When do you think that a girl can think something like the way the girl in the above picture is thinking. Maybe it’s when she is extremely bored out of her mind, or she is behind deadlines and has no time to listen to some stupid talks or maybe things are not going the way she wants them to be. So now, I would be pleased to introduce you to the girl in the above picture, who is ” Me”. And the reason why i was irritated was that…
Ok before i tell you that, you first need to understand why i was so tired talking on the phone on a weekend.
It was a typical Sunday evening for me. I was just sitting in my room, thinking about my next article. And it was really getting irritating as the time passed. I was out of any new topic to start with. I brainstormed for some time, but in vain. It felt that all the words that came into my mind made no sense. Then suddenly I got a call from my friend. She hadn’t called me in years and hence I started thinking what might be the reason for the call. She told me that had this big news. No, it was not her wedding, nor did she came first in the university. She was shifting to a beautiful new home.
She told me the entire story of how it was so well furnished and how perfect it was. After some time I started feeling that I can design someone else’s home if I listen to her for few more minutes. But then the conversation changed its mode. It turned its course from being cheerful to chaotic and full of anxiety. And the reason behind that was the Home loan that she had taken to buy the so called precious house of hers. The down payment was less and the loan was more. I asked her why this particular approach if it’s full of worry. And I got some interesting answer; “If you want to get something good, you have to give away more”. And I thought where had I heard this with context to finance theories. And the word immediately clicked in my mind, “leverage buyouts”. Even though I was bored out of my mind listening to her dream home stories, I actually had to thank her for giving me this idea for starting with my new article. I hurriedly told her that I will help her with the house warming party and told her that I had to go, because of my pending work. And then, there I was I, all ready with my laptop, to write my next article “LBO Analysis“.
You must be thinking how is LBO connected with my friend’s situation? You don’t have to think that I am Crazy, it really is connected. Let me show you how.
LBO Analysis Concept
Consider that the concept of 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, definitely it is not possible to do the entire down payment. Then what do you do? Yes, ofcourse you go for a loan. And most of the times it forms a major part of the entire process. Similar is the concept in LBO analysis.
If we break down it to simple terms, in an LBO, the “down payment” is called Equity (cash) and the “mortgage” is called Debt. I think it’s clearer to all of us now. So let’s start analyzing what does the term Leverage buyout is all about.
A leveraged buyout (LBO) is an acquisition of a company or a segment of a company. But this is a common thing which you may have heard. So what is the major difference that gives it a name of “leverage Buyout”? The answer is,
“The entire process is majorly funded by debt”
In this LBO analysis article I would like to stress on a point 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 here is that, the acquisition of another company is significantly by borrowed money (bonds or loans) to meet the cost of acquisition. Often in such cases the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital.
You might be amazed to know that in LBO there is usually a ratio of 90% debt to 10% equity. The value of 90% debt is indeed a high and hence because of this high debt/equity ratio the bonds usually are 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 that you may want to understand is that Leveraged buyouts have had a notorious history, especially in the 1980’s. 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 were unable to 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 of around $33 billion.
If you have an opportunity to look at a LBO model which is prepared during a LBO analysis, nothing like it. You will then properly understand why LBO was opted 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 give it a thought, the irony here 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 be sometimes regarded as ruthless and a predatory tactic.
LBO Analysis example
By now we have 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 no, then the question is why this approach? And is Yes, then the question is how?
Let us now understand the concept of LBO with an example.
I will be guiding you with 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 are able to borrow $900 more. So now the total that you have is $1000.
Now, let’s say you invest those $1000 and you earn 10% interest on it (go up to $1100).
After you repay your debt of $900, you are left over with $200 ($1100-$900), which is a 100% return on your money you initially put in. Remember that you put $ 100 initially? So if you are left with $200 now, you have got 100% return. I think now you must have got an idea as to why this LBO analysis is opted by the companies.
How does LBO analysis work?
- LBO analysis is similar to a DCF analysis. The common calculation includes the use of 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), whereas in LBO analysis we are actually looking for the internal rate of return (IRR).
