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Leveraged Buyout (LBO) Model

What is a Leveraged Buyout (LBO)?

A leveraged buyout model, or an LBO, is a term used for the acquisition of a company. It is a type of acquisition where total acquisition proceeds are financed with a substantial portion of borrowed funds. There are two parties involved in a leveraged buyout – the buyer company & the target company. In LBO, the acquiring firm finance the acquisition with a mix of equity & debt.

LBO is very much like buying a house on mortgage. When we buy a house on mortgage, we put down some money in cash (down payment) & the remaining payment is done by loan (i.e. debt). The house itself works as a security for the debt. Most of the time loans form a major part of the entire payment. Similarly, in LBO the target company’s assets work as security for the debt, and the majority of finance is debt. The buyer company is usually a private equity firm that invests a small amount of equity and majorly uses leverage or debt to fund the remaining transaction.

The leveraged buyout has had its share of negative publicity. A lot of people consider it as a ruthless, predatory strategy because the assets of the target company are often the collateral for the debt to finance the leveraged buyout. This is not usually sanctioned by the target company. But there are certain advantages to LBO for the target company as well. The acquiring company usually targets companies that are in trouble, maybe financially or in any other way. After the buyout, the acquiring firms channelizes the decision-making process of the target company through their own expertise. Normally, such private equity firms exit it at a suitable time when they are able to realize higher value for the stake in the company.

Example of Leveraged Buyout (LBO) Model

Let us understand the concept of a leveraged buyout with a simple example –

Suppose XYZ Corp. wants to buy ABC Corp without investing a lot of capital. The value of ABC Corp. is USD 2000.00. XYZ Corp. invests USD 200.00 of its own equity & remaining USD 1800.00 it borrows at an interest rate of 5% per year.

Why LBO Model?

In the first year of operations, XYZ Corp earns USD 200.00 (10%) from the cash flow of ABC Corp. Now the total value of ABC Corp. is USD 2200.00. XYZ Corp. repays its interest on debt i.e. USD 90.00 (5% of USD 1800.00). As you can see the company is paying interest of USD 90 to the financial institutions for its investment of USD 1800. Thus XYZ is left with USD 110.00 (USD 200.00 – 90.00) available for equity shareholders. XYZ Corp earns USD 110 on its original investment of USD 200.00. Thus, XYZ earned a 55% return on equity on this transaction.

Now let’s consider how much return XYZ Corp. would have earned had it financed the entire transaction by equity. To acquire ABC Corp, XYZ Corp. has to invest USD 2000.00. In the next one year, XYZ Corp. earned USD 200.00 from the cash flow of ABC Corp. Thus its total return = (200/2000) * 100 = 10%.

Caution

Thus we can clearly see that the returns on leveraged buyout are much higher than a regular transaction.

This example shows a very good return on equity because there is a positive effect of leverage here. This depends on the return on investment i.e. 10% here.

If this return reduces to 4%, the return on equity will be negative. How? Amount left for equity shareholders is $80 (4% on 2000) less $90 (Interest) i.e. – $10 ~ -5%.

If this return reduces to 5%, the return on equity will be minimal. How? Amount left for equity shareholders is $100 (5% on 2000) less $90 (Interest) i.e. $10 ~ 5%.

If this return reduces to 6%, the return on equity will be average. How? Amount left for equity shareholders is $120 (6% on 2000) less $90 (Interest) i.e. $30 ~ 15%.

Leverage Buyout LBO

Steps Involved in Building a Leveraged Buyout Model

Step-1 – Purchase Price and the Amount of Debt and Equity

The first step in a leveraged buyout is to determine a purchase price for the target company. This is a valuation of the company based on various factors within and outside the target company. Once the purchase price is fixed the buyer must decide what percentage of equity & what percentage of the debt will he use to carry out the acquisition.

Step-2 – Listing Sources of Finance & Types of Debts Available

We already know that two types of finances are used to fund a leveraged buyout – equity & debt. We also know the source of equity, but there are various types of debt available to the buyer. These sources include bank debt, bonds, commercial papers, etc. The acquiring company must decide on what type of debt it wants to exercise depending on interest rates, repayment terms, etc.

Step-3 – Build Projections

The acquiring company must build a future balance sheet & income statement projections for the target company. This will help to determine the rate of return from the investment. The buyer must have an approximation for revenue growth, income & expense percentage, net income margin, etc. The buyer can go one step further & compare their own projection calculations with that of equity researchers to account for any discrepancy.

Step-4 – Calculating Cash Flow & Cash Available for Cash Repayment

Further after building projections it is necessary to calculate cash flows. There are various different cash flows such as free cash flow to equity, free cash flow to the firm, unlevered free cash flow, etc. Our motive to calculate cash flow is to calculate cash available for repayment. We will get that by the following formula –

Cash Available for Debt Repayment = Beginning Cash + FCF – Minimum Cash Balance

Where,

FCF (Free Cash Flow) = Cash Flow from Operations – Capital Expenditure & Minimum Balance

Minimum Balance = least amount of cash that a company needs to continue operating, paying employees, and paying for standard expenses

Step-5 – Analyse Repayment Structure

Every type of debt comes with a repayment structure, which says how much debt is payable at what time. Some of this repayment is mandatory while some is optional. The acquiring company should be sure that it can adhere to at least all the mandatory repayments in a timely manner. The projections and estimates are very useful in analyzing this debt repayment structure as well.

Step-6 – Exit

As we already know that most of the time leverage buyout is a method of earning a good return on investment for a private equity firm. Thus it is necessary that the acquiring firm has an exit strategy in place. The acquiring firm at least has some assumptions about how & when it will exit. A standard assumption would be something like – the target company will be sold after 5 years at the same implied EBITDA multiple at which the company was purchased. The basic understanding is that upon exit the acquiring firm will repay all the debt obligations of the target company as a part of the owner’s obligation. But it also gets all the company’s remaining cash at the end of the period as an owner.

Step-7 – Calculating IRR on Initial investment

The purpose of building a leveraged buyout model (LBO) is to calculate returns and determine if the LBO deal is attractive or not. The acquiring company looks at IRR to determine the attractiveness of an LBO. Thus in the final step, the buyer derives an IRR from all the estimates of future projections and related research.

IRR= (Cash Flows)/ (1+r)i

Where:

Cash flows= cash flows in the time period

r= Discount rate

i= Time period

Leveraged Buyout (LBO) Analysis

Leveraged Buyout Analysis is similar to Discounted Cash Flow Analysis, in which the future cash flows are discounted to reach a particular present value. However, in Leveraged Buyout, most analysts calculate an internal rate of return (IRR) to analyze the benefit of acquiring a target company. Internal Rate of Return is nothing but the rate at which the present value of future cash flows becomes zero. The higher the IRR, the more fruitful the Leveraged Buyout.

Leveraged Buyout Vs. Recapitalization

Many people confuse Leveraged Buyout with Leveraged Recapitalization. Even though the base concept is the same in both the strategies, there is one striking difference. In leveraged buyouts, significant debt is taken to finance the acquisition transaction, whereas, in a leveraged recapitalization, the debt is taken to restructure the capital structure of the company.1

1.
Leveraged Buyout. stern.nyu.edu. March 2020. [PDF]
Last updated on : March 3rd, 2020
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  1. Avatar Shalin Soni

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