Leveraged Buyout Definition

What is an LBO
A leveraged buyout is a process when you borrow a significant amount of money in order to complete the acquisition of another company. Now, since the amount of loans taken for acquiring the company is pretty high, so to pay them off, the assets of the acquired company are put to use. They are often kept as collateral for the loans to the creditors. Sometimes, the acquiring company also uses its own assets to keep as collateral for the loans. Now, the main reason behind this buyout is to make sure that when a company is being acquired, the acquiring company is not committing a lot of capital.

The best book to learn about LBO is: Investment banking valuation leveraged buyouts and mergers and acquisitions:

Leverage Buyout LBO Simple explanation video

Historical aspects regarding Leveraged Buyout

The infamous history of leveraged buyouts suggests that they hadn’t been much success in the past. Most importantly, when the 1980s are kept into account, there were various much important buyouts that happened and led to the eventual bankruptcy of acquired companies. Mainly, this was because of the pretty high leverage ratio that amounted to almost 100%. The interest payments were also so large that the operating cash flows of the company just couldn’t make it to meet the exceedingly high amounts and thus, they eventually got bankrupted.
One of the largest LBOs on record was in 2006 when Kohlberg Kravis Roberts & Co. (KKR), Merrill Lynch, and Bain &Co. acquired the Hospital Corporation of America (HCA). The three companies had to pay a whopping amount of $33 billion in order to acquire HCA.

What are the reasons behind LBOs?

When a company is taking so much loan just to acquire another company, it raises questions and puts the acquiring company’s finances at great risk. So, one does wonder about the reasons behind such a buyout. Well, there are three important reasons why companies come to this point.

1. The first reason is when the company wants to take over a public company and make it private
2. When someone is trying to sell a portion of his existing business for its spin-off.
3. The third reason might be the transfer of any private property or the case where a small change is to be made in the ownership of a specific business.
However, in all cases, there is one common requirement that the acquired entity must be a profitable and growing venture. So, spending all the large amounts and acquiring all the loans are worth it.

Break down of LBOs
Usually, there is a ratio of 10% equity to 90% debt in an LBO. Due to the excessive ratio, usually, the bonds issued in this buyout are referred to as the junk bonds instead of the investment grade. Moreover, a lot of people are of the view that the tactic of LBOs is highly predatory and ruthless because the target company never actually sanctions it. Moreover, it is pretty much ironic that the assets responsible for a company’s success are actually being used against the same company by the predator company as collateral.

The process of LBO – How does a leveraged buyout take place?
The leveraged buyouts often contain many complexities and hence they take some time for completion. For instance, consider the example of the JAB holding company. It is a private firm that makes investments in healthcare companies, coffee, and luxury goods. In May 2016, the JAB holding company started the leveraged buyout of Krispy Kreme Doughnuts, Inc. The acquired company came at a whopping price of $1.5 billion, out of which there was a leveraged loan of $350 million along with a revolving credit facility of $150 million through the Barclays investment bank.
However, the Krispy Kreme Doughnut Inc. already had a debt on its balance sheet which was also needed to be sold. Barclays made it more attractive by adding an additional 0.5% interest rate to it. Thus, the LBO was made quite intricate and the deal was almost canceled. Nevertheless, on July 12, 2016, they went through with the deal and closed it.

Attractive aspects of LBO

An LBO generally represents a win-win situation for banks as well as financial sponsors, thus they are quite attractive. In the case of a financial sponsor, he can employ the leverage and thus enhance the rate of returns on his equity. The banks can also make it different from corporate lending and thus attain some significantly high margins by supporting the finances of LBOs. This is because the banks will be charging much higher interest. Moreover, the banks can obtain security or collateral too as proof or surety that they will get repaid.
In a leveraged buyout the managers of a firm, its employees, or other investors attempt to used borrowed funds to buy out the firm stockholders.
How much amount can the banks provide for an LBO
As mentioned, the LBO requires a lot of debt and this depends on how much amount the banks are actually willing to provide for supporting an LBO. The amount varies and is dependent on several factors that are mentioned as follows:
• Overall economic environment
• The quality of the company that is being acquired i.e. whether the operating cash flows of the company are stable, its history, the prospects of growth, and the hard assets, etc.
• The experience and history of the financial sponsor.
• How much equity is being offered by the financial sponsor.
Characteristics of leveraged buyouts
The leveraged buyouts greatly differ in many aspects. However, some characteristics are there that hold true in almost every LBO mentioned as follows:
• Strong management team – The chief executives will have worked with each other and by rolling over their shares in the LBO deal, they might have some vested interests.
• Relatively lesser existing debt – The private equity firm will add up more debt in the capital structure of the company which is to be repaid over time. Thus, this results in a lesser effective purchasing price. If the company already has acquired a huge debt balance, then the deal is very tough to be closed.
• Relatively lesser fixed costs – the fixed costs are to be repaid even if the revenues of private equity firms decline, thus the fixed costs pose risk for the private equity firms.
• Stability in cash flows – the acquired company in the LBO must have a stable operating cash flow.

