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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.
Statistics have found that, 25+ big and small Leveraged Buyout deals have taken place till 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!
- The Concept of LBO
- How does Leveraged Buyout analysis work?
- Steps involved in LBO Analysis
- Leverage Buyout (LBO) Example
- Sources of funds in a LBO
- Sources of Revenue
- Key characteristics of a Leveraged Buyout candidate (Target Company)
- Returns in a LBO
- Exit Strategies in LBO analysis
- LBO Exit Multiples
- Issues to Consider in Leveraged Buyout Transaction
- Applications of the LBO Analysis
- LBO in a nut shell
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What is a Leveraged Buyout (LBO)
Leveraged buyout (LBO) is very similar to buying a house. Suppose you want to buy a big house what will you do?
You will put down some money as cash and go for a loan for the remaining amount. And most of the times loan forms a major part of the entire transaction. Similar is the concept in Leveraged Buyout.
If we break down it to simple terms, in an LBO, the “down payment” is called Equity (cash) and the “Loan” is called Debt.
Maybe it’s clearer to all of us now. So let’s start analyzing what does the term Leverage buyout is all about.
In a Leverage buyout (LBO), you acquire a company or part of a company. But this is a common thing which you may have heard. So what is the major difference that gives it a name of “Leveraged Buyout”?
The answer is: “The entire process is majorly funded by debt”. Yes, remember that Debt forms a major part of a LBO transaction.
Now coming to the parties involved in the LBO deals. There is a Buyer and the Target company.
The Buyer, mostly is a private equity fund who invests a small amount of equity and majorly uses leverage or debt to fund the remainder of the consideration.
Thus, the main point to concentrate here is, the acquisition of another company is significantly by borrowed money (bonds or loans) to meet the cost of acquisition.
The Private Equity firm uses debt to lift its returns. Using more debt means that the PE firm will earn a higher return on its investment. We will see how this happens in the later part of this article.
The purpose of leverage buyouts is to allow companies to make large acquisitions without having to commit a lot of capital.
You might be amazed to know that in Leveraged Buyout, the ratios can go upto 90% debt to 10% equity.
Another interesting fact that you may want to understand is that Leveraged buyouts have had a notorious history, especially in the 1980’s. During that period several prominent buyouts led to the eventual bankruptcy of the acquired companies.
The reason behind the bankruptcies was that the leverage ratio was nearly 100% and the interest payments were so large that the company’s operating cash flows were unable to meet the obligation.
Just so you know, one of the largest Leveraged Buyouts on record was the acquisition of TXU Inc. in 2007 by Kohlberg Kravis Roberts, Texas Pacific Group, Goldman Sachs. The acquisition transaction was of around $43.8 billion.
If you have an opportunity to look at a LBO model which is prepared during a LBO analysis, nothing like it. You will then properly understand why LBO was opted by that firm. So to give you a gist…
- A leveraged buyout model shows what happens when a private equity firm acquires a company using a combination of equity and debt.
- In this process the PE firm aims to earn a return of almost 20 – 25%.
- LBO’s are similar to normal M&A deals, but in an LBO you assume that the buyer sells the target in the future.
If you give it a thought, the irony here is that a company’s success (in the form of assets on the balance sheet) can be used against it as collateral by a hostile company that acquires it. And this is the reason why LBOs can be sometimes regarded as ruthless and a predatory tactic.
Till now we have understood the general definition of Leverage buyout. But let’s understand why companies go for LBO.
Is using so much debt beneficial for the companies? If no, then the question is why this approach? And is Yes, then the question is how?
So let’s start with a simple example to know why the entire LBO analysis!
Let’s say you have $100 with you. But at the same time you are able to borrow $900 more (assuming interest rate at 5%). So now the total that you have is $1000.
Now, let’s say you invest those $1000 and you earn 10% return on it in one year (So it now goes up to $1100).
After you repay your debt of $900 and the interest of $45 (5% of $900), you are left over with $155 ($1100-$900-$45), which is a 55% return on your money you initially put in. Remember that you put $ 100 initially?
So if you are left with $155 now, you have got 55% return. I think now you must have got an idea as to why this LBO analysis is opted by the companies.
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How does LBO analysis work?
- Leveraged Buyout analysis is similar to a DCF analysis. The common calculation includes the use of cash flows, terminal value, 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 whether there is enough projected cash flow to operate the company and also pay debt principal and interest payments.
- The concept of a leverage buyout 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.
Leveraged Buyout Example
Let’s consider a more precise example to understand the concept better.
Suppose you buy a company for $100 using 100% of 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 are 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 year 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 mature business that has proven themselves over the years.
Leveraged Buyout Analysis Steps
Step 1: Assumptions of Purchase Price
- First step is making assumptions on the purchase price, debt interest rate etc.
Step 2: 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 reflects the amount of money required to effectuate the transaction. The Sources tells us from where the money is coming.
Step 3: Financial Projections
- In this step, we project financial statements i.e. Income Statement, Balance Sheet, Cash flow Statement, usually for the period of 5 years
Step 4: Balance Sheet Adjustments
- Here, we adjust the Balance Sheet for the new Debt and Equity.
Step 5: Exit
- Once the Financial Projections and adjustments are done, 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)
Step 6: 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 are you going to get back on your initial investment.
Leverage 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 a 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.
- Next step is to do some financial forecasting 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 yearly installment. Below is the schedule of interest payments and ending debt after each year. Please note that at the end of 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 an Leveraged Buyout
The following are the sources of funds to finance the transaction.
Revolving credit facility
A revolving credit facility 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 “draw down” the revolver up to the credit limit when it needs cash, and repays the revolver when excess cash is available.
Bank debt is a low interest rates security than subordinated debt. But it has more heavy covenants 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 hybrid debt issue. The reason behind that is, it generally has equity instruments (usually warrants) attached with it. It increases the value of the subordinated debt and allow 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 exposure. 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 an Leveraged Buyout. In case of seller notes a buyer issues a promissory note 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 interest 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 capital, 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 ranges 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 a LBO candidate (Target Company)
- Company from a Mature industry
- 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 capital expenditure requirements
- Feasible exit options
- Strong competitive advantages and market position
- Possibility of selling some underperforming or non-core assets
Returns in a 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 represent the discount rate at which the net present value of cash flows equals zero.
Historically, financial sponsors’ hurdle rate, which is the minimum required rate, have been in excess of 30%, but may be as low as 15-20% for particular deals under adverse economic conditions.
Sponsors also measure the success of an Leveraged Buyout investment using a metric called “cash on cash”.
Typical LBO investments return range between 2x – 5x cash-on-cash. If an investment returns 2x cash on cash, the sponsor is said to have “doubled its money”.
The returns in an 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 in LBO analysis
Exit Strategies are used by the private equity firms 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 above examples, EV to EBITDA Multiples 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 in LBO Transaction
Think of you as an investor who wants to invest in 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 leverage
- Sustainability of operating margins
- Margin improvement potential
- Minimum working capital requirements
- Cash required to run the business
- Ability of management to operate efficiently in a highly levered situation
Applications of Leveraged Buyout Analysis
- 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 nut shell
The following chart summarizes some of the important considerations of an Leveraged Buyout. You can get a quick gist of an LBO through it. 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||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, EV/EBITDA|
|Potential exits||Sale, IPO, Recapitalization|