Updated October 12, 2023
Introduction to LBO Analysis
Consider that a leveraged buyout is very similar to buying a house. Suppose you want to buy a big house; what will you do? Due to rising real estate prices, making the entire down payment is impossible. Then what do you do? Yes, of course, you go for a loan. And most of the time, it forms a significant part of the entire process. Similar is the concept in LBO analysis.
In an LBO, we refer to the “down payment” as Equity (cash), and we call the “mortgage” Debt. It’s clearer to all of us now. So, let’s start analyzing the term Leverage buyout: a leveraged buyout (LBO) is an acquisition of a company or segment. But this is a common thing that you may have heard. So what is the significant difference that gives it the name of “leverage Buyout”? The answer is,
“The entire process is majorly funded by debt.”
LBO Analysis Concept
In this LBO analysis article, I would like to stress that the process of Leverage buyout includes a financial buyer, mostly a private equity fund, who invests a small amount of Equity and majorly uses leverage to fund the remainder of the consideration paid to the seller.
Thus, the main point to concentrate on here is that the acquisition of another company is significantly by borrowed money (bonds or loans) to meet the acquisition cost. Often, in such cases, the assets of the Company being acquired are used as collateral for the loans in addition to the help of the contracting Company. The purpose of leveraged buyouts is to allow companies to make significant acquisitions without committing a lot of capital.
You might be amazed that LBO usually has a ratio of 90% debt to 10% equity. The value of 90% debt is indeed high; hence, because of this increased debt/equity ratio, the bonds are usually referred to as junk bonds. 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.
Another interesting fact you may want to understand is that Leveraged buyouts have had a notorious history, especially in the 1980s. 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 could not meet the obligation.
Just so you know, one of the largest LBOs on record was the acquisition of HCA Inc. in 2006 by Kohlberg Kravis Roberts & Co., Bain & Co., and Merrill Lynch. The acquisition transaction was around $33 billion.
Suppose you can look at an LBO model prepared during an LBO analysis; nothing like it. You will then properly understand why LBO was opted for 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%. This return range far exceeds the historical average annual return in the stock market.
- Leveraged buyouts are similar to normal M&A deals, but in an LBO, you assume that the buyer sells the target in the future.
If you think about it, the irony 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 sometimes be regarded as ruthless and predatory tactics.
LBO Analysis Example
We have now understood the general definition of Leverage buyout in LBO analysis. But let’s understand why companies go for LBO. Is using so much debt beneficial to the companies? If not, then the question is, why this approach? And if Yes, then the question is how?
Let us now understand the concept of LBO with an example.
I will be guiding you with the help of two examples to understand. 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 can borrow $900 more. So now the total that you have is $1000.
Let’s say you invest those $1000 and earn 10% interest (up to $1100).
After you repay your debt of $900, you are left over with $200 ($1100-$900), a 100% return on the money you initially put in. Remember that you put $ 100 initially? So, if you are left with $200 now, you have a 100% return. Now, you must know why this LBO analysis is opted for by the companies.
How Does LBO Analysis Work?
- LBO analysis is similar to a DCF analysis. The standard calculation includes 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). In contrast, we look for the internal rate of return (IRR) in LBO analysis.
- LBO analysis also focuses on whether there is enough projected cash flow to operate the Company and pay debt principal and interest payments. The concept of a leveraged buyout is straightforward,
Buy a company –> Fix it up –> Sell it
Here are examples of why companies are doing it:
Let’s consider a more specific example to understand the concept better. Suppose you buy a company for $100 using 100% cash. You then sell it five years later for $200.
Let’s compare that to when you buy the same Company for $100 but use only 50% cash and sell it 5 years later, still for $200 (shown as $150 here because the $50 in debt must be repaid). The following Excel sheet helps to compare the scenarios and their effect on IRR. Scroll the Excel sheet to the right to get better insights into comparison. You may also download the Excel sheet and see how the formulas are used.
Usually, the plan is a private equity firm targeting a company, buying it, fixing it up, paying down the debt, and then selling it for large profits. One thing you should remember is that predictable cash flows are essential to have a reasonable buyout. This is the reason why target companies are usually mature businesses that have proven themselves over the years.
Steps Involved in LBO Analysis
Step 1: Transaction Assumptions
- In the first step of LBO analysis, we must take care of some transaction assumptions. Analyzing the purchase price and financing the deal are essential steps here.
- With this information, a table of Sources and Uses can be created. Uses reflect the amount of money required to effectuate the transaction. The Sources tell us from where the money is coming.
Step 2: Construction of the Proforma Balance Sheet
- Next, we make the changes in the existing balance sheet of the Company to reflect the transaction and the new capital structure. This process leads to the construction of the “Proforma” balance sheet. At this step, intangible assets like goodwill and capitalized financing fees will likely be created.
