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Resources Valuation Leveraged Buyout (LBO)
Leveraged Buyout (LBO)
The use of significant leverage for acquisitions
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What is a Leveraged Buyout (LBO)?
In corporate finance, a leveraged buyout (LBO) is a transaction where a
company is acquired using debt as the main source of consideration.
These transactions typically occur when a private equity (PE) firm
borrows as much as they can from a variety of lenders (up to 70 or 80
percent of the purchase price) and funds the balance with their own
equity.
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Why Do PE Firms Use So Much Leverage?
Simply put, the use of leverage (debt) enhances expected returns to the
private equity firm. By putting in as little of their own money as
possible, PE firms can achieve a large return on equity (ROE) and
internal rate of return (IRR), assuming all goes according to plan. Since
PE firms are compensated based on their financial returns, the use of
leverage in an LBO is critical in achieving their targeted IRRs (typically
20-30% or higher).
While leverage increases equity returns, the drawback is that it also
increases risk. By strapping multiple tranches of debt onto an operating
company the PE firm is significantly increasing the risk of the
transaction (which is why LBOs typically pick stable companies). If cash
flow is tight and the economy of the company experiences a downturn
they may not be able to service the debt and will have to restructure,
most likely wiping out all returns to the equity sponsor.
What Type of Company is a Good Candidate for an LBO?
Generally speaking, companies that are mature, stable, non-cyclical,
predictable, etc. are good candidates for a leveraged buyout.
Given the amount of debt that will be strapped onto the business, it’s
important that cash flows are predictable, with high margins and
relatively low capital expenditures required. This steady cash flow is
what enables the company to easily service its debt. In the example
below, you can see in the charts how all available cash flow goes
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towards repaying debt and the total debt balance (far right chart)
steadily decreases over time.
The above screenshot is from CFI’s LBO Model Training Course.
What are the Steps in a Leveraged Buyout (LBO)?
The LBO analysis starts with building a financial model for the operating
company on a standalone basis. This means building a forecast five
years into the future (on average) and calculating a terminal value for
the final period.
The analysis will be taken to banks and other lenders in order to try and
secure as much debt as possible to maximize the returns on equity.
Once the amount and rate of debt financing are determined, then the
model is updated and final terms of the deal are put into place.
After the transaction closes, the work has just begun, as the PE firm
and management have to add value to the business by growing the top
line, reducing costs, paying down debt, and finally realizing their return.
Summary of Steps in a Leveraged Buyout:
1. Build a financial forecast for the target company
2. Link the three financial statements and calculate the free cash flow
of the business
3. Create the interest and debt schedules
4. Model the credit metrics to see how much leverage the transaction
can handle
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5. Calculate the free cash flow to the Sponsor (typically a private
equity firm)
6. Determine the Internal Rate of Return (IRR) for the Sponsor
7. Perform sensitivity analysis
Image Source: CFI’s Leveraged Buyout Course.
LBO Financial Modeling
When it comes to a leveraged buyout transaction, the financial modeling
that’s required can get quite complicated. The added complexity arises
from the following unique elements of a leveraged buyout:
A high degree of leverage
Multiple tranches of debt financing
Complex bank covenants
Issuing of Preferred shares
Management equity compensation
Operational improvements targeted in the business
Below is a screenshot of an LBO model in Excel. This is one of many
financial modeling templates offered in CFI courses.
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Additional Resources
Thank you for reading CFI’s guide to Leveraged Buyout (LBO). To
further your education, see the following CFI resources:
Free Guide to Financial Modeling Best Practices
DCF Modeling Guide
How to Link the 3 Financial Statements
Degree of Total Leverage
Corporate Finance Career Map
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