Leveraged Buyout (LBO) Model
A financial transaction where a corporate acquisition is facilitated by borrowed funds to finance the acquisition.
What Is A Leveraged Buyout (LBO)?
A leveraged buyout (LBO) is defined as a financial transaction where a corporate acquisition is facilitated by borrowed funds to finance the acquisition.
In an LBO transaction, the acquired company's assets are used as collateral for the loans used to finance the corporate acquisition. This approach can decrease the overall financing cost of the acquisition.
The leveraged buyout (LBO) model is used to model one of the most complex types of transactions in finance. It is built not just for the basic valuation of a company but also to account for the debt raised to finance the transaction and forecast how much return the private equity firm can make.
A leveraged buyout transaction is where a sponsor purchases a company using large amounts of debt financing. These transactions employ incredibly high leverage, with debt comprising anywhere from 50-90% of the purchase.
This debt is raised from various sources, such as banks and private lenders, and the rest of the money is raised from investors (usually 20-30%).
Usually, a leveraged buyout includes purchasing all or majority of the shares outstanding of a company so that the sponsor can take it under their direct control and make extensive changes to increase the company’s valuation before exiting through taking the company public once again or selling it to another private buyer.
Key Takeaways
- LBO modeling involves complex calculations, including estimating purchase price using multiples, determining financing sources, creating pro forma financial statements, calculating exit values, and conducting sensitivity analyses to assess investment risks.
- An LBO is a financial transaction where a buyer, often a private equity firm, acquires a company predominantly using debt financing, with debt accounting for 50-90% of the purchase.
- LBOs involve a mix of debt and equity. Debt is sourced from banks and lenders, while the remaining funds come from investors, usually limited partners of the private equity firm.
- LBOs differ from mergers and acquisitions due to the high leverage involved and the specific focus on enhancing the target company's value for a profitable exit.
- Management buyouts (MBOs) are similar to LBO but involve the existing management purchasing the company's assets and operations.
Understanding a Leveraged Buyout (LBO)
A leveraged buyout (LBO) is when a sponsor, typically a private equity (PE) firm, uses a relatively high amount of debt combined with some equity capital to purchase a company in the hopes that it can increase the company’s share value before its exit.
LBOs are unique as they use an incredible amount of debt financing. Usually, these transactions use anywhere from 50% to 90% leverage.
The remaining part of the transaction is financed by raising capital from equity investors (also called limited partners) of the PE firm and may even include money from the sponsor itself.
Usually, the companies acquired are taken private to improve the decision-making and execution processes much faster. In many cases, the sponsor will form a special purpose vehicle (SPV) to purchase the company’s outstanding shares and take it private.
This reduction in red tape helps the PE firm take quick actions to turn around companies or spin off its assets with little to no hindrances from regulatory authorities or other shareholders.
The usual targets for an LBO are companies with steady cash flows that are non-cyclical and stable during economic downturns. In addition, because of the amount of leverage used, sponsors need to minimize the risk of default on the debt payments (both principal and interest).
A leveraged buyout is typically an intense and fast process. The sponsor intends to manage the company for only 3-5 years before exiting for a profit, which is usually about 20-30% IRR.
Therefore, the longer the sponsor owns the company, the more interest liability builds up from the loans taken. This means that the debt burden will eat into the sponsor’s profit as time passes, increasing the risk to the equity investors.
Once the sponsor has successfully invested in a company and improved its operations, thereby increasing the valuation, it will look to exit and bag the returns, which in most cases are above 20% IRR.
Two primary ways of an exit are:
- Taking the company public through an IPO or
- Looking for another investor willing to acquire the sponsor’s share of equity in the company.
Sponsors look to make a substantial profit from this transaction and usually run very detailed calculations on:
- What are the sources available to finance the transaction?
- When will the debt payments be owed?
- How much will be paid in interest expenses?
- How much will the target company grow?
- What is the return it can promise investors?
- How much return can the firm bag for itself?
Usually, sponsors look for an internal rate of return (IRR) of 20-30%, which is justified due to the considerable risk.
Types Of Leveraged Buyouts (LBOs)
There are two types of LBO models. The quick and dirty (Q&D) models and fully integrated models.
The Quick & Dirty Model
The first and easiest method is dubbed the quick and dirty (Q&D) LBO model. The Q&D model estimates the highest bid price a sponsor would be willing to pay without the need of a pro forma balance sheet and goodwill calculations.
While it may be slightly less reliable than a fully integrated LBO model, it can be built quickly and gives a rough idea of the outlook of the transaction. A Q&D model may be done for preliminary screening to shortlist the targets for acquisition.
