Leverage Buyout (LBO)

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.read more 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!

If you want to learn LBO Modeling professionally, then you may want to look at 12+ hours of LBO Modeling Training

How does LBO analysis work?

Let’s consider a more precise example to understand the concept better.

Scenario 1:

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%

LBO Scenario 1
Scenario 2:

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)

LBO Scenario 2

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

Leverage-Buyout

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Source: Leverage Buyout (LBO) (wallstreetmojo.com)

Follow the steps for Leveraged Buyout Analysis

  1. Assumptions of Purchase Price

    The first step is making assumptions on the purchase price, debt interest rate, etc.

  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 reflect the amount of money required to effectuate the transaction. Sources tell us where the money is coming.

  3. 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.read more, usually for the period of 5 years

  4. Balance Sheet Adjustments

    Here, we adjust the Balance Sheet for the new Debt and Equity.

  5. Exit

    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.read more 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)

  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 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
LBO step 1

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 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 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

LBO Step 2

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

LBO Step 3
  • Therefore your overall return will be 1,286/400= 3.2x returns over 5 years or incorporating the cash flows; we get 21% IRR.
LBO Step 4

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.read more 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

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.read more and limitations. Bank debt typically requires full payback over a 5- to 8-year period.

Bank debt generally is of two types:

  1. Term Loan A

Here the debt amount is evenly paid back over a period of 5 to 7 years.

  1. Term Loan B

This layer of debt usually involves minimal repayment over 5 to 8 years, with a large payment in the last year.

Mezzanine debt

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 Lossread more. 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

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 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.

Common Equity

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

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.

Management Fees

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.

Co-Investment

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)

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 value of cash flows equals zero.

Historically, the financial sponsors’ hurdle 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

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 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.read more 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

Trends in EBITDA Multiple

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

Industry characteristics

  • Type of industry
  • Competitive landscape
  • Cyclicality
  • Major industry drivers
  • Outside factors like the political environment, changing laws and regulations, etc.;

Company-specific characteristics

Applications

  • 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.

ParametersRange
ReturnsBetween 20%-30% generally
Exit Time Horizon3-5 years
Capital StructureA mixture of Debt (High) and Equity
Debt PaymentBank debt paid usually in 6-8 yrs. Higher yield debt paid in 10-12 yrs.
EXIT MultiplesEBITDA, PE ratio, EV/EBITDA
Potential exitsSale, IPO, Recapitalization
Reader Interactions

Comments

  1. AvatarAnthony M Rynjah says

    Thank You, very informative and interesting.

    • AvatarDheeraj Vaidya says

      Thanks for your kind words!

  2. AvatarSaheed YAKUBU says

    it’s a really nice article.

    • AvatarDheeraj Vaidya says

      Thanks for your kind words!

  3. AvatarElnur Badalov says

    Very useful article. Many thanks for that.

  4. AvatarSumit Ghosh Dastidar says

    Hi Dheeraj

    Your insights are quite helpful in brushing up my knowledge in Finance. Please note LBOs are not only a strategy for PE firms to increase return but also a strategy for Companies to acquire targets. I was involved in an LBO years ago where we financed the acquisition through funding from a bank similar to a revolving facility.

    • AvatarDheeraj Vaidya says

      Yes, thanks for your inputs

  5. AvatarTASHI TIBUI MODESTE says

    All I can say is merci in French.
    I love every explanation and I am hook forever to your blog.
    Regards
    Modeste

    • AvatarDheeraj Vaidya says

      Thanks for your kind words!

  6. Avatarjames afful says

    very useful information.Can you please share information on advance accounting.

    • AvatarDheeraj Vaidya says

      Hello James,
      as of now i don’t have much content on advanced accounting. I am planning for blog posts on advanced accounting. Will keep you posted.
      thanks,
      Dheeraj

  7. AvatarMaryat Nirwandi says

    Thank a lot Dheeraj for sharing, very clear explanation. You are amazing !

    • AvatarDheeraj Vaidya says

      thanks Maryat :-)

  8. AvatarPawani Kishore says

    Amazing post Dheeraj. Thanks for delivering the value! Your knowledge and ideas are way too good. Examples on LBO are great.

    • AvatarDheeraj says

      Thanks Pawani!

  9. AvatarHenson Dsilva says

    Very useful and comprehensive. Liked every explanation, it makes it easy to understand and it’s very graphical. Thanks Dheeraj

    • AvatarDheeraj says

      Thanks Henson!

  10. AvatarPraveen Shetty says

    Is there any difference between how analysis is carried out for an LBO and for Private equity. It would be great if you can help me on this.

    • AvatarDheeraj says

      Hi Praveen,

      It is one and the same. LBO is carried out primarily by the Private Equity firms.

      thanks,
      Dheeraj

  11. AvatarARINJAY says

    Very insightful knowledge!

    Thanks for update and sharing. We will wait for excel Template.

  12. AvatarBrian Harris says

    The examples that you have taken for explaining LBO returns helped a lot. Good job. I follow all your post and find that all of them are extremely informative.

    • AvatarDheeraj says

      Thanks Brian :-)

  13. AvatarRizaan Samuels says

    Hi Dheeraj

    Sincerest thank you for sharing your vast knowledge and experience. This is a brilliant article. Please can you inform me when you prepare the article on using annual financial statements to prepare a LBO financial model.

    Thank you again for all the help:)

    Kind regards

    Rizaan

    • AvatarDheeraj says

      Hi Rizaan,

      Thanks for your input. Taken note of this, the complete excel based LBO model is in the pipeline now. You will see the details soon on this website.

      thanks,
      Dheeraj

  14. AvatarGaurav says

    Hi Dheeraj Sir

    You are just awesome. I am regularly following your articles as you have such a vast knowledge in practically way.

    Thanks a ton and god bless you!

    • AvatarDheeraj says

      Thank you Gaurav :-)

  15. AvatarNidhi Malik says

    Hi Dheeraj,

    It is really such a nice article regarding LBO and in such a layman language. Thank you so much for sharing such a valuable part of your vast knowledge bucket.

  16. AvatarDaniel says

    Your articles are always very insightful. Thank You!

    • AvatarDheeraj says

      Thanks Daniel :-)

  17. AvatarNitin says

    Thanks dheetaj nice explained

    • AvatarDheeraj says

      Thanks Nitin!

  18. AvatarFin Brownes says

    Thanks a lot for the article. I am interested in making a LBO model. How do I make an LBO investment recommendation using only an annual report?​

    • AvatarDheeraj says

      Hello Fin,

      Thanks for your comment. Preparing an LBO model for a company requires a professional approach. Very soon, i will update you with another complete article on Preparing an LBO excel model.

      Best,
      Dheeraj

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