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.
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 towards repaying debt and the total debt balance (far right chart) steadily decreases over time.
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:
Build a financial forecast for the target company
Link the three financial statements and calculate the free cash flow of the business