The Q&D includes the considerations of inputs (acquisition, financing, exit assumptions), cash sweep (target cash amount used to pay debt), and model outputs (sensitivity tables, levered valuation, credit ratios, IRRs).
Fully Integrated LBO Models
Fully integrated models are different from Q&D models because of the detail involved. Unlike a Q&D model, a fully integrated model includes constructing a detailed financial statement, debt schedule, pro forma balance sheet, and calculation of goodwill in the purchase.
Once the targets have been shortlisted, a fully integrated model can be built to analyze if the target company is a potentially profitable purchase.
Both models look relatively similar and contain similar steps. However, the fully integrated model is used for a more thorough examination of the transaction with options to plug in and account for minute details.
Components of a fully integrated LBO model may include pro forma capital structure, EBITDA expansion assumptions, and deleveraging strategies. All of these components are instrumental in minimizing the risk maximize equity returns over time.
How to Build an LBO Model?
LBO models are considered one of the more complex financial models, requiring a lot of due diligence to make them accurate and reliable. Usually, these models are created within Excel, as many of its functions are useful for the calculations necessary in this model.
Further, a good LBO model automatically updates itself when its inputs are changed.
Calculate Purchase Price Using DCF And Entry Multiples
First, a sponsor must estimate the purchase price of the targeted company. Typically, they estimate the target company's earnings at the time of acquisition. Then they determine an entry multiple and an exit multiple, which are both usually EBITDA multiples.
The entry multiple is then multiplied with the EBITDA to estimate the target company's enterprise value (EV). The present value of debt is then subtracted, and cash is added to the EV to find the estimated equity value of the target company.
The equity value divided by the number of shares outstanding yields the offer price per share, which is usually at a premium to the target company’s current share price.
The entire process above can be summarized as follow:
It should be noted that there are some other things that are taken into consideration while valuing the target company.
One of the factors is goodwill, which is the value of intangible assets such as intellectual property as well as the brand image and other such things that add value but cannot be seen or touched (not tangible).
Calculate The Amount, Sources, And Use Of Financing Required
After valuing the target company, the sponsor needs to find how much leverage the company will use and how they will finance this acquisition.
This is usually summarized by the leverage ratio, often a debt-to-equity ratio, which measures the amount of debt compared to the amount of equity.
The sponsor typically agrees to covenants with the creditors, which are contractual obligations prohibiting the debtor from certain actions. If they break the covenants, the creditors have the authority to seize the debtor’s assets.
Usually, debt is organized into tranches, which essentially organizes the debt into levels of risk and cost, as certain types of debt will be paid back before others in the event that the sponsor does not have money to pay back all the debt.
The lower tranche debts are paid off last but carry a higher interest rate than the higher tranche ones.
Sources Of LBO Funding
The senior tranche is considered the most secure, carries the lowest interest rate, and is paid back first. It usually includes debt from banks.
It also typically has some of the strictest covenants, including prohibiting the sponsor from paying dividends or engaging in other types of spending before the debt is repaid.
The junior tranche is riskier, carries higher interest rates, and gets paid back after the senior tranche. It is also called subordinated debt.
Most debts are usually paid off through bullet amortization, meaning that the interest needs to be paid throughout the life of the loan and with principal repayment only at maturity. This tranche also usually has less restrictive covenants than the senior tranche, making it riskier.
The mezzanine debt is the lowest and most risky tranche, which is repaid last. However, it also carries the highest interest rate to make up for these.
Mezzanine debt often includes buying the stock at a certain price to incentivize creditors (convertible debt). It is also generally paid back via bullet amortization. This tranche also has less restrictive covenants, giving the sponsor more flexibility.
Finally, the rest of the financing comes from the firm’s investors. This technically isn’t a debt tranche but the equity portion of the financing. In case of financial troubles or liquidation, these investors would be paid back last and sometimes not at all.
However, compensating for this risk is the potential for very large returns (usually 20-30% IRR). The debt is organized under two categories: uses and sources. The sum of both of these sections should be equal.
Check out the video below from our LBO Modeling Course that demonstrates filling in the sources of debt!
Build Pro Forma Financial Statements
An LBO model requires the sponsor to create pro forma financial statements, which are forecasted financial statements used to estimate future financial performance.
In particular, it will involve estimating the balance sheet taking into account the debt used to purchase the target company. As the sponsor company acquires the target company, it will need to know where to allocate money to invest in its operations to boost its value upon exit.
These pro forma financial statements should also forecast future periodic cash flows can help prepare for its cash sweep. A cash sweep in an LBO is the action of using excess cash flows to pay off debt, often before the loan's maturity, to avoid the extra interest expenses.
Once the pro forma financial statements are created and the cash sweep determined, it is time to calculate the exit value.
