LBO.docx

Leveraged Buyout
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. 
 

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.
 
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.
 
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. An IRR is the discount rate at which Net Present Value (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.
 
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.
In case of cash return analysis, the sponsor looks at the return as a multiple of his cash equity investment. However, one important point to keep in mind here is that cash return approach does not take into account the time value of money.
 
Example
In the following illustration, the sponsor contributes $300 million of equity (cash outflow) to the purchase price in Year0 as part of the financing structure and realizes $850 million of cash inflow at the end of Year5, thereby gaining an IRR of 23.2% and cash return of 2.83x (assuming no additional equity investment or dividend received during the holding period).
Equity Investment
(Year 0)
Equity /Dividend
(Year 1)
Equity /Dividend
(Year 2)
Equity /Dividend
(Year 3)
Equity /Dividend
(Year 4)
Equity Proceeds
(Year 5)
($ 300 M)
0
0
0
0
$ 850 M
By definition, IRR is:
($300M) + [0 / (1+23.2%)] + [0 / (1+23.2%)] + [0 / (1+23.2%)] + [0 / (1+23.2%)] + [$850M / (1+23.2%)] = 0
How Does An LBO Generate Returns?
An LBO generates returns through a combination of (i) debt repayment and (ii) growth in enterprise value.
To understand the concept, let's take the scenarios independently. Let's say the sponsor acquires a target for $1.0 billion with $300 million of cash equity (30% of the acquisition price) and $700 million of debt financing (70% of the acquisition price).
 
Scenario I: Debt repayment (but NO increase in EV)
 
Scenario I: Debt Repayment (NO increase in EV)
 
Assumptions
 
Acquisition Price
$ 1.0 Billion
Equity Contribution
$ 300 Million
Investment Horizon
5 Years
Sales Price
$ 1.0 Billion
Debt Repayment
$ 550 Million
In this case, let's assume that the target, during the investment horizon, generates a cumulative free cash flow of $550 million, which is used for debt repayment. As the debt is repaid over the holding period, equity value keeps on growing on a dollar-for-dollar basis. At the end of 5 years, when the sponsor sells the target for $1.0 billion (same price as the purchase price), the equity value of the sponsor increases from $300 million to $850 million (= $300 million + $550 million) despite no increment in the enterprise value. This generates an IRR of 23.2% and a cash return of 2.83x for the sponsor.
 
Scenario II: EV increases (but NO debt repayment)
 
Scenario I: EV Increases (NO debt repayment)
 
Assumptions
 
Acquisition Price
$ 1.0 Billion
Equity Contribution
$ 300 Million
Investment Horizon
5 Years
Sales Price
$ 1.55 Billion
Debt Repayment
$ 0
In this case, let's assume the sponsor does not repay any debt, but reinvests the entire free cash flow (after paying the interest expense) into the business to grow the enterprise value (EV). At the end of Year 5, he sells the target for $1.55 billion and realizes 55% increase in EV. Since the debt claim represents a fixed claim on the business, the EV growth of $550 million accrues entirely to the equity value, thereby raising it to $850 million (= $300 million + $550 million). This scenario also yields an IRR of 23.2% and a cash return of 2.83x.
Thus, we see that both the scenarios have an impact in the returns of the sponsor's equity investment. During the holding period, when the sponsor combines both debt repayment and EV growth together, the potential for higher returns increases tremendously. Usually, EV's growth is attributed to the growth of EBITDA, which is achieved through organic growth, "bolt-on" acquisitions, stream-lining of operations, cost savings, etc.

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