Leveraged Buyout (LBO)

Stands for a leveraged buyout and refers to the purchase of a target company while using mainly debt to finance the acquisition. 

LBO stands for a leveraged buyout and refers to the purchase of a target company while using mainly debt to finance the acquisition

In these types of transactions, the acquirer will opt to put up the target's assets as collateral to raise debt capital to meet the acquisition cost instead of paying with cash. Furthermore, the acquirer will typically want to put up as little equity as possible in the acquisition. 

Leveraged Buyout (LBO)

While investors generally dislike large amounts of leverage (it puts strain on a company's cash flow), debt has significant tax deductions. If a company is able to meet its debt obligations, then the return on equity is usually magnified.

Typically you would see private equity firms acquiring targets through an LBO transaction. When they acquire a target, they will sometimes be referred to as financial sponsors. 

Also, they would engage the investment banks' IBD division (specifically their leveraged finance team) to secure financing. Therefore, if you are interested in corporate finance, you should get a deeper understanding of LBOs.

Why introduce so much risk through high levels of leverage? Financial sponsors can achieve significantly more return on equity (ROE) and internal rate of return (IRR) by putting in as little equity as possible. 

As long as the target can survive the debt obligations, whatever free cash flow that is left will belong to all equity holders, and if the value of all equity holders is small, the return will be higher. 

Leveraged Buyout (LBO)

During the 1980s - 1990s, when LBOs were hot, debt could make up as much as 90% of the purchase of a business. However, now investors and private equity firms are a bit more risk-averse and, therefore, may use closer to 50% debt and 50% equity to purchase a business. 

Generally speaking, private equity firms would target businesses that have stable cash flows, good management, and a large asset base that could be used as collateral. 

However, it is also very common for private equity firms to target businesses in financial distress and apply their expertise to turn around and restructure the business until it is no longer distressing. 

The overall aim would be to increase the value of the target so that it could be sold for more money than what was spent acquiring the target.

Suppose the target firm is in the latter category. In that case, the LBO can sometimes be viewed as predatory because the private equity firm is buying a distressed company using its own assets. That's like saying, "I'm going to save you using your own money, but I get all the profits". 

The LBO process 

There is an element of financial modeling for an LBO transaction. 

There may be similarities to a discounted cash flow (DCF) model. However, the key difference between an LBO and a DCF is that in an LBO, you will be stress-testing the target's financial forecast to see how much debt it can handle.

Aside from that, an LBO focuses on the internal rate of return. If the IRR is not high, it wouldn't be worth it for the private equity firm to sponsor the target.

Lastly, exit equity value is essential in LBOs as the financial sponsors prefer to approximate the value of their equity at the time they are selling the target (they're not likely to hold the target forever).

LBO Process

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.  

  1. 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.).
  2. 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.
  3. 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.
  4. 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
  5. Equity holders.
  6. 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. 

Tax Heaven

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.

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. 

Famous LBO Transactions

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.

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. 

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. 

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