identifying, evaluating, and executing acquisitions by the fund. Management fees typically range from 0.75% to 3% of committed capital, although 2% is common.
Executives and employees of the leveraged buyout firm may co-invest along with the partnership, provided the terms of the investment are equal to those afforded to the partnership.
Key characteristics of an LBO candidate (Target Company)
- A company from a Mature industry
- A clean balance sheet with no or low amount of outstanding debt
- Strong management team and potential cost-cutting measures
- Low working capital requirement and steady cash flows
- Low future CAPEX CAPEX Capex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.requirements
- Feasible exit options
- Strong competitive advantagesStrong Competitive AdvantagesCompetitive advantage refers to a benefit availed by a company that has remained successful in outdoing its competitors in the same industry by designing and implementing effective strategies in offering quality goods or services, quoting reasonable prices and maximizing the wealth of its stakeholders. and market position
- Possibility of selling some underperforming or non-core assets
Returns in an LBO
In Leverage buyout, the financial buyers evaluate investment opportunities by analyzing expected internal rates of return (IRRs), which measure returns on invested equity.
IRRs represents the discount rate at which the net present valueNet Present ValueNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not. of cash flows equals zero.
Historically, the financial sponsors’ hurdle rateHurdle RateThe hurdle rate in capital budgeting is the minimum acceptable rate of return (MARR) on any project or investment required by the manager or investor. It is also known as the company’s required rate of return or target rate., which is the minimum required rate, has been in excess of 30%, but maybe as low as 15-20% for particular deals under adverse economic conditions.
Sponsors also measure the success of a Leveraged Buyout investment using a metric called “cash on cash”.
Typical LBO investments return range between 2x – 5x cash-on-cash. If investment returns 2x cash on cash, the sponsor is said to have “doubled its money”.
The returns in a Leveraged Buyout are driven by three following factors.
- De-levering (paying down debt)
- Operational improvement (e.g., margin expansion, revenue growth)
- Multiple expansion (buying low and selling high)
Exit Strategies are used by the private equity firmsPrivate Equity FirmsPrivate equity firms are investment managers who invest in many corporations' private equities using various strategies such as leveraged buyouts, growth capital, and venture capital. The top private equity firms include Apollo Global Management LLC, Blackstone Group LP, Carlyle Group, and KKR & Company LP. while selling the company after let’s say 5 years.
An exit strategy helps financial buyers to realize gains on their investments. An exit strategy includes an outright sale of the company to a strategic buyer or another financial sponsor or an IPO.
A financial buyer typically expects to realize returns within 3 to 7 years via one of these exit strategies.
Leveraged Buyout Exit Multiples
The exit multiple simply refers to the return of investment.
If you are investing $100 in a company and selling it for $300, then the exit multiple here is 3x. EBITDA is the generally used exit multiple.
Exiting the investment at a multiple higher than the acquisition multiple will help boost IRR (Internal Rate of Return). But it is important that exit assumptions reflect realistic approaches.
As we saw in the above examples, EV to EBITDA MultiplesEV To EBITDA MultiplesEV to EBITDA is the ratio between enterprise value and earnings before interest, taxes, depreciation, and amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a specific company to the peer company in the industry as a whole, or other comparative industries. are also largely used. Following is the chart showing the trend in the EBITDA Multiple over the course of years. The deal multiples in 2014 have reached the 2007 level of about 9.7x-9.8x
Issues to Consider
Think of you as an investor who wants to invest in a share of that company.
Will you directly start trading from your day 1?
No, right! You will analyze the industry and the company and then come to a particular decision.
Similar is the case in LBO analysis. The various issues that you may want to consider before entering the transaction are
- Type of industry
- Competitive landscape
- Major industry drivers
- Outside factors like the political environment, changing laws and regulations, etc.;
- Market share
- Growth opportunity
- Operating leverageOperating LeverageOperating Leverage is an accounting metric that helps the analyst in analyzing how a company’s operations are related to the company’s revenues. The ratio gives details about how much of a revenue increase will the company have with a specific percentage of sales increase – which puts the predictability of sales into the forefront.
- Sustainability of operating margins
- Margin improvement potential
- Minimum working capital requirements
- Cash required to run the business
- The ability of management to operate efficiently in a highly levered situation;
- LBO analysis helps in determining the purchase price of the prospective Company or business.
- It helps in developing a view of the leverage and equity characteristics of the transaction.
- 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.
LBO in a nutshell
The following chart summarizes some of the important considerations of a Leveraged Buyout. You can get a quick gist of an LBO through it. I hope that you have learned about what LBO’s are through this article.
|Returns||Between 20%-30% generally|
|Exit Time Horizon||3-5 years|
|Capital Structure||A mixture of Debt (High) and Equity|
|Debt Payment||Bank debt paid usually in 6-8 yrs. Higher yield debt paid in 10-12 yrs.|
|EXIT Multiples||EBITDA, PE ratio, EV/EBITDA|
|Potential exits||Sale, IPO, Recapitalization|