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Leveraged buyout (LBO) is an acquisition strategy where one employs a significant debt relative to the total capital employed of the target company. . This strategy is commonly used by private equity / LBO firms like KKR, Blackstone, CVC Capital and TPG.
For example, On 1stJanuary 2011, ABC Private Equity has acquired XYZ company for an enterprise value (EV) of $1.0 billion. Thetransaction is funded by $750 million of debt (75% of capital structure) and $250 million of equity (25% of capital structure) from ABC Private Equity funds.
This investment strategy is used to generate attractive returns to the private equity firms during the time of exit from their investment—provided that business plan targets for the target company are achieved. With regards to the above example, after three years of owning XYZ company, on 31stDecember 2013, ABC Private Equity sold XYZ for an EV of $1.5 billion, post full repayment of debt of $750 million at the time of exit, the private equity firm made an equity return of $750 million (EV at exit - debt outstanding) return on an initial equity investment of $250 million equating to an equity IRR of 44%.

Rationale:

A highly leveraged entity has a lot of benefits for an equity investor, including the following:

  • Leverage effect: A marginal increase in the company’s enterprise value can lead to a substantial increase in the value of its equity (see above example). In a bullish scenario, the attractiveness of an LBO will, therefore, increase. On a flip side, the leverage effect also means that high leverage increases the risk factor of aa private equity firm, sincea relatively small decline in enterprise value could severely impact the value of the equity investment. Moreover, high interest charges increase the risk of default by the company becausethe target company has to use a higher proportion of its cash flows in servicing the interest cost.
  • Tax Shield: Interest on debt is tax deductible and the cost of debt is generally lower than the cost of equity. As a result, increasing a company’s gearing should reduce its cost of capital. In other words, given the effect of taxes, debt is cheaper than equity.
  • Management discipline: High leverage increases the discipline on management, since a company’s cash flow is usually quite tight due to the necessary pay-down of interest and debt. Management is, therefore, likely to focus on cost management and optimal capital expenditure.
  • Incentivise management: LBOs are mostlystructured with substantial incentives like bonuses, equity stake and options to managers. This is based on achievement of business targets set by the LBO firms to increase the value of the portfolio company. Theseinitiatives generally motivate the managers of the business to perform better and thereby increase revenues and margins—all of which would lead to a better valuationmultiple at the time of the private equity firm's exit.

Key characteristics of LBO candidates:

The LBO firm will seek to acquire companies with the following characteristics:

  • Company with strong management potential:Management is the key lever for growth, to drive cost management and hence margin expansion and value enhancement.
  • Strong companies with stable cashflows:The company needs to demonstrate stable cash flows since the company will be highly leveraged and need to be in a position to service debt on a regular basis.
  • Market leadership in the operating business:This will ensurestability in cash flows and relatively less capital expenditure requirements to fund growth.
  • Strong exit opportunities:The target company should convince the financial investor with strong exit opportunities in the form of trade sale, secondary buyout or initial public offering.

Key LBO terminology:

Enterprise value: Enterprise value (EV) is calculated by adding together a company's market capitalization, its debt such as bonds and bank loans, other liabilities such as a pension fund deficit and subtracting liquid assets like cash and investments.
IRR:Internal rate of return (IRR) is a measure of return on an investment that takes both the size and timing of cash flows into account.
Senior debt:Senior debt is a debt that is paid first in the event of a default.
Subordinated debt:Subordinate debt is debt,whichin the event of a default, is repaid only after senior debt has been repaid. It is higher risk than senior debt.
Coupon:The interest paid on a bond expressed as a percentage of the face value. If a bond carries a fixed coupon, the interest is usually paid on an annual or semi-annual basis.
Trade sale:A trade sale is a common way of exit to a trade buyer. This allows the management to withdraw from the business and may open up the prospect of collaboration on larger projects.
Secondary buyout:Secondary buyoutrefers to an investment in an existing private equity backed company, which can enable the incumbent investor to realise the value of their investment.
 
Sources: Reuters, mergers-acquisitions.org
Learn about Leveraged buyouts through our Financial Analysis Course called IFAP (Imarticus Financial Analysis Course)

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