Leveraged Buyout

Leveraged Buyout (LBO): Economics and Return Analysis

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EconomicsIn this part, the Part 4 of my article on LBO, I’m going to run you through its economics – the metrics used to judge an LBO candidate and how it generates returns. But before reading further, you may want to take a glimpse of my previous articles on LBO through the following links so that we’re on the same page.

Part1: Leveraged Buyout – An Overview

Part2: Leveraged Buyout – What Makes a Strong LBO Candidate?

Part3: Leveraged Buyout – Key Participants

Metrics Used To Judge An LBO Candidate

There are two metrics that defines the attractiveness of an LBO candidate – (1) Internal Rate of Return (IRR), and (2) Cash Returns.

IRR is the primary metric that measures the total return on the sponsor’s equity investment (which includes additional capital infused or dividends received) during the investment period. For everybody’s benefit, an IRR is the discount rate at which NPV of all the cash flows (inflow and outflow) becomes zero.

The drivers that affect IRR are:

  • target’s financial performance
  • acquisition price
  • financing structure, especially the equity contribution made
  • exit multiple, and
  • holding period.

As mentioned in my first article – LBO: An Overview –, a sponsor seeks a minimum of 20% return on their investment over their holding period of five years. So, it’s obvious (looking at the drivers of IRR) that minimizing the equity contribution and acquisition price, while exiting at a higher valuation by boosting the financial performance of the target, fetches handsome returns.

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Leveraged Buyout (LBO): Key Participants

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ParticipantToday, let’s discuss the key participants involved in an LBO transaction and the role they play in leading the LBO to its success. But before proceeding further, you may want to take a glance at the following parts that highlight my previous write-ups on LBO.

Part1: Leveraged Buyout: An Overview

Part2: Leveraged Buyout: What makes a Strong LBO Candidate?

I’ll start this article with the financial sponsors and investment bankers, and offer insights in detail, followed by a note on investors and target’s management. As you read through it, you will unearth each of the stakeholder’s activities and how they look at the transaction. You will also discover that the sponsor, I-Banker and target management drive the deal.

(1) Financial Sponsors are the private equity firms (PE), merchant banking divisions of investment banks, hedge funds, venture capital (VC) funds and special purpose acquisition companies (SPACs). PE firms, hedge funds, and VC funds raise majority of their investment capital from third-party investors such as pension funds, insurance companies, endowments and wealthy families / individuals (also known as HNI).

This raised capital is organized into funds that are usually established as limited partnerships, in which the General Partner (GP) – the sponsor – manages the day-to-day activities of the fund and are compensated with 1-2% of the committed fund as management fee, besides 20% “carry” on the investment profit.

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Leveraged Buyout: What Makes A Strong LBO Candidate?

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In this article, I’ll discuss the characteristics that define a strong LBO candidate, but before proceeding further, you may want to review my previous article on “Leveraged Buyout: An Overview”.

During the due diligence process, the financial sponsor evaluates the characteristics of an LBO candidate (including its strengths and risks). Most of the time, an LBO candidate will be one or combination of the following, but irrespective of the situation, the target becomes a LBO opportunity only if it can be acquired at a price and using a financing structure that generates acceptable returns with a viable exit strategy.

  • Non-core or under-performing business unit of a large enterprise
  • Distressed company with a turnaround potential
  • A public company that is perceived as undervalued
  • A public company that is considered as a high growth potential but not being exploited by its current management
  • A solid performing company with a compelling business model, defensible competitive position and strong growth potential. This may also tally with the above point
  • Companies in fragmented markets that can be consolidated into a single entity with higher size, scale and efficiency. This is called roll-up strategy.

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Leveraged Buyout (LBO): An Overview

Nitin GargLeave a comment

LBOIn 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.

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