Do LBO investors aim to create value or simply pay off debt?

From Quora, the OP asked the following question:

I'm new to LBOs, just looking into them. I just wanted to ask: do LBO investors look to actually increase the value of the businesses that they acquire, or do they simply look to pay off all of the debt used to finance the acquisitions, so that they can ultimately sell the business and essentially make something out of nothing?

There are four core variables which contribute to the return of a leveraged buyout:

1. Yield
2. Earnings Growth
3. Multiple Expansion (or Contraction)
4. Leverage (i.e. Debt)

Let's buy a typical business but only add/change one of these variables at a time.

If you don't mind I will take a more normal business as an example rather than a hotel because hotels are a very rare breed of investments - part business part real-estate - with some very funky potential acquisition structures (e.g. "OpCo + PropCo" to separate the business from the property and borrow differently against each).

Initial Set-Up
You, the investor, are given the opportunity to buy a widget manufacturer for $200m. The widget manufacturer has been operating for a number of years and produced earnings of $25m last year (let's keep things simple and say this is Earnings before Interest and Taxation, or "EBIT"). You are therefore being given the option to purchase the business at a multiple of 8x EBIT. From a cashflow perspective, let us assume that this manufacturer operates with very steady capex and working capital requirements, such that EBIT = Cashflow from Operations. Above and beyond that, let us assume that the corporation tax rate is 40%.

1. Yield
Let us start by assuming that the business isn't going to grow (variable #2 constant), that we will always be able to sell the business at a multiple of 8x EBIT (variable #3 constant) and that we are paying the entire price upfront (i.e. no variable #4, the entire acquisition is "equity funded"),

Despite the lack of growth, debt etc, we would still make some money, because every year the business will be generating cash, which we can pay out as dividends - and this is our yield.

In this example, every year we will generate $25m of cash from our operations, on which we pay 40% corporation tax, so $10m, leaving us with $15m.

Our annual return will therefore be $15m divided by the $200m we paid for the business, or 7.5%. Not a great return but actually not too bad by itself either.

2. Earnings Growth

Let us now look at our second variable, earnings growth. Let's assume that we believe the business can grow it's profits a bit every year. The growth is entirely from operations - you can either be growing your profits through additional sales growth every year, or by lowering your costs.

This source of growth is considered the core value-add for private equity, and different private equity funds specialise at different aspects of operational improvement. Some funds specialise at super-charging revenue growth, whilst others are 'turnaround' experts who aggressively review the cost base in struggling businesses.

In any case, let us assume this isn't a struggling business and we've figured out through our analysis that the business should be able to increase its profits by 7.5% per year.

If we hold it for one year, what is our return?

• We will have generated $26.9m in earnings ($25m * 1.075) and $16.1m in after-tax cashflows. ($26.9*60%)
• We will then sell the business for 8x EBIT, or $215m (8 * $26.9m)
• Our return is therefore $215m + $16m = $231m divided by the $200m, for a ~15.5% return ("IRR"), or ~8.0% more than in the yield-only case.

What about if we hold it for five years?

• Over 5 years (feel free to check in Excel), the cumulative cashflow yield would have been $94m, and our EBIT would have grown to $35.9m
• Exiting at 8x EBIT would have generated $287m, plus the $94m from cashflow gets us to $381m on our $200m investment, also for a 15.5% IRR (the dividends we receive as we go increase our IRR)

• Note therefore that at this stage the maths on our return work out the same whether we'd done it for a 1-year hold, a 3-year hold or a 5-year hold.

So what's our private equity return so far? ~15.5% consisting of 7.5% from yield and an extra 8.0% from earnings growth, and all of this without debt.

Note: the way the maths work, the quick shortcut is to multiple the yield and growth returns together, so 1.075*1.075 = 1.155. The other relevant measure other than IRR is Multiple of Money (MoM) which is our total cash returned over total cash invested, in this case 1.9x MoM for a 5-year investment

Not a bad return but let's see how we can do better.

