What is a Leveraged Buyout (LBO) Transaction?

A Leveraged Buyout (LBO) transaction is the acquisition of an entity using significant amounts of loaned capital to meet the consideration.

LBO transactions can go up to 9:1 ratio of Debt to Equity.

In a Leveraged Buyout transaction, the target company’s assets become collateral for the loan. LBOs are usually not sanctioned by the acquired company and are therefore often look at as hostile tactics. There are three main reasons to do an LBO:

• Public-to-Private transactions – convert a publicly-traded company into a private one;
• Spin-off a portion of an existing business;
• Transfer private property, as small business owners do.

By using debt, we can reduce the overall financing cost of the acquisition, as the price of debt is usually lower than the cost of equity because interest payments are tax-deductible. Reduced financial costs also increase retained earnings and serve as a lever to increase the return on investment.

Therefore, acquirers usually push for larger debt-to-equity ratios to increase their return. Doing so can lead to employing too much debt and over-leveraging a company. Following this, the company may struggle to generate sufficient cash flows to service the debt, which in turn can lead to debt-to-equity swaps, where owners might lose control in favor of the loan providers.

LBOs are attractive because they’re a win-win both for the bank and the acquirer. Investors get a higher return on their capital, and banks charge higher interest, and also they get more significant collaterals and securities.

Drivers for the decision of a bank to participate in an LBO transaction may include:

• Quality of the target company – stable cash flows, good history, growth prospects, available Property, plant and equipment for pledges;
• The debt-to-equity ratio and amount supplied as equity from the financial sponsor;
• Experience and reputation of the acquirer.

Companies with very stable cash flow performance can get much closer to 100% debt portion, while with regular businesses, it usually varies between 40% and 60%.

Financing of Leveraged Buyouts

Based on the size and structure of the Leveraged Buyout transactions, we can observe two types of debt that are employed:

• Senior Debt – usually carries a lower interest rate and is secured with the target company’s assets as collateral;
• Junior Debt – not secured, subject to higher interest rates (also known as mezzanine debt).

LBO transactions for considerable amounts may have syndicated financing, where the bank arranging the loan sells all or part of it to other financial institutions, to reduce the inherent risk of the transaction.

Choosing Target Companies for an LBO transaction

In almost all Leveraged Buyout transactions, the target company’s assets are the only available collateral to be provided to obtain financing for the debt portion of the purchase. Therefore, companies looking to acquire businesses via an LBO transaction, look for specific traits in the company to be targeted:

• Stable cash flow performance, usually found in mature companies;
• Relatively low fixed costs – fixed costs are an additional risk for investors, as they still have to be covered if revenue decreases;
• Little existing debt – it’s hard for a leveraged company to take on more debt, without starting to suffocate its cash flow; also, banks are less likely to participate in a transaction to acquire a highly-leveraged target company;
• Appropriately valued or somewhat undervalued companies are preferred, as companies with high trade value pose a risk of decreasing in the valuation;
• Ideally, a C-level management team that has worked together for a long time and have vested interest to roll-over their shares when the deal takes place.

Management Buyout (MBO)

Management Buyouts are a particular case of Leveraged Buyout acquisitions, where the management team, having no or close to no shares, acquires a material portion of shares from the owners.

When it’s an external team, we refer to the transaction as Management Buy-in (MBI).

Reasons that can lead to an MBO transaction are as follows:

• Owners want to retire and sell to trusted members of management;
• Owners no longer believe in the business and are willing to sell to the management team, who still believe in the company and want to continue developing it;
• The management team sees value in the business that the owners don’t or don’t want to see and pursue.

Usually, the management involves a financial sponsor in the transaction, to get all the equity portion for the Management Buyout. Business sponsors are mostly willing to participate, as they have added security from the fact that management has a vested interest in the success of the company, and believe in the future of the business, meaning they have an incentive to create value.

Management has the issue of wanting a low purchase price and being employed by the owners wanting a high sale price, which is a conflict of interest.

Secondary Buyouts (SBO)

The leveraged buyout of a company that an investor initially acquired via an LBO transaction, usually between two private equity firms, is called a secondary buyout (SBO).

Some reasons to engage in an SBO might be:

• Sales to strategic buyers or IPO’s might not be a viable option for smaller or highly specialized businesses;
• Secondary buyouts might be a way to generate cash flows faster.

When a company acquired via secondary buyout gets sold to another financial sponsor, the transaction is called a tertiary buyout.

Buyer and Target Companies

The Buyer is usually a private equity fund that invests a small amount of equity and mostly uses debt to fund the remainder of the consideration.

Debt is used to lift the returns – more debt means less equity, which in turn leads to a higher return on investment. This way, acquirers are also able to make more significant acquisitions without substantial capital commitments. There’s an underlying assumption in an LBO deal that the buyer intends to sell the target company in the future, aiming at an average of a 20-25% return on investment.

Target companies usually see LBO’s as hostile and a predatory practice, as in such transactions, the excellent performance of the target company is used as collateral against it.

