EDUCBA

EDUCBA

MENUMENU
  • Free Tutorials
  • Free Courses
  • Certification Courses
  • 250+ Courses All in One Bundle
  • Login
Home Finance Finance Resources Investment Banking Basics Leveraged Buyout (LBO)
Secondary Sidebar
Finance Blog
  • Investment Banking Basics
    • Trust Fund
    • Short Sale in Real Estate
    • How to Invest in Stocks
    • Penetration Pricing Strategy
    • S Corporation
    • Special Purpose Entity
    • Wholesale Price Index
    • Hyperinflation
    • Stagflation
    • Capital Structure
    • Pecking Order Theory
    • Private Placement of Shares
    • What is Stock Market
    • Pyramid Scheme
    • Introduction to Stock Market
    • Fiscal Policy
    • Trust Account
    • Zombie Company
    • Aggregate Demand (AD)
    • Aggregate Supply
    • Diluted EPS
    • Limited Partnership
    • Leveraged Finance
    • Liquidation
    • Holding Company
    • Kickback
    • Kiting
    • Financial Instrument
    • Finance Charge
    • Free Cash Flow to Firm Formula
    • Personal Income
    • Enterprise Value
    • Joint Liability
    • Return on Average Equity
    • Factor Models
    • Beta in Finance
    • Leverage Ratio
    • Investment Partnership
    • Banker??s Acceptance
    • Internal Sources of Finance
    • Insolvency
    • Intercreditor Agreement
    • Forfaiting
    • Debt Restructuring
    • How to Buy Shares?
    • Indenture
    • Incumbency Certificate
    • In House Financing
    • Independent Director
    • Insourcing
    • Holding Company Examples
    • How to Get Into Project Finance
    • How to Manage Your Money
    • Finance vs Consulting
    • Agency Problem
    • Article of Association
    • Career and Scope After B.Com
    • Capital Rationing
    • Financial Guarantee
    • Corporate Governance
    • FHA Loan
    • Fannie Mae
    • Financial Market
    • Fixed Capital
    • Fixed Rate Mortgage
    • Foreign Corrupt Practices Act
    • Foreign Investment
    • Finance vs Marketing
    • Functions of Financial Markets
    • Grace Period
    • Gift of Equity
    • Greenwashing
    • Hard Money Loan
    • CFO Job Description
    • Corporate Finance vs Investment Banking
    • Corporate Finance vs Project Finance
    • Career After BFM/BAF
    • Form S-8
    • Market Cap vs Enterprise Value
    • Quantitative Analyst Career
    • Leveraged Buyout Model
    • Mistakes in Discounted Cash Flow
    • LBO Analysis
    • Golden Handshake
    • Asset Management Company?
    • Private Placement?
    • Marking to Market?
    • Horizontal Merger
    • Special Purpose Vehicle
    • What is Investment Banking?
    • Spin off vs Split off
    • Vertical Merger
    • Merger and Acquisition Process
    • Conglomerate
    • Horizontal Merger Examples
    • Amalgamation
    • LBO Financing
    • Types of Joint Venture
    • Merger
    • Acquisition
    • Greenmail
    • Reverse Merger
    • Sandbagging
    • Pac Man Defense
    • Backward Integration
    • Poison Pills
    • Green Shoe Option
    • Hostile Takeover
    • Forward Integration
    • Acquisition Financing
    • Types of Acquisition
    • Project Budgeting Template
    • Commercial Bank vs Investment Bank
    • Private Equity vs Venture Capital
    • Degree of Operating Leverage
    • Sales and Trading
    • Revenue Recognition Principle
    • Hedge Fund Strategies
    • Merger Examples
    • Vertical Integration Example
    • Vertical Merger Example
    • Financial Markets
    • Equity Examples
    • Biggest IPO's in History
    • Cross Border Merger and Acquisitions
    • Leverage Buyout
    • Mergers and Acquisitions in India
    • Project Financing in India
    • Investment Banking for Dummies
    • Equity Research Report Rules
    • Mergers and Acquisition in 2013
    • Investment Banking Band Chart
    • IPO For Investors
    • Yield Spread
    • Angel Investor vs Venture Capital
    • CFA vs CA
    • Merger vs Amalgamation
    • Joint Venture vs Strategic Alliance
    • Carees in Banking Exams
    • Facebook IPO
  • Accounting fundamentals (700+)
  • Asset Management Tutorial (200+)
  • Banking (44+)
  • Corporate Finance Basics (373+)
  • Credit Research Fundamentals (6+)
  • Economics (88+)
  • Finance Formula (386+)
  • Financial Modeling in Excel (17+)
  • Investment Banking Careers (29+)
  • Trading for dummies (69+)
  • valuation basics (27+)
  • Insurance Resources (14+)
  • Top Finance Books (7+)
Finance Blog Courses
  • Investment Banking Course
  • Mergers & Acquisition Course
  • Financial Modeling Course

