Leveraged Buyout (or LBO) is an important concept in private equity interviews. You are guaranteed to get questions related to LBO during the technical interview round for any private equity firm. However, not many candidates can confidently answer these questions. The reasons for this are first because leveraged buyout is a fairly advanced concept in finance, and second because there are many steps and assumptions involved in the construction of an LBO model, which makes it harder for a candidate to organize their thoughts at the snap of the moment.
1. What is Leveraged Buyout (LBO)?
Leveraged Buyout (LBO): is the way a private equity firm works. Private equity firms acquire an undervalued company with the goal that the target company will get better operationally and financially. But unlike a normal M&A transaction, a private equity firm will not hold the company forever. They will sell the target company once the internal rate of return (IRR) from their investment exceeds their goal, ideally for a higher price. Più muscoli: questi sono i nuovi comandamenti per un bodybuilding di successo natural trenbolone 75 video vintage di bodybuilding nonna.
You can conceptualize this process using the home-flipping example. A PE firm would search for an undervalued company that has potentials for yielding high returns and then purchase it, just like a real estate investor seeks to acquire a house. The real estate investor use a combination of down payment and a mortgage to finance their purchase, while the PE use a combination of debt and cash. The real estate investor will renovate the property to sell it at a higher price. Likewise, A PE firm will run the company for several years to improve management and sell the company eventually to profit from the markup in selling price.
2. Why Leveraged Buyout (LBO)?
Leveraged Buyout (LBO) is often very attractive because private equity firms prefer to use as much debt and as little of their money as possible in funding a deals because:
- Using debt reduces upfront cost of acquisition, which makes it easier to PE firm to earn higher returns
- The PE firms can use the company’s cash flows to repay the debt and make interest payments.
Private equity firms benefit tremendously from LBO and they do so through taking advantage of a legal structure that makes LBO possible.
The PE firm does not technically own the company in a leveraged buyout. Instead, it forms a holding company, which it owns, and it is this holding company that acquires the target company. Banks and other lenders that help finance the transaction lend to this holding company, so the debt is at the holding company level. Managers and executives owning shares after the deal takes place actually owns shares in the holding company. This structure is important because it means that the acquired company is responsible for paying all the debt, not the PE fund. The PE firm not only borrows other peoples’ money to do the deal, but it doesn’t even borrow the money directly – the company borrows money so the PE firm can do the deal.
3. What Makes an Ideal Candidate for an LBO?
| Characteristics | Ideal LBO Candidate |
|---|---|
| EBITDA Multiple (EV/EBITDA) | Lower to mid-range EBITDA multiple (determined by comparable company analysis) |
| Balance Sheet | Significant fixed assets like PP&E to be used as debt collateral |
| Income Statement | Low fixed cost, high recurring revenue, high EBITDA, revenue growth not really essential |
| Cash Flow Statement | Stable cash flows, minimal capital expenditure and/or working capital requirements. |
| Management Team | Strong CEO and CFO, ideally rolling over their equity to participate in the LBO |
| Industry | High barriers to entry, growing industry with little risk of technological disruptions, ideally a market leader in a fragmented industry |
4. Walk Me Through a Leveraged Buyout (LBO)
Having understood conceptually what LBO is and how it works, it is now helpful to transition into building the model. There are four steps involved in an LBO model.
Step 1: Make basic transaction assumptions
At the most basic level, you need to know the purchase enterprise value and the proportion of debt and equity used. To calculate the acquisition price (or enterprise value) for a public company, you would calculate the purchase equity value and then adjust for cash and debt in order to arrive at the enterprise value.
There are no hard and fast rules to calculating purchase enterprise value as it gets confusing when existing investors and the management team roll over their shares in the transactions and sometimes fees are involved. So it is best to be flexible with this item on the model.
In making assumptions about how much debt is required for a deal, analysts often use multiple tranches of debt depending on investors’ risk appetite. PE firms might be risk-seeking and go up to 6x Debt/EBITDA. They have to find investors who are willing to make loans that are similar to them in their risk appetite. These more aggressive investors might be hedge funds, merchant banks, or mezzanine funds; they could also be institutional investors that specialize in higher-risk Debt.
Step 2: Project cash flows and debt repayment
In order to project cash flows and debt repayment, some key assumptions about the business’ financial conditions need to be made. Assumptions, however, vary depending on the level of details given. Oftentimes, analysts will make key forecasts for the following metrics:
Here is another example of key financial assumptions about the business’ operations
In a more detailed version, you would make three groups of assumptions: the base case (if the business operates as normal), the upside case (if the business goes right), and the downside case (if the business goes wrong). The next step for you is to create a dynamic model that allows you to choose the case you want to use for the analysis.