Leveraged Buyouts always have the same concept:

BUY -> FIX UP -> SELL

Sources of Funds to Finance Leveraged Buyout Transactions

1. Revolving Credit Facilities – used to help fund a company’s working capital needs;
2. Bank Loans – carry a lower interest rate, but usually subject to strict covenants and with more limitations;
3. Mezzanine Debt – a form of hybrid debt issue with equity instruments;
4. Seller Notes – this is when the seller uses part of the consideration to grant a loan to the acquirer; it is easier to negotiate terms with the sellers than with banks, and seller notes are usually cheaper than the alternatives;
5. Equity capital from the buyer;
6. Management fees – LBO firms charge a management fee related to identifying, evaluating, and executing acquisitions by the fund; commonly, these are around 2% of committed capital.

Critical Characteristics of LBO Target Companies

As we already discussed above, acquirers look for specific traits when choosing a target company for an LBO transaction. LBO target companies have some particular characteristics that can be used to identify them:

• From a matured industry;
• A clean balance sheet with low or no debt;
• Strong management;
• Steady cash flows;
• Low working capital requirements;
• No big CAPEX projects planned for the foreseeable future;
• Feasible exit options;
• Options to sell non-core assets;
• Strong market position;
• Identifiable competitive advantages.

Returns in a Leveraged Buyout

Financial analysts review investment opportunities via Internal Rates of Return (IRRs), which measure profits from invested equity. IRR is the discount rate at which the Net Present Value (NPV) of cash flows equals zero. Usually, the hurdle rate for LBO’s is above 30% return.

A popular measure of returns from an LBO investment is cash-on-cash. A 2x cash-on-cash performance means that the financial sponsor has ‘doubled its money’. Typically LBOs range between 2x to 5x cash-on-cash return.

Three factors drive returns in Leveraged Buyouts:

• De-levering (paying down debt);
• Operational improvements (revenue growth, cost cuts, and others);
• Multiple expansion (buying low and selling high).

Gains on LBO investments are realized through an exit strategy, which can be an outright sale to another financial sponsor or strategic buyer, or going through an Initial Public Offering (IPO). Acquirers usually plan an exit strategy within three to seven years after the transaction.

Steps of Leveraged Buyout Analysis

1. The assumption for the purchase price, interest rate on the debt portion, and others;
2. Creating Sources and Uses of funds
   • Sources – where the funds come from;
   • Uses – the funds required to go through with the transaction;
3. Prepare a projection of the financial statements (Income Statement, Balance Sheet, Cash Flow Statement), usually for five years;
4. Perform Balance Sheet adjustments with the new Debt and Equity;
5. Prepare Exit assumptions – most commonly looking to sell the investment after five years, and at the same EBITDA multiple it was acquired;
6. Internal Rate of Return (IRR) calculation on the initial investment – we calculate the selling value of the company, which allows us to calculate the value of the equity stake of the investor, that we can then use to analyze IRR.

Application of Leveraged Buyout Analysis

Performing analysis on an LBO transaction helps us to determine the purchase price of the prospective target company. It also helps us to develop a view of the equity and leverage characteristics of the transaction. LBO analysis also suggests we calculate the minimum valuation of the sale. In the absence of a strategic buyer, the investor should be a willing buyer at a price that delivers the expected hurdle rate of the firm.

LBO Transaction Analysis Example

Let us look at a simplified example to understand better how an LBO transaction works. We are looking at the ABC target company, with sales at 45 mil euro and an EBITDA ratio of 12%. This ratio gives us an EBITDA of 5.4 mil euro and applying an 8x multiple arrive at a purchase price of 43.2 mil euro.

We then negotiate a 25% to 75% debt-to-equity split, meaning our investment will be at the amount of 10.8 mil euro, while 32.4 mil euro we will finance via a bank loan. The bank sets the annual interest at 2%, and we will be making one payment of 1.5 mil euro per annum, to cover interest first and principal with the balance.

Based on these input data, we can calculate our repayment schedule. Here it is for the next 20 years:

We plan our exit strategy to keep the investment for ten years. During this period, we observe an 8% annual growth rate for EBITDA, which means EBITDA will be 11.7 mil euro for the tenth year. As the business is in a growing industry, we aim to sell it at a 10x EBITDA multiple. This multiple gives us a Selling price of about 116.6 mil euro. In the tenth year, we have outstanding debt for 23 mil euro. After covering this amount, Equity (cash in hand) we are left with is 93.5 mil euro, which is a return of 8.66x.

Preparing a simple table with cash flows and remembering to subtract the annual debt payment of 1.5 mil euro from the net cash flow from the sale, give us a starting point to calculate IRR. Internal Rate of Return is a somewhat complicated calculation, so we are using Excel’s IRR() formula to calculate it for us. The calculation gives us an IRR of 18%, which is a bit low for an LBO model. Depending on our required hurdle rate, having calculated the IRR will help us decide whether investing in the ABC target company is a good idea, or not.

This was a look at Leveraged Buyouts (LBOs), what they are and how to analyze an LBO investment opportunity.

Do not forget to download the working file in Excel below: