Leveraged Buyout (LBO)

What is a Leveraged Buyout (LBO)?

A leveraged buyout, or LBO, is a debt-heavy technique for acquiring another company. In finance, leverage is the purchase of an investment through debt. A buyout is essentially another word for acquisition, hence the name.

Private Equity firms most commonly use LBOs, but any institution with lenders can do an LBO. Private equity firms perform Leverage Buyouts for financial gains, so they typically try to purchase companies at the lowest price possible typically.

Many believe the first leveraged buyout occurred in 1955 when McLean Industries Inc. acquired the Pan-Atlantic Steamship Company and Waterman Steamship Corporation. In the deal, McLean borrowed 42 million and raised 7 million in preferred stock.

Once the deal was settled, 20 million of Waterman's cash and assets were used to pay off the loan.

The 1980s saw a major boom in LBOs. However, many of the acquired companies went bankrupt during this time. This is because of a debt-to-equity ratio close to 100%. Today, LBOs are usually 60% to 80% debt.

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A leveraged buyout is an acquisition strategy that relies on using a heavy amount of debt to finance the purchase, with the goal of selling the company later.
The first leveraged buyout was believed to be in the year 1955 when McLean Industries acquired the Pan-Atlantic Steamships Company and Waterman Steamship Corporation.
Leveraged buyouts are used mainly by private equity firms, along with corporations and hedge funds.
In an LBO, the major components are purchasing, financing, paying off with cash flow, exiting, paying off debt, and calculating the return.
Some common types of LBOs are the repackaging plan, the split-up plan, the portfolio plan, and the savior plan.

What are the Steps in a Leveraged Buyout (LBO)?

An LBO has six key steps:

Purchasing a company

When PE firms acquire a company, they evaluate it based on factors such as cash flow, industry, growth opportunities, efficiency, management team, and exit options.

Target companies need to generate a lot of cash to pay back the debt being taken on. Many PE firms choose to focus on a specific market niche for strategic advantages such as network, familiarity, and value creation.

Firms want to acquire a company that has growth potential or that can be merged with an acquired company to grow even larger. PE firms also want to target companies whose efficiency can be improved to enhance cost savings.

PE firms also look to acquire companies with proven management teams or install their own. Most importantly, private equity firms want to acquire a company with many exit opportunities.

Once a target company is chosen, it is time to come up with a valuation of how much to pay for the company. The EBITDA multiple based on comparable companies is the most common valuation method used in a leveraged buyout.

The EBITDA Multiple is the Enterprise Value divided by EBITDA. For example, if a firm is looking to acquire a company with an EBITDA of 1,000,000 and comparable companies have an EBITDA multiple of 4. The value of the target company would be $4,000,000.

Private equity firms typically buy companies from investment banks that sell them to clients. However, they sometimes buy directly from owners.

Financing

In an LBO, firms try to pay with majority debt to gain the highest returns possible. The financing of an LBO can be broken down into three parts:

Senior debt: This is considered the cheapest form of debt in an LBO because of the lowest interest rate. Senior debt comes from commercial banks and credit companies. It typically lasts 5 to 6 years. They are the first lenders to be paid back if liquidation occurs.
Subordinated debt: This is the most expensive form of debt in an LBO since it does not have collateral. Subordinated debt is sourced from public markets, CDOs, and mezzanine funds. It is typically taken on for 7-10 years.
Equity: This portion is paid by the private equity firm that is performing the leveraged buyout. In this situation, the firm is looking to make an IRR of 15% to 25% after holding the company for 3 to 5 years.

Senior debt usually finances 35% to 45% of an acquisition. Subordinated debt is typically between 15% and 35%, and equity is 20% to 40%.

An easy way to think about financing an LBO is to compare it to purchasing a home. When someone buys a home, they pay a down payment and take out a mortgage. The equity is the down payment, and the mortgage is the debt.

Paying off with Cash flow

Now imagine that this home you bought is an investment property. As a landlord, you use rent to pay off the mortgage, giving you more equity in the home. Meanwhile, the home is also appreciated in value, similar to LBOs.

During an LBO, the private equity firm does not use any of its personal funds to pay off debt. Since they have acquired a new company, they are now the owners. They use the cash flow generated from that company to pay off the debt and interest taken on to acquire it.

This phase of the LBO lasts around three to five years. Within that time, the Private Equity firm should accomplish two things. The first is a larger share equity in the company, and the second is that its value should increase.

Selling the Business

During an LBO, the Private Equity Firm should increase the company's EBITDA within the time it owns it. Private Equity firms increase company value through operational efficiencies, strategic endeavors, and more.

The EBITDA multiple should usually stay the same after three to five years. During the selling stage of a leveraged buyout, there are several options:

IPO: In an IPO, the private equity firm sells the shares on the stock market to investors. Typically, this is the longest exit option because firms do not sell all of their shares at once
Strategic buyer: A strategic buyer is one who is looking to create synergies with their purchase. An example of this would be a manufacturing company purchasing another manufacturing company from a private equity buyer.
Secondary Buyout: A secondary buyout is when a private equity firm sells its company to another private equity firm. Strategic buyers will pay more than secondary buyers due to the premium paid for synergies. In addition, PE firms want the highest returns possible, so they will often wish to pay less.

Pay off debt

The next step in a leveraged buyout is paying off the remaining debt and keeping the rest. By this point, there should be a lot less debt left than when initially buying the company. This is because cash flows were used to pay off debt while owning it.

Another way to consider it is to imagine selling a rental home. Rent would have been used to pay off the initial mortgage, creating a larger equity stake in the home. The home would then be sold for more than it was originally bought for.

The proceeds first go to paying off the mortgage, and the homeowner keeps the rest. The same is true for selling stock acquired in a leveraged buyout.

Calculate returns

The last step of an LBO is to calculate the returns. Most private equity funds aim to have an IRR of 20% or greater. Let's say a PE firm initially invests 1,000,000 and ends with three million total five years later.

The PE firm would use the formula:

Annualized Rate of Return = (Ending Value/ Beginning Value)^{(1/number or years)} -1

Annualized rate of return= (3,000,000/ 1,000,000)^(⅕) - 1

Annualized rate of return = 24.57%

Understanding the steps of a leveraged buyout is essential before learning how to model an LBO. To learn more about LBO modeling, check out the course: WSO LBO Modeling Course or read the article Leveraged Buyout (LBO) Model.

Leveraged Buyouts Types

Four of the most common types of leveraged buyouts are the repackaging plan, the split-up, the portfolio plan, and the savior plan.

The Repackaging Plan: A repackaging plan is when a private equity firm acquires all the shares of a public company and takes it private. The private equity firms then rehabilitate the company's performance and take it public again.
The split-up plan: When a company is acquired, its parts are then broken and sold individually. This is because the parts of the company are often worth more individually than the company as a whole.
The Portfolio Plan: A competitor often does this instead of a private equity firm. A competitor uses a lot of leverage to acquire similar businesses.
The Savior Plan: When employees of a failing business use an amount of debt to acquire the company they work for.

Walk me through an LBO

Keeping your technical overview at a high level in an interview is essential. Therefore, start with a high-level overview and be ready to provide more detail upon request.

A high-level LBO process is outlined below, but make sure you understand every part of the process.

Calculate the total acquisition price, including the acquisition of the target’s equity, repayment of any outstanding debt, and any transaction fees (such as the fees paid to investment banks and deal lawyers, accountants, consultants, etc.).
Determine how that total price will be paid, including equity from the PE sponsor, roll-over equity from existing owners or managers, debt, seller financing, etc.
Project the target’s operating performance over ~5 years and determine how much of the debt principal used to acquire the target can be paid down using the target’s FCF over that time.
Project how much the target could be sold for after ~5 years in light of its projected operating performance; Subtract any remaining net debt from this total to determine projected returns for
Equity holders.
Calculate the projected IRR and MoM return on equity based on the amount of equity originally used to acquire the target and the projected equity returns upon exit.

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Leveraged buyout: example

This example will show you how an LBO can increase an acquirer’s return on equity. Let’s say that you were presented with the option to acquire a business.

This business operates in a stable industry where revenue streams are unlikely to change. Therefore, it would be safe to assume that its income will remain the same for as long as it operates.

The business is currently financed by only equity and has no debt. It has a pre-tax income of $1.5 million. The corporate tax rate is 33%, while the acquisition cost would be $10 million.

Through simple calculation, you realize that your net income would be $1 million, and if you paid $10 million, you would have a return on equity of 10%.

EBIT: $1,500,000

Tax expenses (33%): ($500,000)

Net income: $1,000,000

Cost of acquisition: $10,000,000

Return on equity:10%

A return on equity of 10% is pretty good! However, when you consult your financial advisor, he recommends that you leverage the target for an LBO. He advises you to meet the cost of acquisition using $9 million in debt at 10% interest and $1 million in equity.

