LBO Model (Leveraged Buyout)
In the last edition, we had discussed – What is Financial Modeling , and to take that discussion further, this time around we will we try and understand what is an LBO Model
- A leveraged buyout (LBO) transaction occurs when an investor acquires a controlling interest in a company’s equity through substantial use of debt.
- The investor (e.g., a private equity fund) invests a small amount of equity (relative to the total purchase price) and uses leverage (debt or other non-equity sources of financing) to fund the remainder of the consideration to be paid to the seller.
- The debt instruments used in an LBO transaction include a combination of bank and capital market instruments such as bonds and high-yield debt. The bonds used to finance an LBO transaction are typically not investment grade and, thus, involve significant risks.
Key stakeholders in an LBO transaction include:
- Target Co: The company being acquired under the LBO transaction
- New Investors: Financial sponsor or investors investing equity to buy the Target Company’s equity
- Lenders: Debt providers financing the LBO deal
- New Co: New entity or the company created after the LBO deal
Leveraged Buyouts – Characteristics of an ideal LBO candidate (“Target Co”)
- Low debt loads : Low debt to equity ratios
- Stable cash flows : Strong, predictable operating cash flows with which the leveraged company can service and pay the acquisition debt
- Steady business : Mature, steady (non-cyclical) business
- Tangible assets : Hard assets (property, plant and equipment, inventory and receivables) that may be used as collateral for lower- cost secured debt
- Scope for operational improvement :Potential for the new management to make operational or other improvement to the firm’s business to boost cash flows
- Low capital expenditure / working capital requirements :Moderate capital expenditure / product development (R&D) and working capital requirements, so that cash flows are not diverted from the principle goal of debt repayment
- Viable exit strategy : The company must present a viable exit strategy to the seller. The seller should be able to cash out his/her investment at all times, perhaps even through the divestiture of non-core subsidiaries
Leveraged Buyouts – Entry & Exit; Risk & Return Trade offs
Entry & Exit Multiples
- At the time of acquisition, a company is generally valued using valuation multiples (e.g., EV/EBITDA or debt to EBITDA); at the time of exit, an investor desires a higher valuation multiple, in order to cover the increased risk associated with high debt
- Common exit strategies include an outright sale of the company to a strategic buyer or another financial sponsor, an IPO, or recapitalization
- A financial buyer typically expects a return on its LBO investment within 3–7 years via one of these strategies
Risks – An LBO transaction is typically a ‘high-risk and high-return’ process. Given the high-risk nature of such deals, there are a number of risks in store for both equity and debt holders.
- Equity holders: Equity holders face increased operating risk, resulting from increased interest costs through high debt levels. Furthermore, any minor change in the enterprise value can have a significant impact on the equity value as the value of debt remains constant
- Debt holders: Debt holders face the risk of default, as an LBO-backed company is highly levered
Returns – The returns in an LBO transaction are driven by three factors: De-levering (paying down debt), operational improvement (margin expansion, revenue growth), and multiple expansion (buying low and selling high). Two common metrics used to evaluate LBO returns are hurdle rates and cash-on-cash returns
- Hurdle Rates: Financial buyers evaluate investment opportunities by analyzing the expected internal rates of return (IRRs). Historically, the hurdle rates (or the minimum required IRRs) have been in excess of 30%, but may be as low as 15–20% for particular deals under adverse economic conditions
- Cash on Cash Returns:Sponsors also measure the success of an LBO investment using a metric called “cash-on-cash” (CoC). CoC is calculated as the final value of the equity investment at exit divided by the initial equity investment and is expressed as a multiple. Typical LBO investments return 2.0x–5.0x CoC. If an investment returns 2.0x CoC; for example, the sponsor is said to have “doubled its money”
LBO Model is one of the most prominent models made in investment banking and a must in case you want to work in Private Equity or M&A.
We look forward to your comments and shares.