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What is LBO?
LBO or leveraged buyout is basically acquiring a company with a small amount of equity (say 5-10% of the total cost) and using debt to fund the remaining (90-95%). This implies that the acquisition is done primarily using borrowed money and with this high leverage, the buyer (Private equity firms) hope to earn a higher return on its investments.
The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital.
How does the LBO work?
In this section of what is LBO, we will try to understand how the LBO works using a simple example so that afterward the LBO financing becomes clear.
Let’s say that you have a business. It’s a great business and there’s no debt as of now and it generates a pre-tax income of $1.5 million a year. And your net income is $1 million assuming that you’re paying a third of what you earn to Government.
- Now Mr. B contacts you and praises your enterprise and desires to buy the company in $10 million. To you, it’s a great deal because you have been earning $1 million per year and $10 million looks pretty attractive to you. So you agree for the buy-out.
- Mr. B, on the other hand, checks his funds and finds out that he can only invest $1 million himself and the rest he has to arrange from somewhere else.
- So he asks a bank to lend him the rest of the amount. The bank disagrees to lend the money, thinking that it would be a risky business. Then Mr. B goes out and sees that your company has great assets. So he shows the assets of the company, uses the assets as collateral and convinces one of the banks to lend the money at 10% interest rate per annum.
- So Mr. B invests $1 million of his own funds and borrows $9 million from the bank and pays you off $10 million and buys the business. Now the business doesn’t consist of equity only. There are $1 million equity and $9 million in debt. So this would be called a leveraged buyout since debt is used heavily in this whole deal.
We will now check whether this deal is profitable for Mr. B or not. After buying the business, if we assume that the firm still generates $1.5 million in pre-tax income, here’s how the calculation will go.
- Even if the firm generates $1.5 million in pre-tax income, net income won’t be $1 million after paying $0.5 million taxes. Now, Mr. B needs to pay an interest on the borrowed funds. He has borrowed $9 million at the rate of 10% per annum.
- That means he needs to pay $900,000 as interest. That means, the company has the pre-tax income of ($1.5 million – $900,000) = $600,000. He will pay the same tax rate as the interest is tax-deductible.
- He will get a net income of $400,000 assuming that he would pay one-third part of the pre-tax income as taxes.
- Now this $400,000 is pretty good income if we compare what Mr. B has put in. He has put in $1 million of his own money. That means if the net income remains similar for the next 3 years, he would get back his invested money and more.
In this example, Mr. B has taken the help of the bank. In big deals, usually, the company targets a competitor company and takes help of private equity firm. Private equity firm then goes out and puts in some of its own money and takes a loan from other financial institutions.
Summary of LBO
This section of what is LBO summarizes most of the important features of LBO.
|Returns||Between 20%-30% generally|
|Exit Time Horizon||3-5 years|
|Capital Structure||A mixture of Debt (High) and Equity (low)|
|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|
This has been a guide to what is LBO? Here we explain LBO in a simple language along with examples. Here we also look at the features of Leveraged Buyouts in a table summary format. You may learn more about Investment Banking from the following articles –