Leveraged Buyout (LBO)

By Jesal ShethnaJesal Shethna

What is a Leveraged Buyout?

What is a Leveraged Buyout

A leveraged buyout means using financial leverage or debt as the principal element in an acquisition. In direct meaning, LBO refers to the takeover of a company while utilizing debt to buy the company. The target company’s assets are kept as collateral to raise the debt, and its cash flow is used to pay off the debt. 

LBOs work on the anticipation that the returns generated on the purchase will be greater than the interest that has to be paid on the debt. Hence, the acquirer can experience good returns by investing only a small part of their own capital. The investors usually sell the firm four to seven years from the purchase date and exit it with a profit. It is how LBOs usually work.

Leveraged buyouts (LBO) have become a common landscape when acquiring private firms. Moreover, it has become a standard practice within the private equity industry. Looking back in the past, LBO started gaining prominence 1980s. 

Key Takeaways

  • In a simple explanation, a Leveraged Buyout (LBO) is buying a company using debt as capital. The cash flow from the bought company repays the debt. Buyers or Acquirers sell the company after a few years for a substantial profit.
  • The potential LBO candidate should have key characteristics. A strong market position, efficient management, stable assets & cash flow, and an exit plan are some of the characteristics. 
  • One can determine a good LBO candidate and target using ratios. Formulas are Equity/Enterprise value, Enterprise value/Free cash flow, and Enterprise value/EBITDA.
  • A Good LBO leads to the advancement of the company’s management, business strategies, and technical developments. It also helps save tax and increase financial returns.
  • Examples of a successful LBO are Manchester United Football Club, First Data, Hilton Hotels, and HCA Healthcare. 

Characteristics of a Good Leveraged Buyout Candidate

Characteristics of s good Leveraged Buyout Candidate

Start Your Free Investment Banking Course

Download Corporate Valuation, Investment Banking, Accounting, CFA Calculator & others

It requires experience, credibility to secure funds, and confidence in financing sources to execute an LBO deal. Above all, the foremost requirement is a good LBO candidate. Some peculiarities make a company a viable LBO target. When a sponsor evaluates the potential LBO candidate, they focus on its key strengths and risk areas. 

Usually, underperforming divisions of a company, companies in fragmented markets requiring a new strategy, or troubled companies needing a turnaround are potential candidates for LBO. Overall, “What Makes a Good Leveraged Buyout?” revolves around the basic purpose; the ability to pay back the debt with the target firm’s cash flow. 

The several features of a good leveraged buyout (LBO) are as follows.

All in One Financial Analyst Bundle(250+ Courses, 40+ Projects)
Financial ModelingInvestment BankingUS GAAPCFA-Level 1 & 2
Equity ResearchM & A ModelingPrivate Equity ModelingForex Trading
Price
View Courses
250+ Online Courses | 40+ Projects | 1000+ Hours | Verifiable Certificates | Lifetime Access
4.9 (86,389 ratings)

1. Stable and Predictable Cash Flow

It is very critical for a potential LBO candidate to have a steady and foreseeable cash flow considering the highly leveraged capital structure. Thus, in LBO, free cash flow (generating cash excess to current requirements) is considered King.

  • It indicates that the business can pay its interest payments on the debt.
  •  It will be easier for the firm to get a loan.
  •  It would remain solvent in case of a downturn or slump. 

A business with sustainable and healthy cash flow is an attractive LBO candidate. For example, business in mature markets, constant customer demand, long-term sales contracts, and strong brand presence signify steady cash flow generation. 

2. Strong Asset Structure

Businesses with a strong asset structure, which includes tangible assets, can get cheaper loans by using them as collateral. These collaterals include current assets, such as inventory and cash, and hard assets, such as property, plant/ factories, and equipment (PPE). Hence, the business can obtain low-interest financing, requiring less cash to repay the loans. 

The equation is simple; the more valuable and abundant the assets, the more available and cheaper the debt. The availability of assets also increases the sponsor’s likelihood of providing debt, as they can recover the loan amount in case of possible bankruptcy.

3. Potential for Efficiency Enhancement

Though the LBO candidate should have a robust business model, the sponsors also look for opportunities to improve the target’s efficiency and lead to cost savings. Reducing expenses can free up cash, aiding in the early repayment of debt. 

Some measures to help decrease costs and improve business effectively are,

  • Reducing corporate expenditure.
  • Rationalizing business operations and supply chain.
  • Executing on a different management information system.
  • Looking for new suppliers and customers.

During the due diligence stage, the sponsors consider these factors to ensure value is built for the target LBO candidate.

4. Minimal Capital Expenditure (CapEx)

The principal goal of the acquirer is to repay the debt. They would not want to make large capital expenditures to keep the business growing. The acquirer would not want to make large cash outlays to keep the company running but rather pay off the debt as early as possible. 

When the company incurs high CapEx, it consumes cash that could have paid for interest and principal debt. Knowing about these factors in advance can help in planning the cash outflows.

5. Clean Balance Sheet with Low Debt

A target company with low debt means few commitments to pay off the loans. The deal is risky if the company already has debt on its balance sheet due to the existing cash outflow. This situation makes raising the debt required for the leveraged buyout challenging. 

The requirement for a good leveraged buyout is a candidate with little or no existing debt. So, it can primarily use cash flow to pay off the principal and interest due on the debt.

6. Strong Market Position and Competitive Advantage

The target business needs to have products in the market that are well established. Also, the products must generate cash flow to maintain a good position in the market. It will certify that the target company will not be affected after the LBO.

The factors that reflect a strong market position are,

  • Rooted customer relationships
  • Superior quality products and services
  • Good brand name and recognition
  • Suitable cost structure
  • Economies of scale, etc. 

Based on these factors, the sponsor and the acquirer can decide if the target has a secure market position. Companies that are a part of the established and definite markets are more favorable for an LBO transaction than those belonging to the novel markets.

7. Divestment of Assets

Divestment sells the company’s assets, including equipment, machinery, land, investments, non-core business divisions, and subsidiaries, for quick cash. If the cash flow to pay off the debts is endangered, acquirers select this option. The company can even reinvest the cash with newer strategic objectives. Anyhow, it has to be taken into consideration that such investments and assets should not be a significant contributor to the company’s income.

8. Business with Proven Management

Businesses with a good management team are very attractive and valuable LBO candidates. A highly leveraged capital structure with rigid performance targets requires talented people with a successful track record. The sponsors and acquirers highly acknowledge management with prior experience in restructuring activities.

Supposing the existing management team lacks efficiency, the acquirers make certain necessary changes. In short, they can add, replace, or remove certain members or make a new team altogether. Whatever the situation, having a strong management team is a prerequisite for a good LBO transaction.

9. Viable Exit Options

The objective of an LBO is to get significant returns on the investment, which comprises selling the company a few years down the lane. Unless a good exit strategy is in place, the LBO may not occur. Hence, it becomes important to determine if they can sell the business at a higher multiple than the starting deal.

Ratios to Determine a Good LBO Candidate

Ratios to Determine a good Leveraged Buyout

Certain ratios aid in the search for a good leveraged buyout candidate. Ratios like Equity/Enterprise value helps determine the leverage the company currently holds. The higher the ratio, the lower the leverage the company carries on its balance sheet.

