In the above picture you can see two persons Mr. Dave who runs ABC Ltd. and there is Mr. Steve who is the owner of XYZ Ltd. Let me ask you this question, given an option out of the two businesses, which one would like to buy? I am
sure it’s not that difficult and you would go for buying ABC Ltd. The reason is very simple Mr. Steve’s XYZ Ltd. seems to be completely out of business and of course you would not want to own a company which cannot provide returns on your investment. So the solution was quite simple here. But when it comes to real life situation where a company decides to buy another there are various considerations which makes a deal to be labeled good one.
As the name would imply a leverage buy out is using financial leverage or debt as the principal element in an acquisition. In simple words LBO refers to the takeover of a company while utilizing mainly debt in order to buy the company. The debt is raised keeping the assets of the target company as collateral also the acquired firm’s cash flow is used to pay off the debt. LBO’s work on an anticipation that the returns generated on the purchase will be greater than that of the interest to be paid on the debt. Hence the acquirer will be able to experience good returns by investing only a small part of its own capital. The investors or the acquirers as they say usually sell the firm four to seven years from when they purchase it and exit it with a profit. This is how usually LBO works.
Leverage buy outs (LBO) have become a common landscape when it comes to acquiring private firms. Moreover it has become a standard practice within the private equity industry. Looking back in the past LBO started gaining prominence 1980’s. This industry has evolved greatly since that time and now thousands of companies are being bought each year. This article What Makes Good Leverage Buyout discusses the various factors which are considered before a Leverage buy out deal is done.
What Makes Good Leverage Buyout- Characteristics
In order to execute an LBO deal it requires the experience, credibility to secure the funds and the confidence of financing sources. But that comes later, what is required first is a good LBO candidate. Every company cannot be considered as a viable LBO target, there are certain peculiarities which makes a company one. When the sponsor is evaluating the potential LBO candidate, they focus on its key strength and risk areas. Usually these LBO’s are underperforming divisions of a company, companies who are in fragmented markets that require a new strategy or the troubled company that require a turnaround. Regardless of the situation, What Makes Good Leverage Buyout revolves around the basic purpose which is the ability to pay back the debt used to buy the firm with the target firm’s cash flow. Based on this there are several features of a good leveraged buyout (LBO), which will be now discuss.
Stable and predictable cash flow
It is very critical for a potential LBO candidate to have steady and foreseeable cash flow taking into consideration the highly leveraged capital structure. Especially when it comes to LBO transaction free cash flow is considered to be the King. What is free cash flow? It is the cash that an organization is able to generate in excess to the current requirements. It indicates that the business will be able to pay its interest payments on the debt and hence it will be easier for the firm to get a loan, and also that it would remain solvent in case of downturn or slump. An LBO candidate is considered to be attractive when the business characteristics show sustainable and healthy cash flow. Indicators such as business in mature markets, constant customer demand, long term sales contracts, and strong brand presence all signify steady cash flow generation. The cash flows are predicted and sensitized upon the historical instability and future conditions to ensure cash flows in complicated scenarios.
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Strong asset structure
If the business has a strong asset structure which includes tangible assets it can help in getting cheap loans using them as collateral. These collateral’s include current assets such as inventory and cash as well the hard assets such as property, plant/factories and equipment. The business can obtain low interest financing which will require less cash in order to repay the loans. So the equation is simple the more valuable and abundant the assets the more available and cheaper the debt would become. Strong asset structure would also discourage new entrants into the market as it would require capital investment of that level. . Also the availability of assets increases the inclination of the sponsor to provide debt as in event of possible bankruptcy the loan amount can be recovered.
Potential for efficiency enhancement
Though it is desired that the LBO candidate must have a robust business model, the sponsors are looking for opportunities that would improve the targets efficiency and lead to cost savings. Reducing the expenses will free up the cash aiding in early repayment of debt. Various measures such as reducing corporate expenditure, rationalizing business operations and supply chain, executing on a different management information system, look out for new suppliers and customers can help in decreasing costs and improving business effectively. During the due diligence stage these factors are taken into consideration to ensure value is created for the target LBO candidate.
Minimal Capital Expenditure (Capex) requirements
The principle goal of the acquirer is of debt repayment hence they would not want to make large capital expenditures in order to keep the business growing. The acquirer doesn’t want to have to make large cash outlays to keep the company running and growing but pay off the debt as early as possible. In situations where high Capex is incurred it consumes cash which would have been otherwise used for interest and principle debt repayments. Further their needs to be a differentiation made at the due diligence stage between the kind of Capex viz. maintenance Capex which is required for the business to be running and other is the growth Capex required to expand the existing business operations. Knowing about these factors in advance would help in planning the cash outflows.