Having established forecasts and scenarios, you would then go about modeling financial statements for 5 years into the future. Analysts often start with the income statement, and then the balance sheet, and finally the cash flow statement. In the process of doing this, it is important to remember how the three financial statements are linked together. Another key part that will help with arriving at the final future free cash flow is supporting schedules. Supporting schedules are sections in an LBO model that help fill in information that cannot be worked out using just three financial statements. Those include a working capital and depreciation schedule and debt & interest schedule.
Example of working capital and depreciation schedule
Example of debt and interest schedule
Step 3: Make exit assumptions and calculate the returns
At the end of the projection period, we will assume that the PE firm sells the company to another firm, a normal company or another PE firm. Normally, we will use an EBITDA exit multiple to calculate the exit enterprise value. For example, if we use a 10x EBITDA exit multiple, and the EBITDA at the end of the 5 year projection period is $100 million, then we get the exit enterprise value of $1000 million.
The standard assumption in an LBO model is that the PE firm must pay the remaining debt balance upon exit and claim the company’s cash. Therefore, in calculating the equity proceeds to the PE firm, we subtract net debt and add cash. However, the assumption on cash is often murkier. If the remaining cash is not substantial, the PE firm might claim the cash. On the contrary, if the company has significant excess cash, the PE firm might also have a choice to issue a dividend to itself.
The next step is to calculate return metrics. Two return metrics often used in private equity are internal rate of return (IRR) and Money-on-money multiple (otherwise known as MOIC). A detailed elaboration on IRR and MOIC can be found in this article.
Rules of thumbs for calculating IRR:
The most important approximations are as follows:
- Double Your Money in 1 Year = 100% IRR
- Double Your Money in 2 Years = ~40% IRR
- Double Your Money in 3 Years = ~25% IRR
- Double Your Money in 4 Years = ~20% IRR
- Double Your Money in 5 Years = ~15% IRR
- Triple Your Money in 3 Years = ~45% IRR
- Triple Your Money in 5 Years = ~25% IRR
We can even go further and perform a returns attribution analysis.
For the return from EBITDA growth, we subtract the initial EBITDA from the final year EBITDA and multiply the difference by the purchase EBITDA multiple and multiply by the PE firm’s ownership percentage.
For the returns from Multiple Expansion, we subtract the Initial Multiple from the Exit Multiple, multiply by the Final Year EBITDA, and then multiply by the PE firm’s ownership %.
For the return from “Debt Paydown and Cash Generation” we take the Total Return to Equity Investors and subtract the returns sources above.
Step 4: Draw conclusions
In order for the conclusions to be comprehensive, analysts often perform sensitivity analysis on key variables such as purchase and exit multiples, debt level, revenue growth, and EBITDA margin levels. Based on the IRRs and MOICs from the sensitivity analysis, you then evaluate if it is a good investment for the PE firm.
Your final recommendation should look something like this:
“Since we could realize an IRR of 20% and a MoM multiple of 2.5x in our Base Case and a 1x multiple even in the most pessimistic scenarios, we recommend doing the deal and acquiring Company X for an EV / EBITDA multiple of 10.0x. The company has been spending progressively less on CapEx as a % of revenue over time, even when its revenue is growing year on year. Even if its growth rate declines to the levels it were during the midst of the pandemic recession in March, the math still works. For the deal not to work, the company’s revenue growth would have to decline to (-15%), which is well below even the worst-performing company in the industry.”
We hope that the fundamentals of the leveraged buyout model are covered well in this article. LBO is an advanced model that requires sophisticated understanding of financial and operational situations of a business, as well as different forms of funding. The LBO model also requires a lot of flexibility. Depending on the fine prints of the transactions, the model might vary in terms of its level of details and difficulties of calculations. That said, LBO is an extremely important model in private equity, and for anyone who wants to break into this industry, understanding how to build the model is what you need to do as an analyst.
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FAQs
What does LBO stand for? ›
A leveraged buyout, or LBO, is the process of buying another company using money from outside sources, such as loans and/or bonds, rather than from corporate earnings.
What does LBO stand for on Wall Street? ›What Is a Leveraged Buyout? A leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company.
What is an example of LBO? ›Private equity companies often use LBOs to buy and later sell a company at a profit. The most successful examples of LBOs are Gibson Greeting Cards, Hilton Hotels and Safeway.
What makes an attractive LBO candidate? ›What Makes a Good LBO Candidate? LBO Candidates are characterized by strong, predictable free cash flow (FCF) generation, recurring revenue, and high profit margins from favorable unit economics.
Is LBO Modelling difficult? ›The leveraged buyout model (LBO) is often viewed as extraordinarily complex, but it shouldn't be. This video series will teach you how to build an LBO model, and introduce you to purchase accounting, making balance sheet adjustments and detailed debt schedules.
