LBO Buy-Side

What Is LBO Buy-Side?

An LBO, a leveraged buyout, is the process of acquiring a company through a leveraged amount of debt for financing. An LBO on the buy side is similar but has its characteristics and procedures.

A buy-side leveraged buyout aims to acquire a business using leverage while simultaneously providing the best internal rate of return to equity investors. 

When referring to the buy-side, the entities involved usually consist of private equity firms, insurance companies, hedge funds, pension funds, and unit trusts. These entities typically possess large pools of funds for completing financial ventures.

Leveraged buyouts vary based on deal types and can have very different outcomes based on the process carried out by the acquirer and the target company. The outcome depends on many factors, including due diligence, synergies, market conditions, etc.

Since leverage is involved, the acquirer on the buy-side must carefully assess and plan the operation to ensure profits. An unsuccessful leveraged buyout can lead to a loss in resources, time, and even principal investment in certain situations. 

Different types of Leveraged Buyouts

Leveraged buyouts can be a daunting concept to grasp, so we will break down the most common types of leveraged buyouts, which include the repackaging plan, the split-off, the portfolio plan, and the savior plan. 

Each buyout type is utilized for different purposes and scenarios and depends on the acquirer's plan for the best outcome for the overall deal-making process. The first three deals are more common, while the savior plan is typically only used in bankruptcy cases. 

1. The repackaging plan

The process involves a private equity firm using leveraged loans to take a current public company private by buying all the company's outstanding shares. 

Typically, the private equity firm's objective is to revamp the company through various measures and then take the company to its initial public offering after the repacking process. 

Doing so will save the company a lot of time, effort, and resources on expenses and responsibilities involved by being a public company. The management team can transfer those efforts into R&D, market expansion, and product-focused objectives. 

These deals are typically carefully thought through, as private equity firms must borrow a large amount of money (70-80% of the purchase price) to finance the leveraged buyout. As a result, if no significant changes are made, the acquisition may be fruitless. 

2. The split-off

A split-off typically refers to a company deemed more valuable when its subsidiaries are broken off. This scenario normally occurs in conglomerates that have made irrelevant acquisitions over the years and are not seeing a complementary benefit. 

This practice is considered predatory, as the buyer is from the outside and usually employs aggressive tactics. Firms sometimes would have to dismantle the acquired company and sell its parts to the highest bidder. 

Split-offs can lead to massive layoffs as part of the restructuring process, but the acquirer and the seller may benefit from this deal. 

The dismantled and sold piece may experience growth after its separation from the conglomerate corporate structure, and the conglomerate may free up capital to utilize in other ventures. 

3. The portfolio plan

This plan entails one company acquiring its competitor through proper analysis. However, if the process goes well, this leveraged buyout can benefit multiple parties, including the acquirer, the seller, and the shareholders. 

Also known as the leveraged build-up, the portfolio plan is considered an aggressive and defensive strategy because a leveraged build-up effectively expands a company's market share while simultaneously removing competition. 

Typically, under a portfolio plan, a company would use leverage to acquire a competitor from which it could gain synergy. Careful analysis is a must, as the acquirer needs to ensure that the return on invested capital is greater than the acquisition cost. 

This LBO is considered risky because if the analysis is proven wrong, the whole plan could backfire and lead to significant losses. On the other hand, a successfully leveraged build-up can lead to a reasonable stock price for shareholders, retained management, and future prosperity. 

4. The savior plan 

The so-called savior plan is usually a leveraged buyout with great promises but a late arrival. It usually consists of a company's managers and employees using leverage to save another company on the brink of failure or bankruptcy.

The savior plan is rare, as the process involved is highly complicated and risky. Moreover, the likelihood of success for these deals is intrinsically low if the "saved" company remains with its initial management and market strategies. 

Another precaution of the savior plan is that the acquirer may need to be able to pay back the leverage rapidly enough to offset the borrowing interest, thus reducing the overall financial return. The company must turn its acquired target around to see gains. 

Purpose and characteristics of an LBO 

Private equity firms and other financial services companies pursue leveraged buyouts due to interest in the target's business area or market potential. Since many of these acquirer firms have expertise in different industries, they invest accordingly. 

The acquirer looks to utilize their expertise and knowledge to make the acquired target a more profitable and successful business. For example, in certain LBO operations, privatizing the company can save the target from unnecessary financial expenses.

Substantial amounts of debt are utilized in LBOs, with an average ratio of around 80-90% debt, while the rest comes from equity. Due to the high debt-to-equity ratio, the bonds issued in the buyout are usually not investment-grade but junk bonds. 

The LBO analysis from private equity firms generally gives a "floor" price of their target company's worth. It allows the financial sponsor to determine the right price to pay for the target while still having an opportunity to garner returns. 

Since the creation of leveraged buyouts, private equity firms have received many criticisms on the predatory nature of LBOs. Due to leverage, PE firms do not take on as much risk, but the target company depends entirely on the LBO's outcome.

The transaction structure of the LBO operation is more straightforward than it may sound. A simple diagram from Macabacus explains it well: the new investors form a new corporation to acquire the target while the target becomes a company subsidiary.

The Procedure of a Leveraged Buyout Analysis

An LBO analysis is critical for PE firms to determine their target's profitability and reasonable acquiring price. Of course, each PE firm may differ in its approach, but a typical leveraged buyout analysis on a target company is usually as follows. 

