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.
Table of Contents
- What is a Leveraged Buyout?
- Characteristics of a Good Leveraged Buyout Candidate
- Ratios to Determine a Good LBO
- Advantages of a Good Leveraged Buyout
- Case Study of a Good LBO
- Good Leveraged Buyouts of the past – Examples
- FAQs
- Recommended Articles
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
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.
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,
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- 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
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
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.
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.
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.
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.
