Understanding Core Concepts

Understanding Leveraged Buyouts (LBOs)

Leveraged buyouts (LBOs) are widely popular within the realm of acquisitions. Whether it be investment banking or private equity, LBOs are a key component in how these verticals are able to function. Additionally, if you’re looking to break into investment banking or private equity, there is a very high likelihood that they are looking for candidates who understand the dynamics of an LBO and how they provide value to investors. Private equity places a large emphasis on understanding how to perform an LBO model and will most likely make the interviewee walk through how to conduct one step-by-step. Being able to understand these concepts will put you one step ahead of others when breaking into this competitive sphere.

Let’s take a look…

What is a Leveraged Buyout (LBO)?

A leveraged buyout is the acquisition of another company using a large amount of debt (loans & bonds). This is what the name “leverage” suggests, as many firms seek to use debt in order to cover costs of the acquisition without giving up their own cash or equity. Typically in an LBO, the assets form the company being acquired are used as collateral if the acquiring firm were to fail to repay their debt.

Why Would a Firm Want to do an LBO?

Leveraged buyouts are unique as they allow much smaller companies to acquire companies who are relatively much larger. This allows the smaller company to leverage a relatively small amount of their assets in hopes to either take a larger company private or restructure and grow it for future sale. Many private equity firms take part in LBOs as they are able to leverage a small amount of capital in order to acquire or invest in large positions within a company in hopes of growing the firm for future sale (“cashing out”).

Leveraged buyouts take place mainly for three reasons:

1. To take a public company private (typically for restructuring and growth)

2. To sell a portion of a business (spin-off)

3. To transfer ownership of private property

It is important to note that when conducting an LBO, firms are taking a risk, but they are giving up relatively little amounts of equity. This provides value as the acquirer doesn’t have to give up a large position of their equity in order to acquire another firm. They can give up a small portion versus using their own funds to acquire the company. This eliminates having to give up your own capital while investing in another position. Obviously these positions will have to be covered eventually, but there is no initial loss in equity from the acquirer. If the acquiring firm were to default, the target firm’s assets are used as collateral.

Understanding the Characteristics of an LBO

Leveraged buyouts typically consist of a ratio of around 90% debt and 10% equity. This allows acquiring firms to give up small positions of their equity in order to amplify their growths. It is also important to note that this ratio makes the bonds highly speculative thus classifying them as junk bonds.

Leveraged buyouts are a little interesting in the fact that these acquiring firms are using the target firm’s profitability - in terms of its balance sheet and cash flows - against itself as collateral.

What Makes a Company Attractive for an LBO?

Private equity firms typically target mature, stable, and established companies when they consider acquisitions. Speculative industries and companies provide a great deal of risk, thus higher likelihood of lower cash flows and higher chance of default. This would cause the acquirer to lose their assets that were used as collateral if this were to happen. The bottom line: gains. No private equity firm wants to take a great deal of risk when leveraging themselves in positions of great magnitude.

Advantages and Disadvantages of an LBO

Advantages:

1. Allows smaller firms to acquire larger firms (leverage)

2. Increases your rate of return (smaller investment has larger control)

3. Minimizes equity contribution (leverage)

4. Can be financed using SBA-backed loans (allow the company to be acquired with 10% equity)

Disadvantages:

1. Little financial cushion (left financially exposed if problems arise)

2. Equity can disappear - and fast (if the acquisition fails, everything can be lost as those assets that were acquired are used as collateral)

3. Cannot secure additional financing, as the loans use the target business’ assets as collateral

Key Takeaways

• An LBO is the acquisition of another company with the use of borrowed funds (loans or bonds)

• Popularity of LBOs declined in the 2008 financial crisis, but have recently picked up momentum again

• Typically has a debt/equity ratio of 9:1 (almost entirely borrowed funds)

• LBOs are seen as predatory and aggressive, as they use the target companies balance sheet and profitability against it - pledging their assets as collateral