Step 3: Create a Cash Flow Model
- The third and crucial step is to create an integrated cash flow model for the Company. Here, the Company’s income statement, balance sheet, and cash flow statement are projected for some time (mostly five years). The balance sheet has to be launched based on the newly created proforma balance sheet. While projecting the debt and interest, the post-transaction debt must be considered.
Step 4: Calculate the value of the Private Equity Firm’s Equity Stake
- Once the model is created, assumptions about the private equity firm’s exit from its investment can be made. A general belief is that the Company will be sold after five years at the same implied EBITDA multiple at which the Company was purchased. There is a reason why we calculate the sale value of the Company. It also allows us to calculate the value of the private equity equity stake, which we can then use to analyze its internal rate of return (IRR).
Let’s Play with Some Numbers!
So now we understand what the steps involved in LBO analysis are. However, two different concepts are reading the theory and simplifying it with some numbers. Let’s jam with some numbers to get clear insights into LBO analysis. Let’s get you into a role-play now. You must think you are a successful businessman for at least one day. I know I have made some of my friend’s dreams come true. So let’s get started.
- 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. You need 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 sale of the Company is $500, and the EBITDA margin is 20%, then the EBITDA comes to $100 (500*20%).
- It means that you may have to pay 8*$100= $800. ( 8 times the EBITDA multiple).
- 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, you will use $400 of Equity and $400 of debt.
- Now, think you plan to sell that Company after 5 years at the exact EBITDA multiple of 8.
- The next step is to do some financial forecasting to see what the Company’s future cash flows 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).
- In the above third step, we calculated the EBITDA for the Company to be $100. We will assume that the EBITDA of the Company can grow from 100 to 150 over 5 years.
- You can pay $20 of debt each year (100/5), i.e., 100 over the next five years.
- Remember that you have spent 400 of Equity and taken 400 of debt earlier? So after 5 years, EBITDA is 150, and assuming you can sell at 8 times multiple, you will get 150*8=1200.
- From that 1200, you need to repay 400 of the debt. But you have already paid 100 over the last 5 years. Therefore, you only have 300 to repay. That leaves you with 1200-300= 900 of Equity.
- Therefore, your overall return will be 900/400 2.25x returns over 5 years, which comes to around 18% IRR.
Sources of Funds in LBO Analysis
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 repay the revolver when excess cash is available.
- Subordinated or High-Yield Notes
The public usually refers to them as junk bonds. Companies sell these bonds to the public, and they demand the highest interest rates to compensate holders for their increased risk exposure. The public bond market or the private institutional market may raise subordinated debt, and it typically has a maturity of 8 to 10 years. It may have different maturities and repayment terms.
- Bank Debt
Bank debt is a lower interest rate 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: The debt amount is evenly paid back for 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.
- Mezzanine Debt
It is a form of the hybrid debt issue. The reason is that 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.
- Seller Notes
Buyers can use seller notes to finance a portion of the purchase price in an LBO. In the case of seller notes, a buyer issues a promissory note to the seller wherein he agrees to repay over a fixed period. 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 with a bank or other investors.
- Common Equity
A private equity fund contributes equity capital by pooling the capital raised from various sources. These sources include pensions, endowments, insurance companies, and HNIs.
Key Characteristics of an LBO Candidate
- Mature Industry and the Company
- A clean balance sheet with no or low amount of outstanding debt
- The 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
Sources of Revenue
1. Carried Interest
Carried interest represents a share of the profit 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.
2. 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.
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.
Returns in LBO analysis
In a 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 have set their hurdle rate, representing the minimum required rate, at levels exceeding 30%. However, the hurdle rate may be as low as 15-20% under adverse economic conditions for specific deals.
Sponsors also measure the success of an LBO investment using a metric called “cash on cash”. Typical LBO investments return range between 2x – 5x cash-on-cash. If an investment generates a 2x cash on-cash return, we say that the sponsor has “doubled its money.”
Three following factors drive the returns in an LBO
- 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
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, 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.
The exit multiple refers to the return on investment. If you invest $100 in a company and sell it for $300, then the exit multiple here is 3x. The generally used exit multiple is EV/EBITDA. Exiting the investment considerably higher than the acquisition multiple will help boost the sponsor’s IRR. But, exit assumptions must reflect realistic approaches.
Issues to Consider in LBO Transaction
Think of you as an investor who wants to invest in that company’s share.
Will you directly start trading from 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
- The ability of management to operate efficiently in a highly levered situation
Applications of the LBO Analysis
- LBO analysis helps in determining the purchase price of the prospective Company or business.
- It helps develop a view of the leverage and equity characteristics of the transaction.
- Calculate the minimum valuation for a company since, without 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.
So, I guess you must have understood some of the basics of LBO Analysis. The concept of LBO analysis is very important, and I have explained it to you simply. I would like to also comment on some more information I may have missed. You can also share this article with your friends.