3. Multiple Expansion or Contraction

So far we've been assuming we always exit our investment at 8x EBIT. However, like all investors, we know that picking the right time to buy and the right time to sell can really help or hinder our investment.

Let's assume however that we held onto this business for 5 years, so generated $94m in dividends over that time and created a business with profits of $36m.

What if other investors suddenly realised what a great business we had? Or if we'd managed to grow the business into more exciting/sustainable products? Perhaps people would now be willing to pay more than 8x EBIT for it, maybe even 10x...

How would 10x EBIT look?
Exit value of $359m (10x $35.9m) plus cashflows of $94m equal $453m, over our original investment of $200m gives an IRR of ~20% and MoM of 2.3x

Pause and Summarize so Far

We purchased a business for $200m at 8x EBIT entirely with our own cash, and grew its profits by 7.5% per year for 5 years. We made the business more valuable and other investors were willing to buy it from us at 10x EBIT.

We generated a great return without using any debt: we got an IRR of 20%, and multiplied our investment by 2.3x.

If we roughly apportion the sources of value creation so far, they came ~35% from Yield, ~35% from Growth, and ~30% from Multiple Expansion.

4. Leverage

Now let us indeed bring debt into the equation. With respect to your specific example, I think it's misleading because I've never heard of an LBO with 100% debt funding! More likely, this $200m widget manufacturer would have been bought with ~60% debt (so lets say $120m), with the difference of $80m being paid up-front by the private equity fund as equity. You never get to buy a business without putting some of your own money up!

So we borrowed $120m from various lenders. These lenders are taking quite a big risk, because it's a big loan that is secured only by the underlying business (quite like a mortgage). As a result, they will charge us a very high interest rate, which net of any tax impact costs us 10% or $12m per year.

How does this affect our 5-year return?
Instead of using the $94m of cashflow to pay ourselves dividends, we are now using it to pay 5 years of interest at $60m (5* $12m), plus we further pay down the rest of the debt so there's only $86m left after 5 years ($120m-$34m)
We still sell the business for 10x EBIT or $359m, we use that money to partly pay back the remaining debt of $86m and are left with $273m ($359m-$86m)
Our IRR looks a lot better (~28%) and our MoM reaches 3.4x ($273m/$80m invested)

It's important to note that the debt boosted our return, but the actual act of paying it down wasn't where the value was created - because we can only pay down debt with cashflows, and we could have paid ourselves those cashflows as dividends anyways if we hadn't borrowed to buy the business.

If we roughly apportion the sources of value creation so far based on IRRs, they now came ~25% from Yield, ~25% from Growth, ~20% from Multiple Expansion and ~30% from Leverage.

Additional Discussion on Leverage

Why is it that the leverage is boosting our return so much? If we didn't use debt, we would have gotten at ~20% annual return, but with it we get ~28%.

Let me perhaps frame it in a clear way: you as the investor had the opportunity to buy a business that would give you a 20% annual return. In the meantime, someone offered you a loan at 10% for up to 60% of the price.

Of course you would take the loan if you were sure about the 20%! For every $10m you borrowed and invested, you would have gotten $2m in returns but only paid out $1m in interest - gaining $1m. So you are capturing the gap between the 20% underlying return and the 10% interest rate.

Does this always work? No. Because sometimes your underlying return is lower than the cost of debt:
Let's say we bought the business but it didn't grow and we didn't get any multiple expansion
After 5 years, we would have generated 5 * $15m in cashflows from the business, less 5 * $12m in interest repayments - so $15m net
Our debt would therefore stand at $120m-$15m = $105m
We would sell the business for $200m, repay the remaining $105m of debt and get $95m back on our $80m investment
This is an IRR of 3.5% and a MoM of 1.2x - much lower than the 7.5%/1.4x we would have gotten if we hadn't used debt
This is an example of buying a business with an underlying return of 7.5% but paying for it with debt costing you 10% - you are losing the 2.5% gap for every $1m of debt you use

Hope that helps and answers you question!

https://www.quora.com/Leveraged-Buy-Outs/Do-LBO-investors-aim-to-create…