Your financial advisor tells you that by introducing leverage, you’d now have to pay $900k in interest expenses annually, and while that may seem like you would have a lower net income, you will have a higher ROE.

EBIT: $1,500,000

Interest expense: ($900,000)

Earnings after interest: $600,000

Tax expenses (33%): ($200,000)

Net income: $400,000

Cost of acquisition: $1,000,000

Return on equity: 40%

By introducing leverage, you increased your return on equity by 4 times. The key reason behind the increase in the return on equity was because of the benefits of debt.

Because debt is considered an expense, earnings spent on debt repayments are not taxed.

This is one of the greatest benefits of debt: tax shields. The formula for a company’s tax shield from debt is simply the interest expense multiplied by the corporate tax rate. In this scenario it would be $900k * 33% = $300k.

This is also evidenced by the tax expenses being reduced from $500k to $200k.

While leverage may seem like a great idea, there is a reason why most companies are not mainly financed by debt. The truth is that debt does put pressure on a company’s cash flows, and although it could magnify a company’s returns, it will also magnify its losses when times are bad.

What would happen to the ROE if the target’s EBIT fell to $600k in both scenarios?

Note

This example was oversimplified to show why leveraged buyouts are a good option in a transaction. This is NOT a financial model, and in practice, leveraged buyouts are much more complex.

To gain a deeper understanding of leveraged buyouts, take a look at WSO’s LBO modeling course.

Open Famous LBO transactions configuration options

Famous LBO transactions

Here, you’ll see some famous LBO transactions of companies that many will have heard about. However, do note that most of this is publicly available information, and you can find out more about LBO transactions online.

1. Hilton Hotels Corporation

Blackstone acquired Hilton in 2007 for ~$26 billion. Before the acquisition, Hilton was trading on the public markets, and Blackstone decided to take it private.

The acquisition was financed by $20.5 billion (78.5%) in debt and $5.6 billion in equity. At the time, Blackstone purchased all common stock at an estimated 40% premium.

This LBO was generally deemed a success, and the company IPOed again in 2013. However, by the time Blackstone sold all of its stake in Hilton in 2018, they realized about $14 billion in equity value. That’s almost 3 times the equity they had initially put up to acquire Hilton.

2. Dell Technologies

Silver Lake Partners took Dell Technologies private in 2013 for ~$25 billion. Roughly 70% of the LBO was financed using debt made available by Credit Suisse, RBC, Barclays, Bank of America, and Merill Lynch.

The deal was successfully executed despite resistance from some shareholders, including famous activist investor Carl Icahn. Dell Technologies then went on to relist in the NYSE in 2018.

3. HJ Heinz

HJ Heinz was acquired by 3G Capital & Berkshire Hathaway around 2013, with an acquisition cost of around $23 billion. The debt financing in this deal was made available by J.P. Morgan and Wells Fargo.

Heinz merged with Kraft around 2015, which was already public at that time. Source: CNBC

If you look at all the LBO examples above, you might be able to notice a pattern.

Private equity firms gain 100% controlling interest in targets, manage them for a long time (over 5 years), and after all that, they cash out via IPO (but this isn’t the only method).

After using large proportions of debt to buy up the target, over time, their improvement in earnings before interest after taxes would be used to repay debt obligations.

Because the Private Equity firm put up so little equity to acquire targets in the first place, the value of that equity by the time it is sold will have appreciated by a significant amount. This results in a hefty ROE or IRR.

Conclusion

A leveraged buyout has been used to acquire another company since the 1950s. They were super popular in the 1980s; however, most of the companies they acquired went bankrupt because of the nearly 100% leverage.

Today, private equity firms mainly use leveraged buyouts as an investment method. They look to buy companies with high leverage, pay off debt with cash flow, and then sell the acquisition a few years later.

This process can be broken down into six steps. The first step is purchasing a company that has a promising return. After this, it financed a highly leveraged rate using senior debt, subordinated debt, and equity.

Next, the debt can be paid off using cash flow from the acquired company, which allows for a higher equity stake. After three to five years, the Private equity firm should have increased the company value and be ready to exit. Exit options are typically IPOs or selling.

After selling the company, the remaining debt must be paid off, and the remaining debt must be kept. Private Equity firms aim to have an IRR of greater than 20% over this time frame.

To better understand LBOs, watch this video: