In the past two weeks, I have written 22 articles, covering finance concepts, business strategy and advanced finance. This week onwards, I’m thinking of dedicating my articles to advanced finance, spending the next few weeks on one of my favorite topics in finance, the Leveraged Buyout (LBO), which is nothing but an acquisition of a target by some smart investors using debt to finance a large portion of the purchase price.
While it’s unclear about its history, it’s generally believed that LBOs were carried out in the years following World War II. Back in 1970s and 1980s, firms like Kolberg Kravis Roberts and Thomas H. Lee Company saw an opportunity to profit from companies that were trading at a discount to their net asset value through bust-up approach – buy the company, break them up and sell off the pieces (what is called the corporate raiding).
In this article, I’m going to present an overview on LBO, followed by a series of articles, discussing its characteristics, sources of capital, financing structure, economics and exit strategies. After reading this post, do leave your sincere thoughts in the comments section below.
As briefed above, a leveraged buyout is an acquisition of a company, business, division or asset that is financed with a combination of equity and borrowed funds (also called debt). The equity portion contributes 30 – 40% to the purchase price and debt portion 60 – 70%. This disproportionately high level of debt is secured by the target’s projected free cash flow (FCF) and asset base which enables the sponsor to contribute a relatively small portion of equity to the acquisition price. The ability to borrow such high levels of debt based on a small equity investment is vital to the financial sponsor to earn an acceptable return. This high level of leverage also provides a tax shield – they save on the taxes because interest expense on debt is tax deductible. The image above depicts the flow of funds and how it works. Pay attention to the arrows.
LBOs are used by financial sponsors to acquire a broad range of businesses (private, public, division or subsidiaries) with the goal of realizing an acceptable rate of return on their equity investment upon exit, typically through a sale or an IPO of the acquired business. Historically, financial sponsors have sought an annualized return of 20% for an investment horizon of five years.
Characteristics of a Strong LBO
A company with strong, stable and predictable cash flow and good asset base serves as an attractive LBO candidate. This is the most important characteristic of a LBO candidate. The strong cash flow gives the creditors an assurance for servicing the scheduled interest payments and the strong asset base provides greater comfort to the lenders. Combination of these two factors (strong cash flow and asset base) increases the chance of acquiring a higher bank loan. However, when the credit markets are robust, creditors focus more on the cash flow generation ability of the target. I’ll discuss more on this in the subsequent articles.
Sources of Capital
The debt portion in a leveraged buyout is sourced through various types of loans, securities, and other financial instruments. The prevailing debt market condition plays a vital role in determining the leverage levels, the cost of financing and key terms. Because the entity often has a high debt/equity ratio, the issued securities (like bonds) are usually not of investment grade and are referred to as junk bonds.
Depending on the size and purchase price of the acquisition, the debt is provided in different tranches:
- Senior debt, which is supported by assets, has the lowest interest margins
- Junior debt (usually mezzanine debt) is usually unsecured and hence, carry a higher interest margin
In large deals, all/part of these two types of debt is replaced by high-yield bonds (also known as junk bonds). Depending on the size of the LBO, debt and equity portion can be funded by more than one party. In larger transactions, debt is often syndicated in an attempt to diversify the investment and hence, mitigate its risk. Another form of debt that is used in LBOs is seller notes – the seller effectively uses parts of the sales proceeds to grant a loan to the borrower. Such seller notes are prominent in management buyout (discussed below) or in situations with very limited bank financing.
As a rule of thumb, senior debt carries an interest rate of 3–5% (on top of LIBOR) with a payback period of 5–7 years, and junior debt 7–15% with a payback after 7-10 years in one installment. The junior debt often comes with warrants with payment-in-kind for its interest payments.
The equity portion of the LBO financing structure is usually raised from a pool of capital managed by the sponsor. These funds often range from tens of millions to tens of billions of dollars.
Investment Horizon
During the investment horizon of the sponsor, the cash flow of the target serves as the primary source of capital to service and repay the debt. As the debt portion of the capital structure decreases because of its repayment, the equity portion increases. During this period, the sponsor also aims to improve the performance of the acquired business and grow it through various strategies (including “bolt-on” acquisitions), thereby increasing its enterprise value and further enhancing its potential returns. One important point to keep in mind while structuring the deal is that LBO financing structure must balance the target’s ability to service and repay debt with its need to use cash flow to manage and grow the business.
Key Participants
LBOs demand certain key participants to play a key role. One such participant is investment bank. Investment banks arrange and underwrite the debt used to fund the acquisition. They provide a financing commitment to support the sponsor’s bid in the form of legally binding letters – the commitment papers – which promise funding for the debt portion against various fees and subject to certain conditions (including the sponsor’s contribution of acceptable levels of cash equity).
Economic Condition
When the economy is robust, the number of LBO deals increases because of low interest rates which makes the cost of debt financing inexpensive. It also increases when the economy is under performing (thus making the target undervalued). However, as the number of LBO deals increases, competition also increases which eventually drives up the premiums paid for the targets.
History of LBO
I’m not going to discuss much about the history of LBO, but will definitely mention one popular deal that happened in 1988. In this year, KKR purchased RJR Nabisco for $24 billion in what was at that time considered to be the largest LBO deal in the history. The deal was eventually immortalized in a book and in a television movie, both of them entitled “Barbarians at the Gate.”
Risks and Advantages of LBO
The most obvious risk of an LBO is that of financial distress. In events such as economic recession, litigation, or changes in the regulatory environment, there may difficulties while making periodic interest payments, and can welcome liquidation or technical default (violation of the debt covenant). Besides, weak management at the target and misalignment of their incentives with the shareholders can also lead to a failed LBO.
On the flip side, apart from the tax savings (because of the tax deductibility on the debt interest payment), there are other advantages of LBO. Large interest payments and repayment of the principal amount can compel the management to improve/enhance the financial performance and operational efficiency of the target and initiate strategic moves like divesting in non-core businesses, downsizing, cost cutting or investing in better technology which, otherwise, would not have been taken up.
There is another important characteristic of an LBO which contributes to its success. The top executives are encouraged to commit a significant portion of their personal net worth to the deal. Through this step, the financial sponsor guarantees that management’s incentives are aligned with its own.
Management Buyout
Management Buyout (MBO) is type of LBO that occurs when the management of the company decides to buy the company from the parent or private owners. They can also take their public company or a division of the company private. The managers may invest some of their own capital with the remaining portion contributed by the investors while the bulk of the funds are borrowed. Once the acquisition is completed, the acquired entity becomes a separate company with its own shareholders, board of directors and management team. In an MBO, the buyers are outsiders, but in LBO, the buyers are insiders.
This brings us to the end of the overview section. The next article will feature the characteristics of a strong LBO. Stay tuned …
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