Similarly, Enterprise value/Free cash flow and Enterprise Value/EBITDA help determine the right company to buy. Companies with positive EV/Free cash flow, high enterprise value, and Equity/Enterprise value of more than 100% would be considered for an LBO.

Advantages of a Good Leveraged Buyout

  • The increased debt levels decrease the taxable income, leading to lower tax payments. The tax shield, due to high debt levels, enhance the firm’s value.
  • Poorly managed firms can go the private way and undertake valuable transformation. Modifying the management and staff, reducing excessive expenditures, and working towards earning considerable returns are a few.
  • If the acquired firm’s returns are higher than the interest payment, the equity holders will gain from the financial returns, increasing the firm’s worth.
  • The huge amount of principal and interest payments will force the management to revisit their business strategies. They will work to improve their performance and operating proficiency.
  • It allows the management to emphasize changing the managerial behavior. It can be done by disassociating from the non-core businesses, investing in technological developments, etc.

Case Study of a Good LBO

Safeway

Safeway

In July 1986, the Dart Group approached Safeway with an offer to be acquired. Safeway rejected the offer by basing it on the inadequacy of value and stating that the Dart Group did not have the best interests of the company. The Dart Group was attempting a hostile takeover, due to which Safeway accepted to be acquired by KKR & Co in the same month. The deal closed in November with an offer of $4.25 billion. 

KKR left the reigns of management to Safeway and only worked around the assets. It was a combined effort of both companies to reform the firm. KKR provided Safeway the strategies to increase growth by removing failed or underperforming divisions of the company.

In the beginning, the debt was about $5.75 billion, of which $2.29 billion was paid by an aggressive sale of assets. By selling the non-performing assets, closing almost half of its branches (2,326 to 1,161), and restructuring the management, the company increased its sales and revenue. Today, in 2022, Safeway’s annual revenue is 37.6 billion.

Good Leveraged Buyouts in the past – Examples

Executing a Good Leveraged Buyout is a skill not many can master. Though, in the history of LBOs, Kohlberg Kravis Roberts & Co (an American global investment company) stands tall, with 200+ private equity investments since 1976. Here is a brief of a few examples of such successful LBOs.

Amphenol

1. Amphenol

Kohlberg Kravis Roberts (KKR), in 1997, announced that it had acquired majority stock holding in Amphenol. It was a company making coaxial cables and electronic connectors. The value of the deal was a whopping $1.5 billion on average.

The deal increased the leverage in the capital structure of Amphenol. In 1999, in just a year, Amphenol filled for a public offering of 2.75 million shares. It consequently helped them to pay the debt and decrease their leverage.

HCA Healthcare

2. HCA Healthcare

Formerly known as Hospital Corp. of America (HCA), it was bought for $33.2 billion. The deal took place in 2006, where Bain Capital, KKR, and Merrill Lynch were the investors. Considered to be one of the largest private equity deals. It set one more record when it went public and filed IPO under the guidance of Bain and KKR, raising approximately $3.8 billion. This amount was considered the largest ever assisted by a private equity group. The most recent revenue shows $51.5 billion.

Global Atlantic

3. Global Atlantic

The announcement for the acquisition of Global Atlantic by KKR was made in July 2020. The approximate transaction value was $4.7 billion. Only the news of the announcement was enough to bring in new investors. The firm saw a 25% growth in assets within six months of the announcement. 

In 2021, KKR finally announced the acquisition of Global Atlantic. Although KKR only acts as the financial manager, the company otherwise runs the same. 

What Makes Good Leveraged Buyout Infographics

Learn the juice of the article in a single minute. What Makes a Good Leveraged Buyout? – Infographics.

FAQs

1. What is a Leveraged Buyout? How does it work?

A Leveraged Buyout means using borrowed money as an investment to buy or takeover a company. The buying company takes a loan from a sponsor to buy the target company. It later uses the target company’s generating cash flow to pay off the loan. 

