Overview
A leveraged buyout is the acquisition of a company using a significant amount of borrowed funds to pay for the purchase price of the company. The purchase of the company comes from a combination of equity capital (contributed by the sponsor/consortium, plus potentially some investors, such as management) and debt instruments (financed through banks and other lenders). The debt will constitute most of the purchase price. After the purchase of the company, the debt/equity ratio is typically high (i.e., usually the total debt will be about 60-80% of the purchase price).
In an LBO, the cash flow generated by the acquired company is used to service (pay interest on) and pay down (pay principal on) the outstanding debt. For this reason, while companies of all sizes and industries can be targets of LBO transactions, companies that generate a high amount of cash flow are the most attractive.
Several factors determine the overall return for the sponsor or consortium in an LBO:
- Growth in the operating profit/cash flow of the company over the life of the investment.
- The exit multiple on EBIT/EBITDA relative to the entry or acquisition multiple.
- The amount of debt that is paid off over the time horizon of the investment.
Other typical uses of LBO modeling include:
- Determining the equity returns (through IRR calculations) that can be achieved if a company is bought privately, improved, and then ultimately sold or taken public
- Determining the effect of recapitalizing the company through issuance of debt to replace equity
- Determining the debt service limitations of a company based on its cash flows
Criteria for Selecting LBO Candidates
The following characteristics determine the level of a successful LBO:
Mature industry and/or company: The stock price of the target company is trading at a lower multiple to free cash flow than new companies in high-growth industries.
Clean balance sheet with no or low amount of outstanding debt: Companies with high levels of pre-existing debt limit the amount of new debt that it can withstand, and new debt is crucial for the LBO.
Strong management team and potential business improvement measures: Effective and efficient management focused on cost optimization / growth opportunities.
Strong competitive advantages and market position: Good position relative to current and potential competitors to maintain profit margins / cash flows and help provide possible growth opportunities for the business.
Steady cash flows: Stable, recurring cash flows to service the debt for the LBO. Cyclical or highly seasonal companies are not such good candidates for an LBO.
Low future capital expenditure and working capital requirements: LBO returns are generated from growing the business. Growth must be used to finance new capital expenditures and new working capital requirements for the business. Therefore, businesses that have relatively high capital expenditure and working capital requirements will be less attractive for an LBO.
Possible sale of underperforming/non-core assets: Divisions or side businesses that are performing weakly can be sold to raise cash to pay off outstanding debt that is used in the purchase of the company.
Feasible exit options: Once the business has been restructured (both operationally and financially), LBO investors seek to exit the investment within a 4 – 7 years span (strategic sale, initial public offering, or sale to another LBO investor). Holding the company beyond the optimal selling point reduces the expected annual return on the investment, because leverage decreases every year.
Capital Structure
Each leveraged buyout is structured differently, however the difference mainly comes from the percentage of each component of the capital structure. Some deals include a little bit more of one component than another, or an alternative component (such as one type of debt financing rather than another), but overall there is a fairly specific recipe that is almost always used.
Around half of an LBO’s capital structure typically includes Senior Debt, also known as Bank Debt financing. Senior Debt has a lower cost of capital than other tranches of the capital structure. This occurs because Senior Debt has a priority claim on the cash flow of the business and is also secured by assets of the company.
Additionally, Banks set performance criteria agreements (“covenants”) for the company to follow the Senior Debt arrangements. These covenants include minimum coverage of interest (the interest coverage ratio) and a maximum allowable debt/cash flow ratio. These performance ratios are typically scrutinized every quarter.
In addition, Senior Debt requires closing fees in the form of financing fees plus an Original Issue Discount. These are effectively upfront charges paid to the lenders for the consideration of lending the company/sponsor the money to purchase the company.
High Yield Debt, or Subordinated Debt, often represents a third of the capital structure of the newly acquired company. High-yield debt has higher financial costs than senior debt, but with less restrictive covenants or limitations. The high-yield debt issuers are ahead of the equity holders in the event of a liquidation of the company, but behind the Senior Debt.
High-yield bondholders will not receive any compensation until the Senior Debt holders are paid in full. High-yield bonds are often referred to as Junk Bonds because the potential loss of investment capital is significant in many cases, and the bonds have little security for the investors aside from the cash flow generated by the company.
Subordinated debt can also consist of various types of mezzanine financing (PIK notes, convertible preferred debentures, quasi-equity). These additional securities make a smaller slice of the capital structure (around 5% apiece) and are junior to other forms of debt. They thus require an even higher expected return than other forms of subordinated debt but decrease the amount of equity consideration the sponsor must contribute to purchase the company.
The more high-yield and mezzanine financing used, the higher the equity returns for the sponsor are likely to be, because they reduce the sponsor’s required investment amount, but do not limit the potential gains to equity holders if the company increases in value.
Equity, which represents the private equity fund’s capital in an LBO, is the most junior tranche of the capital structure. In other words, common equity shareholders are paid last during a liquidation of a company, after all other stakeholders. The equity is typically around 20-30% of the notional value of the capital structure, though it is sometimes more for certain deals.
Because the company is so heavily leveraged at acquisition, equity holders require a large projected internal rate of return on investment—typically, investors seek annual returns in the range of 20% to 40%. Again, if problems occur during the investment, equity holders may very well receive no value on their position, particularly if the company defaults on its borrowed debt payments, so the required returns to compensate for that risk are high.
Operating Assumptions
Financial projections, typically in the range of 5-10 years after the transaction close, act as the basis of the model. Usually the CFO of an LBO candidate company will provide financial projections for the company developed by management.
Key questions when developing an LBO transaction analysis will generally include the following:
- What is the outlook for the company’s industry?
- Does the company operate in a cyclical or seasonal industry?
- What is the outlook for the current state of the domestic and global economy?
- How was the company affected in past recessions?
- To what degree does the company exhibit operating leverage?
- Realistic assumptions and scenarios analysis (base, high, low).
Regarding the base case scenario, the following guidelines are used:
- Projected revenue should grow at a rate consistent with past performance, and industry.
- EBITDA margins should be kept flat, and consistent with past results (i.e. average margins from the prior 3 years).
- Working capital requirements should be projected in connection with recent prior years.
- Capital expenditures should grow at a slow rate, typically consistent with inflation.
- Depending on the specific circumstances of the company being analyzed, some of these base case assumptions might vary.
- Review projections to be realistic and not overly optimistic.
For more details please see our LBO Model
Potential Exits and Returns Analysis
The major LBO goals consists of:
- Improving the company
- Paying down debt
- Selling the company for a profit
Expected return (Internal Rate of Return, or IRR) more than 25% is required to consider an LBO of a potential target company. Potential exit multiples (EBITDA and P/E) and maximum amount of debt the target can handle are determined to achieve such high returns without taking on excessive risk.
Sources and Uses
The Sources and Uses table traces the flow of money being used for various purposes to complete the transaction: the Sources of funds (lenders and equity investors) and the Uses of those funds (paying previous debt holders, previous equity holders, transaction fees, etc.). The sum of the Sources and Uses must be equal.
For more detail on a leveraged buyout model, please see our LBO Model