Is an LBO a hostile takeover? ›LBOs are also commonly known as hostile takeovers because the management of the targeted company may not want the deal to go through. Leveraged buyouts tend to occur when interest rates are low, reducing the cost of borrowing, and when a particular industry or company is underperforming and undervalued.
Is LBO good or bad? ›Leveraged buyouts (LBOs) have probably had more bad publicity than good because they make great stories for the press. However, not all LBOs are regarded as predatory. They can have both positive and negative effects, depending on which side of the deal you're on.
Is it illegal to do a leveraged buyout? ›An LBO transaction shall be considered unlawful only if carried out without valid commercial reasons and for the exclusive purpose of fraudulently obtaining a tax advantage.
What is the largest LBO ever? ›- Safeway (1988): $4.2 billion.
- Energy Future Holdings(2007): $45 billion.
- Hilton Hotels (2007): $26 billion.
- PetSmart (2007): $8.7 billion.
- Alltel (2007): $25 billion.
- Kinder Morgan (2006): $22 billion.
- HCA Healthcare (2006): $33 billion.
A leveraged buyout (LBO) occurs when someone or an entity purchases a company using almost entirely debt. The purchaser secures that debt with the assets of the company they're acquiring, and it (the company being acquired) assumes that debt.
How does an LBO make money? ›
A leveraged buyout (LBO) is a type of acquisition whereby the cost of buying a company is financed primarily with borrowed funds. LBOs are often executed by private equity firms who raise the fund using various types of debt to get the deal completed.
Why leveraged buyouts are in trouble? ›Higher costs and slowing economic growth will squeeze the profits of private-equity-owned firms. With share prices lower it becomes harder to sell or float firms at attractive valuations.
What are the risks of an LBO deal? ›Risks Of An LBO
Three key types of risks associated with LBOs are often interest rate risk, depending on the type of financing structure, as well as operational risks and the possibility of an industry shock.
What is a leveraged buyout? A leveraged buyout, also called an LBO, is a financial transaction in which a company is purchased with a combination of equity and debt so the company's cash flow is the collateral used to secure and repay the borrowed money.
What are the three main drivers of LBO returns? ›- De-levering (paying down debt)
- Operational improvement (e.g. margin expansion, revenue growth)
- Multiple expansion (buying low and selling high)
A business with sustainable and healthy cash flow is an attractive LBO candidate. For example, business in mature markets, constant customer demand, long-term sales contracts, and strong brand presence signify steady cash flow generation.
Why are managers likely to work harder after an LBO? ›Why are managers likely to work harder after an LBO? The managers have greater ownership interest.
How long does it take to learn an LBO? ›Basic LBO Modeling Test – A relatively easy practice test that usually takes around 45 minutes (and an hour at most).
How long should it take to do a paper LBO? ›Most Paper LBOs must be completed in 10-15 minutes. And Interviewees must write out and show all of their calculations. For most candidates, the two scariest aspects of the process are: On-the-spot Mental Math.
Can LBO be higher than a DCF? ›11. Would an LBO or DCF give a higher valuation? Technically it could go either way, but in most cases the LBO will give you a lower valuation.
What happens to shareholders in an LBO? ›
LBOs transform ailing companies by taking them private and restructuring them. During an LBO, shareholders face a grab bag of benefits and risks as they relinquish ownership to the private equity firm and management team.
Are leveraged buyouts ethical? ›LBOs also raise a number of ethical issues, notably about conflicts of interest between managers or acquirers and shareholders, insider trading, stockholders' welfare, excessive fees to intermediaries, and squeeze-outs of minority shareholders.
What happens to cash in an LBO? ›In a leveraged buyout, or LBO, the acquiring firm or entity uses the cash and other highly liquid securities on the target's balance sheet to pay off the debt from the acquisition. This is one reason companies like to keep cash and other marketable securities low as reported on the balance sheet.
What is the minimum cash for LBO? ›Minimum cash balances might range anywhere from 2% to 10% of sales. Company management will have a pretty good idea of what figure to use, as might more senior investment bankers. In any case, don't lose any sleep over this number.
How to do a leveraged buyout with no money? ›In principle, a buyer can acquire a business with 'no money down' if the seller's asking price is lower than the value of the company's assets. For this strategy to work, the seller has to sell the company for 90% of the assets value (or less).
Can a company refuse a buyout? ›Planning Ahead. Your partners generally cannot refuse to buy you out if you had the foresight to include a buy-sell or buyout clause in your partnership agreement. These clauses and provisions set terms in advance regarding how the company will proceed if one partner wants out.
Is an LBO considered M&A? ›An LBO is often carried out as part of a mergers and acquisitions (M&A) strategy. Sometimes, LBOs are also used to acquire competitors and enter new markets to allow a company to diversify its portfolio. But business people and private equity firms very often opt for an LBO due to the tax aspects.
