Leveraged Buyout (LBO)

This article outlines what an LBO is, why leverage is employed, and what steps are involved in the transaction.

What is a 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 fund the balance with their own equity.

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 huge 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.

What type of company is a good candidate for a 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 them to service the debt.

What are the steps involved in a 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 at a terminal value for the final period.

Next, the analysis will be taken to banks and other lenders to try and secure as much debt as possible to maximize the equity returns.  Once the amount and rate of debt financing is determined, the model is updated and final terms of the deal are put into place.

After the transaction closes the work as 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.

Additional information

Read more about a specific type of LBO called a management buyout (MBO).

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