1. The firm develops operation assumptions and future projections to find the target's EBITDA and cash flow for debt repayment over the investment period, usually around 3-7 years.
2. The firm decides on the deal's adequate leverage levels and capital structure, which often involves a combination of mezzanine financing, senior debt, subordinated debt, and more. These statistics should result in the firm's realistic financial coverage and credit data. 
3. The firm estimates the multiple at which it would exit the investment, similar to the entry multiple. 
4. The firm calculates and sensitizes the equity returns (IRR) for a range of leverage levels and exit multiples, analyzing the outcomes to determine the best outputs. 
5. The firm solves for the price that can be paid to meet the parameters determined. 

The equity returns (IRR) in LBO transactions are quite significant for investment firms. Equity returns represent the discount rate at which the net present value (NPV) of cash flow is equivalent to 0, found in a discounted cash flow analysis. 

In buy-side LBOs, PE firms typically keep their minimum required IRR at a value above 30%. But in certain situations, firms can also settle for a 15-20% projection under adverse economic conditions. This percentage is also known as the hurdle rate. 

The hurdle rate and another metric called cash-on-cash (CoC) are the main measurements to determine leveraged buyout success. 

CoC is expressed as a multiple and calculates the final value of the equity investment at exit divided by the initial equity investment. 

In the case of CoC, LBO investments typically want a return multiple of 2.0x - 5.0x. The returns in leveraged buyouts are mainly influenced by three factors: de-levering, operational improvement, and multiple expansions. 

Risk and exits in LBOs

Risk is present in every leveraged buyout transaction and is displayed on different scales for equity and debt holders. 

The risk for equity holders primarily lies in the operational risk due to the significant scale of financial leverage but is also displayed in other aspects.

The interest payments that the acquirer faces can sometimes amount to huge debts to lead the company into default. At the same time, the enterprise value can have magnified impacts on the company's equity value due to the amount of leverage. 

In terms of debt holders, they carry the risk of the transaction's outcome, but its threat is to a lesser extent compared to the equity holders. 

This is because they have the most senior claims on the company and usually get a partial or total return on investments, even in bankruptcies. 

Both equity and debt holders pay close attention to the buyout's exit strategy and its outcomes. The typical result for a leveraged buyout exit is an outright sale of the company to another firm of interest, an IPO, or recapitalization. 

When calculating multiples for the LBO exit, it is crucial to remember that the outcome must be carried out with realistic approaches. Although multiple expansion does allow the firm to garner a higher IRR, it is usually an unjustifiable assumption.

Evaluating a target for LBO

There are many factors to consider when a firm chooses a target for the leveraged buyout. Many of these factors of concern can be separated into industry, company-specific, and market conditions. 

Industry characteristics should consider the type of industry, the competition, the cyclicality, industry drivers, and regulations. These characteristics are also closely correlated with market sentiments (cyclicality is heavily linked to economics).

Company characteristics are more specific and include growth opportunities, operating leverage, working capital requirements, etc. 

Marketing conditions include accessibility and expected equity returns. 

After meticulously considering the factors above, firms may get hints that a target company might be a good fit through its characteristics. Of course, no target company will be perfect, but meeting some commonly beneficial requirements can increase the odds. 

For instance, the target company can be considered a good candidate if it currently possesses a stable business and a leading industry position. In addition, it would help if the company is undervalued but is operated by a strong management team. 

When investing, investors look for discounts that deserve more value, which is no different in leveraged buyouts. Firms want to see a promising target that isn't bloated with a valuation but rather a sleeper company that can be restructured to success. 

Example of an LBO Transaction

Having discussed the different aspects of a leveraged buyout, it seems fitting to add a prominent example of such a transaction. Blackstone's leveraged buyout deal on Hilton Worldwide in 2007 is considered an excellent case study in LBOs. 

The transaction in 2007 was all-cash, as Blackstone offered 20.5 billion dollars in debt and 5.6 billion dollars in equity, amounting to the 26.1 billion dollars total deal. The debt-to-equity ratio utilized is similar to the above, about an 80-20 ratio. 

At the time of the buyout, Blackstone paid 47.50 dollars each for all outstanding stock of Hilton, which was a 40% premium on its stock price. 

In 2018, 11 years after the acquisition, Blackstone sold off all their shares of Hilton and garnered almost 14 billion dollars in profit. 

Some key factors made the deal successful for both parties. Blackstone had already invested extensively in hospitality, while Hilton needed a partner to scale and increase margins. 

The conditions were also adequate, as both companies and the industry were mature.

With restructuring operations taking place, Hilton had a successful IPO in 2013. Gradually, Hilton started to reduce their stakes, walking away with huge profits while Hilton flourished in hospitality on a worldwide scale. 

Conclusion

LBO Buy-Side transactions represent a strategic approach by private equity firms and financial sponsors to acquire target companies through leverage, aiming to provide optimal returns to equity investors.

These transactions involve meticulous analysis, strategic planning, and risk management to ensure successful outcomes.

Leveraged buyouts encompass various types, each tailored to specific purposes and scenarios, with the ultimate goal of enhancing shareholder value and driving profitability.

Through careful evaluation of target companies, consideration of industry dynamics, and assessment of market conditions, private equity firms seek to identify opportunities for value creation and growth.

While leveraged buyouts carry inherent risks, effective execution can lead to significant returns for both equity and debt holders.

Overall, LBO Buy-Side transactions represent a strategic avenue for investors to capitalize on opportunities and drive value creation in the corporate landscape.

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