Updated July 21, 2023
Introduction to LBO Financing
LBO stands for the leveraged buyout, of these two terms, ‘buyout’ refers to a transaction in the private equity domain, where the buyer buys a controlling stake in the ownership of the target company and ‘leveraged’ refers to debt, therefore, the leveraged buyout involves using some of the owned money and some borrowed money to acquire the company and later using the cash flows of the company to pay off the debt.
Explanation of LBO Financing
Mostly, the buyout takes place for larger companies that are more stable but inefficiently managed and the purpose of the buyout is to make these companies efficient. For these companies, the predictability of cash flow is higher and the assets owned by them are also higher.
This is the reason why Private Equity firms agree to get involved in debt financing because they are reasonably sure that the cash flows will be sufficient to pay off the debt and therefore the risk is quite measurable. This is similar to the process of buying shares on margin. Also, this is not just acquiring the shares, but it is more of acquiring the company to run the same and making it more efficient.
How Does LBO Financing Work?
LBO is the analysis of how a change in the capital structure along with a few other parameters will affect the returns that a Private Equity firm can generate from its investment in the target company. Therefore the purpose of this analysis is to come up with a range of prices that the PE can negotiate and pay to acquire the controlling interest.
The factors that are considered in the analysis are as follows:
- Expected Cash flows of the target company of which the PE investor will receive the shares proportionate to the percentage of his investment. These are calculated and provided by the target company’s management and are vetted for many different tests to establish reliability. This is important because these form the way of repaying the debt that the PE investor has taken up and also for the calculation of the return on investment. Generally, a predetermined investment horizon is considered while conducting such an analysis.
- Expected Return of the Capital Providers: Once the CFs is established, it needs to be compared with the expected returns of the various capital providers to analyze whether the CF is sufficient to meet the return requirement. Without this, there is no meaning to the calculation of expected CFs because they won’t imply anything.
- Availability of Financing: Further, once it is determined how much is required, it is also required to figure out how much debt can actually be raised. At times the lenders may refuse to provide the required amount and thus the transaction might not take place at all.
Strategies of LBO Financing
- At times the seller of the company provides the debt capital to the buyer for making the purchase of the target company. This gives the buyer the opportunity to negotiate the term of the payback and therefore provides him some flexibility. Further the seller gets a little bit of surety of the amount she will receive and also the responsibility of the company is transferred to the buyer.
- In most cases the PE firm borrows a massive portion of the buyout price. Almost as much as 90% while puts in only 10% equity. However, if the equity percentage increases to 30% or more, it is called and own fund LBO however, for it to stay an LBO, the debt must be at least 50%
- In case of LBO the debt issued might get the priority in payment over other existing debts, which is the case of LBO through senior debt issue.
- At times the PE firms might not want to give the debt the seniority right, then it may use subordinate debt but here it will have to pay a higher interest rate.
Example of LBO Financing
In 2013, Berkshire Hathaway and 3G capital acquired H. J. Heinz Company. The Acquisition price was $ 28 billion. This transaction involved a debt of $12 billion, which amounted to 42% of the acquisition price. There has been a lot of debate as to whether it is a PE deal or not because the buyers have suggested that they may increase equity and have longer term interest in the same, however, it still remains one of the most talked about LBOs
However, in the process of making the company more efficient, the new owners decided to merge it with Kraft foods in 2015 which is one of the popular exit strategies of a PE investment. Therefore ultimately it turned out to be an LBO.
Advantages and Disadvantages of LBO Financing
Below are the advantages and disadvantages:
Following are the advantages:
- Increased Efficiency: The LBO is conducted for the purpose of creating more efficiency. In case of the Heinz deal, right after the deal culminated, several employees were laid off and several austerity measures were taken by the new owners to make the company more efficient.
- Managing Competition: LBO takes place also among competitors, wherein a bigger company which sees the target company as a threat makes an attempt to acquire the competitor and capture the market share which it feels can be eaten out by the target company. LBO is helpful because it speeds up the process otherwise there might not always be equity capital that is easily available.
- Diversification: Like in other M&A activities, the LBO is also used to diversify the portfolio of a company where in it is able to invest in a new product to get an exposure in this new domain and gain the advantage when this new product picks up.
Following are the disadvantages:
- Debt Costs: As LBOs are heavily financed by debt, the interest burden is very high and even though a lot of due diligence goes into the CF forecast, a forecast is after all a forecast and may not always come true. Therefore it is a high risk high reward scenario and no matter if the company is stable enough, the debt burden might be too high to cover up.
- Resistance: As is the case with any M&A activity, the smooth amalgamation of the company and the owners is not always easy to acquire and therefore there might be challenges as to the coming together of the cultures and values of both.
So all in all, LBO is a format in which the Private equity firm takes over a controlling interest in a company that is large enough and has stable cash flows. The process involves a high level of debt financing and therefore it is so called. The cash flows from the company are used to pay off the debt and over time the debt component is reduces to generate greater returns.
In most cases the investment horizon is not too long nor too short and the exit from the investment is also an integral part of the investment decision, but is not completely drafted before-hand because until and unless the control is shifted, the exit strategy might not get the required validation.
This is a guide to LBO Financing. Here we also discuss the introduction and how does lbo financing work? along with advantages and disadvantages. You may also have a look at the following articles to learn more –