Calculate Exit Value Using Exit Multiple
Usually, PE firms plan to exit a leveraged buyout in about 3-5 years. With future cash flows already forecasted, the exit value is calculated by multiplying the final predicted cash flow with the exit multiple.
Usually, both the multiple of money (also known as cash on cash) and the internal rate of return (IRR) of the investment are calculated.
Please check out the video below from our LBO Modeling Course that explains how to calculate IRR using Excel!
Building A Sensitivity Analysis Table To Estimate The Margin Of Error
Once the model is complete, the next step involves performing a sensitivity analysis to check for vulnerabilities in the model and the margin of error to profit from the investment. Typically, attractive companies have large profit margins, which minimizes the risk that the model is incorrect and the deal is unprofitable. A sensitivity table shows various entry and exit multiples and the different IRRs that are possible with varying combinations of the two. Check out our video on sensitivity analysis from our LBO Modeling Course!
M&A vs. LBO
A merger is when two companies combine to form a single company, usually because they can take advantage of synergies, a word used to describe the benefits available to the merged company, which was not available to the individual companies.
An example of synergies is reduced shared expenses due to the merger. Another is enhanced operational efficiency, which can improve both profits and valuation.
In short, companies merge because their value as a single entity is greater than the sum of the individual companies. Acquisitions are very similar to mergers; however, one company acquires another instead of the two companies merging.
The following are the differences between an M&A and an LBO:
| Aspect | M&A | LBO |
|---|---|---|
| Nature Of Transactions | These transactions can be friendly or hostile. | LBOs are initiated and executed by a private equity firm. |
| Financing | M&A transactions can be financed through cash, stock, or even a combination of both. | Mostly, these transactions are financed through debt. Sometimes, a small portion of equity is contributed by the stakeholders. |
| Risks Involved | The existence of synergies appearing as a result of the merging of corporations will minimize the risk exposure to the corporations. | Since a majority of the financing is executed through debt financing, there is a heavy risk involved. |
| Focus | M&A can be initiated to focus on expansion, cost reduction, or even diversification. | LBOs are typically initiated to gain advantage of the corporation, then selling it after 3-5 years through an IPO or a private sale. |
| Control | The acquirer is handed over the control of the merged corporation or the acquired firm. | The acquirer becomes the controlling entity of the target company. |
| Timeframe | The duration of completion of an M&A deal can vary, but its typically shorter than an LBO transaction. | The initial investors have a timeframe of 3-7 years before exiting via an IPO or a direct sale. |
The biggest difference between LBOs and M&A is how synergies are calculated. In the merger model, the company must combine the two companies’ assets on the balance sheet to analyze potential areas of synergy.
This is done through the accretion/dilution analysis to understand whether the share price would be positively or negatively impacted.
LBO vs. MBO
A management buyout (MBO) occurs when a company's management buys its assets and operations. In many cases, this is accomplished by purchasing the company's outstanding shares to take it private under the management's ownership.
A leveraged buyout (LBO) and a management buyout (MBO) are very different, though they may sound very similar. We explore these differences below.
| Aspect | Leveraged Buyout (LBO) | Management Buyout (MBO) |
|---|---|---|
| Financing | LBOs are typically financed through debt predominantly, but in some instances, a small portion of equity is also used to finance the transaction. | MBOs include a combination of debt financing and equity investments, and sometimes external equity investments. |
| Control | The acquiring company gets the control of target company and its operations. | The management gets control over the target company. |
| Focus | The primary focus is on financial restructuring, operational optimization, and an external sale or an IPO. | MBOs aim at operational enhancements and long-term value creation that align with management's vision and mission. |
| Risks Involved | Since there is heavy reliance on debt financing, the transaction is exposed to heavy risk. | The exposure to risk is relatively compared to an LBO because the management acquires the company and already has experience managing it. |
| Timeframe | For an LBO to be completely executed, it takes about 3-7 years. | An MBO may take about way too long because the intention of management is to make the acquisition fit the management's strategic vision. |
| Exit Strategy | One of the primary exit strategies under LBO is an IPO; the business owners can also plan a private sale. | Similar to an LBO, an MBO has exit strategies like going public, sale of the business, and selling the shares back to the company, or selling shares to other investors. |
MBOs typically require substantial financing, which is usually provided by hedge funds, private equity firms, debtors, or the company itself.
The biggest difference between an MBO and an LBO is that the former is perpetrated by the company's management that is being bought out, while the latter is done by a sponsor who has no relation to the target company.
It may be surprising that leverage is not a key differentiating factor, as both LBOs and MBOs require substantial financing to complete the transaction.
Likewise, both are typically done for similar reasons: to take a company private so that the management or sponsor can make major changes to the target company’s operations to increase efficiency and profitability and improve its valuation before taking it public once again.
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