2. What Characteristics make a good LBO candidate?

A few key characteristics of a good LBO candidate are stable cash flow, strong assets, minimal CapEx, viable exit options, etc. To know more, refer to the section “Characteristics of a Good Leveraged Buyout Candidate” in this article.

3. Which is the largest LBO? What are examples of a good leveraged buyout?

The largest LBO in history was the acquisition of TXU Energy (Energy Future Holdings) in 2007. The deal was valued at $45 billion. However, the buyout was a big failure. Some successful examples of a good LBO are Safeway, McLean Industries, HCA Healthcare, etc.

4. How do you value an LBO?

The basic information needed to perform a valuation is the enterprise value, free cash flow value, and EBITDA. In addition, the knowledge of the repayment model and an exit plan will be useful. 

5. What is LBO analysis?

It simply means analyzing the price at which a buyer can acquire the target. The amount is called the floor valuation. It usually determines if the buyout will generate a return for the acquirer and what is the maximum amount that could be paid.

Recommended Articles

Here are a few links to articles that will help you learn more about a good leveraged buyout.

  1. How to Manage a Business Effectively 
  2. Large Cap vs. Small Cap
  3. Free Cash Flow to Firm
  4. Funding Requirements
Popular Course in this category
All in One Financial Analyst Bundle- 250+ Courses, 40+ Projects
  250+ Online Courses |  1000+ Hours |  Verifiable Certificates |  Lifetime Access
4.9
Price

View Course

Related Courses

Investment Banking Course (123 Courses, 25+ Projects)4.9
Mergers & Acquisition Course (with M&A Projects)4.8
Financial Modeling Course (7 Courses, 14 Projects)4.7
1 Shares
Share
Tweet
Share
Primary Sidebar
Footer
About Us
  • Blog
  • Who is EDUCBA?
  • Sign Up
  • Live Classes
  • Corporate Training
  • Certificate from Top Institutions
  • Contact Us
  • Verifiable Certificate
  • Reviews
  • Terms and Conditions
  • Privacy Policy
  •  
Apps
  • iPhone & iPad
  • Android
Resources
  • Free Courses
  • Investment Banking Jobs Offer
  • Finance Formula
  • All Tutorials
Certification Courses
  • All Courses
  • Financial Analyst All in One Bundle
  • Investment Banking Training
  • Financial Modeling Course
  • Equity Research Course
  • Private Equity Training Course
  • Business Valuation Course
  • Mergers and Acquisitions Course

ISO 10004:2018 & ISO 9001:2015 Certified

© 2022 - EDUCBA. ALL RIGHTS RESERVED. THE CERTIFICATION NAMES ARE THE TRADEMARKS OF THEIR RESPECTIVE OWNERS.

EDUCBA
Free Financial Modeling Course

3 Statement Model Creation, Revenue Forecasting, Supporting Schedule Building, & others

*Please provide your correct email id. Login details for this Free course will be emailed to you

By signing up, you agree to our Terms of Use and Privacy Policy.

EDUCBA Login

Forgot Password?

By signing up, you agree to our Terms of Use and Privacy Policy.

EDUCBA
Free Investment Banking Course

Corporate Valuation, Investment Banking, Accounting, CFA Calculator & others

*Please provide your correct email id. Login details for this Free course will be emailed to you

By signing up, you agree to our Terms of Use and Privacy Policy.

EDUCBA

*Please provide your correct email id. Login details for this Free course will be emailed to you

By signing up, you agree to our Terms of Use and Privacy Policy.

Let’s Get Started

By signing up, you agree to our Terms of Use and Privacy Policy.

This website or its third-party tools use cookies, which are necessary to its functioning and required to achieve the purposes illustrated in the cookie policy. By closing this banner, scrolling this page, clicking a link or continuing to browse otherwise, you agree to our Privacy Policy

Loading . . .
Quiz
Question:

Answer:

Quiz Result
Total QuestionsCorrect AnswersWrong AnswersPercentage

Explore 1000+ varieties of Mock tests View more