Learning the theory of an LBO
There are a lot of financial modelling courses and resources out there to practice LBO modelling tests but what would you recommend to do to actually learn the theory behind an LBO. I realise that the modelling tests are pointless at this point since I don’t fully understand the theory of an LBO yet so would love to hear what some of you used to learn the theory if you didn’t major in finance in school.
Best analogy is taking out a mortgage to buy a home, renting it out for a few years, make a few improvements, and selling it for (hopefully) more than what you paid
I understand the basics but would definitely need to learn the details of each component but not sure if there’s any resources that actually teach you the theory, not just modelling walk throughs
I think you're overcomplicating it. There is no real "theory" beyond:
That's it. Anything more complicated is unnecessary
Can you break it down one level further?
- What are the tradeoffs as debt/equity goes from 50/50 to 70/30 to 90/10? How does this affect the universe of appropriate LBO candidates? (industry, maturity, cashflow stability, asset light vs heavy).
- Given the amount of capital raised, why does the industry's alpha persist? In your example, why doesn't the $100 business get bid up to $150, $180, or $200 if its intrinsic value is $200?
- What do LBO firms typically do to unlock more value? Are there set of standardized strategies or playbook thats utilized? Ex. Better to target firms that are non-professionally managed. Is it better that the industry is fragmented or consolidated? Other factors, etc, etc.
Your post is a nice schematic of the general theory but the industry is quite mature now since its start in the 60s. As buyouts have become more competitive, I'm curious what the more nuanced drivers of value a modern LBO shop has to consider in practice?
Why don’t you plug the example into excel and play around with the inputs and figure it out for yourself. Maybe put in a chart so you understand how it works. Also keep in mind leverage works both ways. You invest $100 and get back $50, you still get back 50 cents on the dollar. You invest $50 and borrow $50 to buy something for $100 and only get back $50, and you just lost all your investment. Dialing up/down leverage doesn’t make it a better/worse return.
Industry’s alpha? Vs what the stock market? Lots of reasons. You can’t really panic sell an illiquid company, the illiquidity protects you from your worst instincts. You can actually control the company, and PE owners are generally better stewards than a board of old complacent farts. Better alignment. Public company CEOs are incentivized to keep their job as long as possible. PE portfolio company CEOs will get life changing rich if it’s a successful investment for the PE firm. Those are the main factors.
Yes, there’s a tried and tested LBO playbook. Buy businesses with predictable cash flows, install best in class operators/management and make sure they have skin in the game, build a board of real contributors with value added perspectives, beat the shit out of banks so you get the absolute best cap mkts execution, drive procurement savings across all 50 of your portfolio companies to drive purchasing power, don’t piss away capital on stupid shit, find bolt-on acquisitions that are hugely accretive via synergies and multiple arbitrage.
On an entirely separate note, why don’t you just do your own research? You’ll actually learn this stuff intuitively instead of asking people to spoon feed you finished product knowledge which you’re not likely to retain anyway because you didn’t figure it out yourself? It’s not that hard.
This. don't overcomplicate the "theory". You're assessing what you'd pay for a business now and looking at what it's worth when you're done with it. The biggest factor is you look to exercise is however many levers you can pull in that period to increase returns outside of the business growing (ie. leverage, margin expansion, acquiring the business on the low etc)
The one thing I don't understand is why not grow the cash flow and keep portcos indefinitely?
Imagine once you get your equity capital back, your investment will print money. Sure, nothing lasts forever (competition, business/industry/sector pressures, economic contractions, etc.).
This is literally what Warren Buffet/Berkshire Hathaway has been doing for decades with immense success. Now I'm seeing family offices do the same thing.
If a business can be sold for a price that can't be refused, then absolutely consider a sale. But with inflation and so much dry powder on the sidelines, business values will continue to go up. I'm seeing certain businesses sell for 20x adjusted EBITDA! Fucking seriously?
Yea. Check out GP-led secondaries - continuation funds
That’s why you buy an insurance company and invest long lived premiums
Hopefully you’ll have enough cash on hand to handle redemptions
Buffett figured this out with Geico, and then Marc Rowan is running that same playbook with Athene
Isn't that what the insurance company Markel is doing? They have their "Ventures" team that seems to do exactly this, although not nearly as big as Berkshire.
There are also funds setup specifically with longer hold periods that target this type of strategy (Blackrock Long Term Capital, CVC Strategic Opps, KKR has one too). It would make sense for the largest pension funds to execute on something like this, focusing on companies that deliver steady returns but without stellar growth prospects (partly because you're also not pursuing a growth strategy by pushing management to grow 20% p.a). Challenge of course is that you still need to do most of the things a solid PE shop would do to ensure company hums along efficiently and those resources don't come cheap.
This does happen, but remember that PE funds don’t exist in a vacuum - their capital comes from LPs and is governed by the structure of a legal entity, and these LPs like to get their money back. Some LPs are more comfortable with longer or indefinite holds, but most won’t sign up for it upfront, which is why they committed capital to a fund with a defined life and you need to raise a new structure (such as through a secondaries transaction) if you want to keep holding.
Family offices don’t have this problem - with a single capital source they can hold indefinitely. This concept is becoming increasingly popular, so you’re starting to see evergreen funds pop up as well, though they’re still a minority today
Would recommend “multiple expansion’s” website for a lot of solid theory material, particularly their “Capital Structure and Returns” piece.
One fundamental point to keep in mind, not only for LBOs but for analyzing capital structures generally, is that debt is only beneficial to equity returns as long as the cost of debt (interest) is lower than the return on assets aka EV (could characterize this as unlevered free cash flow yield %). This is a helpful tool for considering whether issuing another more junior tranche of debt at a higher interest rate is a good idea.
Put simply, if you were to buy a factory for $100MM dollars which generates $5MM of annual unlevered free cash flow (before interest expense), the three financing options are ranked in the order which provides the best returns to equity, all else being equal :
1) $50MM of debt at 4% tax adjusted interest rate, $50MM equity
2) $100MM of equity
3) $50MM of debt at 6% tax adjusted interest rate, $50MM equity
Essentially, leverage will only hurt ROE if ROA drops below the cost of debt. Conversely, leverage will always help ROE if ROA is above the cost of debt. Note, the proportion of debt to equity does not change the order above.
Would caveat that all of the above can change based assumptions on growth, working capital, aggressive debt paydown after financing a good transaction, a refi in the near term to a lower interest rate, multiple expansion, etc, but the general principles above are a good frame for analyzing capital structures.
How to make money via an LBO:
1) Buy a company on the cheap.
2) Use an appropriate amount of leverage quantum and the right leverage structures.
3) Grow revenues. Initiate cost savings.
4) Optimize the exit.
Repeat.
These comments aren't very helpful. PM me and I can give you a PDF of a book that will cover all the components/aspects of an LBO from an academic standpoint. Very helpful and only thirty pages long or so.
Just messaged!
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