Clean balance sheet with low debt
A target company with low debt would mean few commitments to pay off the loans. If the company already has debt on its balance sheet, it would make the deal risky as there is already cash outflow. This situation would make it challenging for raising more debt which is a requirement for the leveraged buyout. Therefore for a good leveraged buyout there is a requirement of a candidate with no or little existing debt so that the cash flows can be primarily used to pay off the principal and interest due on the debt to be taken.
Strong market position and competitive advantage
Is it important that the target business has products which are well established in the market and keeps generating cash flow to maintain a good position in the market. This will make sure that the target company will not be affected after the LBO and make the cash flows less prone to risks. The factors that reflect strong market position could be 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 would decide if the target has a secure market position.
Divestment of assets
Divestible assets include equipment, machinery, land etc. which are an extra means for the acquirers to raise cash in case the cash flowsw to pay off the debts are endangered. Similar to assets the seller could sell out the investments, non-core business divisions and subsidiaries to generate quick cash. This cash could also be used to reinvest with newer strategic objectives. But of course it has to be taken into consideration that such investments and assets should not be a significant contributor to the income of the company.
Divestment of assets
Companies that are a part of the established and definite markets are considered to be more favorable for an LBO transaction rather than those belonging to the novel markets. Stability plays an important role as there are predictable demand and revenue which acts as a barrier to potential entry into the market signifying non-disruptive cash flows.
Business with proven management
Businesses with a good management team are very attractive and valuable LBO candidates. When it comes to a highly leveraged capital structure with rigid performance targets require talented people with a successful track record. Management which has a prior experience of incorporating restructuring activities would be highly acknowledged by the sponsors and acquirers. In cases where the existing management team lacks efficiency the acquirers would make certain important changes by adding, replacing or deleting certain members and make a new team altogether. Whatever may be the situation having a strong management team is a pre-requisite for a good LBO transaction.
Viable exit options
The basic objective of an LBO is to get significant returns on the investment made, which comprises of selling the company few years down the LBO took place. Unless a good exit strategy is in place the LBO perhaps won’t take place. Hence it becomes important to determine if the business could be sold at a higher multiple than at the time of entering the deal.
Benefits of a good leverage buy out
- The acquiring firm can maximize the shareholder value of the firm by creating a much stronger and profitable combined entity.
- The increased levels of debt decreases the taxable income of the acquired firm hence leads to lower tax payments. This tax shield because of the high level of debts enhances the value of the firm.
- Firms that are poorly managed can go the private way and undertake valuable transformation by modifying the management and staff, reducing excessive expenditures and work towards earning considerable returns.
- If the acquired firm’s returns are more than that of the interest payment, the equity holders would also gain from the financial returns and in turn increase the firm’s value.
- The huge amount of principal and interest payments will force the management to revisit their business strategies and improve the performance and operating proficiency.
- It gives opportunities to the management to emphasize on changing the managerial behavior by disassociating from the non-core businesses, investing in technological developments etc.
Ratios that determine a good leveraged buyout candidate
There are certain ratios that aid in the search of a good leverage buyout candidate. Ratios like the Equity/Enterprise value helps in determining the leverage that the company currently holds. The higher the ratio the lower is the leverage the company carries on the balance sheet.
Likewise valuation ratios such as Enterprise value/Free cash flow and Enterprise value/EBITDA help in determining the correct company to be bought. Companies that have positive EV/Free cash flow, high enterprise value and Equity/Enterprise value of more than 100% would be considered fir for an LBO.
Good leverage buyouts in the past
Kohlberg Kravis Roberts (KKR) in 1997 had announced that it had acquired majority stock holding in Amphenol which was into making coaxial cable and electronic connector. This deal was valued at a whopping $1.4 billion on an average. This consequently had increased the leverage in the capital structure of Amphenol. But just after a year in 1999, Amphenol filed for a public offering of 2.75 million shares. This consequently helped them to pay the debt and decrease the leverage.
In 2007 KKR bought out the internet commerce giant First Data whose deal value was expected to be around $29 billion. It is deal considered to be one of the largest technology deals in the history of LBO’s. After this deal First Data has undergone expansion into markets abroad notably also in Ireland which is the Europe’s emerging technology hub.
This deal took place in 2006 where Bain, KKR and Merrill Lynch bought Hospital Corp. of America (HCA) for $32.7 billion. 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 $3.8 billion. This amount was considered to be the largest ever assisted by a private equity group.
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