Leveraged Buyout LBO Model in Simple Words
When consideration is given to the matter of the leveraged buyout model that is constructed by engaging in the usage of the Excel program, this refers to the conducting of an evaluation for a transaction that is classified as being a leveraged buyout, which in shortened form is referred to as LBO. It is noted that such a transaction is regarded as being the acquiring of a business that is financed via the application of a large amount of debt. It is further realized that the collateral that is used for the funding of a leveraged buyout is derived from the assets pertaining to the acquisition business as well as the assets of the business that is taking over the new business.

Leveraged buyout valuation model:

LBO model or Leveraged Buyout model is a representation system, during the acquisition of a public or private company with a significant amount of borrowed funds, which needs to enable investors to properly assess the transaction and earn the highest possible risk-adjusted internal rate of return (IRR). LBO model consists of a process of determining a fair valuation for a company, determining the equity returns (through IRR calculations), determining the effect of recapitalizing the company and determining the debt service limitations of a company from its cash flows.

See leveraged buyout model example video:

Usually, the process of this type of transaction involves the purchaser having a desire to make the lowest amount of investment possible in terms of pursuing and engaging in the usage of debt for the sake of being able to finance the rest of the price of the business. Or sometimes other sources that are classified as being non-equitable may also be used for this purpose. The objective of the LBO model seeks to empower inventors to be able to assess transactions in a proper manner and to be able to achieve the most optimal level of internal rate of return that is noted as being risk-adjusted.

Within the context of the leveraged buyout, the reason for the business that is investing or the buyer to engage in the acquiring of the new business is for the sake of earning returns that are optimally high as possible in terms of their investment of equity by applying the usage of debt for the sake of augmenting the possible returns. The organization that does the acquiring sets forth the determination of whether the investment is worthy of pursuit via conducting calculations in regard to the potential internal rate of return. Usually, the minimum in such cases is set forth as being thirty percent and higher. The internal rate of return sometimes can be even at a low rate of twenty percent for deals that are regarded as large or in such cases that the conditions of the economy are regarded as being unfavorable. Once the acquisition has been made, the ratio pertaining to the debt and equity is generally one to two times more as a result of the fact that the debt makes up fifty to ninety percent of the amount of the purchasing price. The cash flow of the organization is then applied for the sake of being able to pay for any debt that is outstanding.

Concerning the structure of a leveraged buyout model

Within the scenario of engaging in the transaction of a leveraged buyout, the investors, which are regarded as private equity or which may be a firm that specializes in leveraged buyouts, may form a new organization that is used for the sake of being able to obtain the desired business. Following the completion of a leveraged buyout, the target business then is regarded as a subsidiary that pertains to the new organization or the two businesses may undergo a merger for the sake of formulating one business enterprise.

Considering capital structure within the leveraged buyout model

When the term capital structure is used in regard to the scenario of a leveraged buyout, this correlates to the elements of funding that are applied during the process of buying a company for acquisitions. Though the reality is that there is different structuring that is applied in each case of leveraged buyouts, it is recognized that generally there are many similarities pertaining to the capital structures of many businesses that are purchased new. In such cases, debt is the largest portion of the funding for leveraged buyouts. The usual capital structure is to seek to supply funding that is the least costly and that holds the least amount of risk. Then other additional sources of funding are applied.

It is noted that the capital structure of a leveraged buyout may contain debt that is obtained via a bank. Bank debt is also sometimes called senior debt. This is the cheapest funding that is available that is used for the sake of buying a company that is targeted during the process of a leveraged buyout. This would make up fifty to eighty percent of the capital structure for the leveraged buyout. This provides an interest rate that is lower in comparison to other forms of financing. This is why this type of funding is the highest preference among investors. On the other hand, debts with banks are associated with covenants along with limitations as well that place restrictions on business regarding the payments of dividends for shareholders, increasing other debts with the bank and purchasing other businesses when the debt is regarded as being yet active. The time for paying back debts with banks is set for five to ten years. If there is the liquidation of the business prior to the full payment of the debt, the debt with the bank must be paid immediately.

There can also be the application of high yield debt. This is regarded as being debt that is not secured. It generally carries an interest rate that is considered to be quite high in order to provide good compensation for the investors who have risked their finances. This type of debt possesses limitations that are less restrictive in comparison to bank debts. In such cases that a business decides to undergo liquidation, it is required for there to be the payment of the high yield debt before any payment is provided for holders of equity. But this type of debt is still paid only after the debt with the bank has been paid first. This debt can be accessed via private institutional markets or public debt markets. The period for paying back this type of debt is set for eight to ten years. This type of debt sets forth options that offer bullet repayment details or early repayment details.

When we talk about capital markets, bonds, stocks, usually in reports we can read about the LBO model. I hope that this article was simple enough to help you to understand this concept.