Definition of Leveraged Buyout Model
Leveraged Buyout Model refers to a purchase transaction of a company that involves the acquisition of another company, whereby the payment towards the purchase consideration/cost of acquisition is made by using a substantial amount of borrowed money. In a Leveraged Buyout Model, the debt ratio may go up to 90% of the total acquisition price with equity being at a minimalist percentage of around 10%.
Explanation
In a financial transaction of acquiring or purchasing a company, the buyer company may entail a loan from a sponsor or bank or lender, in order to meet the cost of acquisition for the purchase of such a company. In doing so, the assets of the company being acquired are kept as collateral for the purpose of borrowing money for the acquisition of the company.
- This whole process of acquiring the company with the help of borrowed money is referred to as a Leveraged Buyout model. This model also ensures a smooth cash flow in the transaction.
- As attractive as it may sound, the Leveraged Buyout model does seem to offer a win-win situation for the lender of money as well as the buyer investing towards equity.
- The seller receives the full sale consideration, the sponsor lends the money to earn interest and keeps the assets as collateral, and finally the buyer who has the control with low investment amount.
Steps Involved in building Leveraged Buyout Model
In order to build a Leveraged Buyout model, you may follow these steps:
- Primarily, assumptions to be considered in the transaction are mutually by both the parties, with an apt purchase price being decided by the parties involved in the transaction
- Valuation of the business is carried out of the company being acquired, based on present revenues and earnings
- Once an appropriate valuation arrives, financial projections are done for roughly the next 5 years time frame
- Any adjustments, as may be required are made to the financial statements and numbers, based on new debt and equity being issued
- Finally, the exit value of the selling company shareholders is determined
- Lastly, the internal rate of return is computed considering the date of exit and the purchase value
Examples
In today’s time, there are various companies, especially private equity funds, which use the Leveraged Buyout model route to buy a company, run the company and make it profitable, and eventually sell such companies at a profit.
These merger & acquisition (‘M&A’) transactions have been on a rise lately, and the number only seems to be growing year on year basis.
If we dig into history, we can find information about one of the largest Leveraged Buyout model transactions pertaining to an acquisition taken place in the year 2006 of Hospital Corporation of America. An amount of $33 billion was paid by KKR, Bain & Co., and Merrill Lynch, collectively, towards the acquisition of Hospital Corporation of America.
Assumptions of Leveraged Buyout Model
Assumptions play an important role in a Leveraged Buyout model. Various assumptions are required to be made in order to process the transaction in the mentioned model.
Assumptions may pertain to:
- Determination of purchase price,
- Proportion for debt
- Proportion of equity
- The valuation of the company under acquisition
- The amount of funds required to carry out the transaction
- Accounting for fees, such as professional fees, statutory fees, legal counsel fees,
- Taking into consideration any charges towards documentation and other transaction-related costs
- Any other key factor which may have an effect on the model
The reader may understand that these are certain standard assumptions that are made generally in a leveraged buyout transaction. The assumptions may vary and may be required to tweak on case to case basis.
Structure of the Leveraged Buyout Model
When we talk about the structure of Leveraged Buyout, either of the following scenarios is possible:
- An existing entity uses its borrowed funds or debt to acquire the new company; OR
- A new entity with existing shareholders is created which will acquire the company; OR
- A new entity with new investors is created to acquire the company.
The buyer company may decide to either make the target company a subsidiary company and add it in its group structure or absorb the company and merge it with one of its existing companies.
Advantages and Disadvantages
Below are the advantages and disadvantages
Advantages
Below are the advantages:
- Lesser equity means fewer shareholders. Ultimately less co-ordination and efforts required for any shareholder approvals
- Turnaround time for making decisions reduces significantly
- In the case of the sick unit or mismanaged companies, this model helps improves the management of the company
- The buyer gets to claim tax benefit on interest payments on borrowed funds
- Higher rate of return in hands of equity shareholders
- In a growing economy, the Leveraged Buyout model may prove to be very efficient with high chances of success
Disadvantages
Below are the disadvantages:
- Lesser risk towards equity shareholders may result in loose management of the company
- Conflict of interest amongst shareholders may lead to struggles in arriving at conclusion and decisions for the good of the company
- Due to the acquisition, there may be employee lay-offs of the company being acquired
- In a scenario that targeted returns are not achieved such that the returns are even less than the cost of financing, it may lead to bankruptcy
- If the assets against which the loan is taken are not cash-rich or cash-generating, it may lead to issues in line of credit, the image of the company and also the future prospects
Conclusion
To conclude the above discussion in few words, the Leveraged Buyout model is a transaction wherein investors or maybe large companies make use of borrowed funds or debt or loan to finance the acquisition of another company, keeping the assets of such acquired company as collateral against the borrow funds. This method has its own share of advantages and disadvantages and every case needs to be evaluated in its individuality as to whether this model would be feasible or turn out to be an aggressive strategy.
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