Can a buyout be forced? ›Absent breach of a contract or the law, a shareholder can't typically force another shareholder to sell. But a shareholder can seek to enforce the terms of a buy-sell agreement, a shareholder agreement, or another valid contract.
Are LBOs still popular? ›Leveraged buyouts (LBOs) continue to be a popular choice in the merger and acquisition environment. This type of financing is characterized as one in which purchase of the target company is financed through a mix of equity and debt, and the cash flows or assets are then used to secure and repay the debt.
What is the difference between an LBO and M&A? ›Leveraged Buyout Models
Unlike an M&A model where the acquirer is often a strategic buyer, the private equity firm is more return-driven, and the LBO model is, therefore, more focused on the Internal Rate of Return (IRR) of the transaction.
Do investment banks use LBO? ›
Investment bankers typically use LBO analysis to obtain an LBO market value for a company.
What happens to goodwill in an LBO? ›Goodwill, which is not an identifiable asset, is eliminated to facilitate the calculation of net identifiable assets. To reflect this change eliminate goodwill on the balance sheet and reduce retained earnings by the same amount.
Who is one of the largest financier of LBO in the world? ›Some well-known private equity firms in the business of doing LBOs are Kohlberg Kravis Roberts & Co. (NYSE: KKR), Blackstone Group LP (NYSE: BX), Carlyle Group LP (NASDAQ: CG), Texas Pacific Group (TPG Capital), Bain Capital and Goldman Sachs Private Equity.
What happens to existing debt in an LBO? ›For the most part, a company's existing capital structure does NOT matter in leveraged buyout scenarios. That's because in an LBO, the PE firm completely replaces the company's existing Debt and Equity with new Debt and Equity.
What are the key drivers of an LBO? ›The core drivers of value creation in an LBO are Purchase Price, Cash Flow, and EBITDA Expansion.
Why shouldn't you hold a leveraged ETF? ›In the long term, new risks arise. Because of how leveraged ETFs are constructed, they are only intended for very short holding periods, such as intraday. Over time, their value will tend to decay even if the underlying price movements are favorable.
What is an alternative to leveraged buyout? ›Possible alternatives to an LBO include purchase of the company by employees through an Employee Stock Ownership Plan (ESOP), or a merger with a compatible company.
How do you structure an leveraged Buy Out? ›- Build a financial forecast for the target company.
- Link the three financial statements and calculate the free cash flow of the business.
- Create the interest and debt schedules.
- Model the credit metrics to see how much leverage the transaction can handle.
With leveraged buyouts, the overall goal is to increase the company's equity value as the debt is paid off. Therefore, making more profits for investors. Purchasing a company through an LBO is similar to taking a mortgage on a home. You make a down payment on the home and borrow the rest of the money from the bank.
What are the three ways to create returns through an LBO transaction? ›- De-levering (paying down debt)
- Operational improvement (e.g. margin expansion, revenue growth)
- Multiple expansion (buying low and selling high)
How does the LBO process work? ›
In an LBO, the existing owners of the company (the "target firm") typically sell a majority or all of their shares to the buyer, who then assumes the company's debt. The buyer then uses the company's assets and cash flow to pay off the debt taken on to finance the purchase.
How do you evaluate an LBO? ›An LBO transaction is evaluated by calculating an internal rate of return (IRR). The IRR compares the equity investment upon exit versus the amount invested at entry and calculates an annualized return on the investment.
What are the risks of leveraged buyout? ›Risks Of An LBO
Three key types of risks associated with LBOs are often interest rate risk, depending on the type of financing structure, as well as operational risks and the possibility of an industry shock.
Using Goal Seek to Value a Company in an LBO
You can use Goal Seek (Alt + A + W + G) to determine how much a private equity firm could pay for a company, if it exits at a specific multiple and is targeting a specific IRR or cash-on-cash multiple.
A leveraged buyout is when one company is purchased through the use of leverage. There are four main leveraged buyout scenarios: the repackaging plan, the split-up, the portfolio plan, and the savior plan.
How long does it take to learn LBO? ›Basic LBO Modeling Test – A relatively easy practice test that usually takes around 45 minutes (and an hour at most).
What is the difference between DCF and LBO? ›What is the Difference Between LBO and DCF? In an LBO, all cash flows between the parties involved are modeled to estimate each party's rate of return. In DCF analysis, cash flows are also modeled, but the rate of return is estimated based on risk to provide an estimated value for that particular investment.
Does LBO or DCF give a higher valuation? ›11. Would an LBO or DCF give a higher valuation? Technically it could go either way, but in most cases the LBO will give you a lower valuation.