LBO – Leveraged Buyout

The use of significant leverage for acquisitions

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 fund the balance with their own equity.

 

LBO

 

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 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 them to service the debt.

 

What are the steps involved in an 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.

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.

 

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:

  • High degree of leverage
  • Multiple tranches of debt financing
  • Complex bank covenants
  • 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.

 

LBO financial model example

 

To learn more about the above model and learn step-by-step launch our financial modeling courses now!

 

Additional information

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

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