- LBO analysis also focuses whether there is enough projected cash flow to operate the company and also pay debt principal and interest payments. The concept of a leverage buyout is very simple,
Buy a company –> Fix it up –> Sell it
And here are examples of why companies are doing it:
Let’s consider a more precise example to understand the concept better.
Suppose you buy a company for $100 using 100% cash. You then sell it 5 years later for $200.
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 $150 here because the $50 in debt must be repaid).
The following excel sheet helps to compare both the Scenarios and it’s 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 entire plan is, a private equity firm targets a company, buys it, fixes it up, pays down the debt, and then sells it for large profits.
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 mature business that has proven themselves over the years.
Steps involved in LBO Analysis
Step 1 – Transaction Assumptions
- In the first step of LBO analysis we need to take care of some transaction assumptions. Analyzing the purchase price and financing of the deal are some important steps here.
- With this information, then a table of Sources and Uses can be created Uses reflects the amount of money required to effectuate the transaction. The Sources tells 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 the goodwill and capitalized financing fees are likely to be created.
Step 3 – Create Cash Flow Model
- The third and the 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 a period of time (five years mostly). The balance sheet has to be projected based on the newly created proforma balance sheet. While projecting the debt and interest, post-transaction debt must be considered.
Step 4 – Calculate value of 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 assumption 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 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).
Let’s play with some numbers!
So now we have understood what are the steps involved in LBO analysis. But, reading the theory and actual simplifying it with some numbers are two different concepts. So let’s try to jam with some numbers to get clear insights into LBO analysis. Let’s get you into a role play now. Yes, you have to think that you are a successful businessman atleast for one day. I know, I have made some my friends dream 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. 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 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 of 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 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.
- 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).
- In the above third step we had calculate the EBITDA for the company to be $100. Now we will assume that the EBITDA of the company can grow from 100 to 150 over 5 years.
- Let’s say that you are able to 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 that you can sell at 8 times multiple, you will get 150*8=1200.
- From that 1200, you need to repay 400 of 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.
- Therefor 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 repays the revolver when excess cash is available.
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 exposure. 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.
Bank debt is a low interest rates 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:
1. Term Loan A- Here the debt amount is evenly paid back over a period of 5 to 7 years.
2. Term Loan B- This layer of debt usually involves minimal repayment over 5 to 8 years, with a large payment in the last year.
It is a form of hybrid debt issue. The reason behind that is, it generally has equity instruments (usually warrants) attached with it. It increases the value of the subordinated debt and allow for greater flexibility when dealing with bondholders.
Seller notes can be used to finance a portion of the purchase price in an LBO. In 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.
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.
Key characteristics of a LBO candidate
- Mature industry and the company
- Clean balance sheet with no or low amount of outstanding debt
- 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 under performing or non-core assets
Sources of Revenue
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.
LBO firms charge a management fee associated with identifying, evaluating and executing acquisitions by the fund. Management fees typically ranges 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 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’ hurdle rate, which is the minimum required rate, have been in excess of 30%, but may be as low as 15-20% for particular deals under adverse economic conditions.
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 returns 2x cash on cash, the sponsor is said to have “doubled its money”.
The returns in an LBO 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 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 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.
The exit multiple simply refers to the return of investment. If you are investing $100 in a company and sell it for $300, then the exit multiple here is 3x. EV/EBITDA is the generally used exit multiple. While exiting the investment at a multiple higher than the acquisition multiple will help boost the sponsor’s IRR. But it is important that exit assumptions reflect realistic approaches.
Issues to Consider in LBO Transaction
Think of you as an investor who wants to invest in 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
- 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
- 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 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.
The Final Word,
So I guess you must have by now understood some of the basics of LBO Analysis. The concept of LBO analysis is very important and I have tried to explain it to you in a simple way. I would like to also comment on some more information which I may have missed. You can also share this article with your friends.
Me on the other hand, I need to get going and find some house warming party gift for my friend. I hope I get something perfect which is good enough for her perfect little home!!!
LBO Analysis Infographics
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