Due to the proliferation of private investment vehicles (e.g., private equity firms and hedge funds) and their considerable pool of capital, LBOs have become an increasingly large part of the capital markets and M&A landscape. The resurgence of mergers and acquisitions observed in the past few years has been fuelled in part by a surge in private equity transactions, in particular leveraged buyout (LBO) deals.
The LBO market has continued to expand across many segments and expanded significantly for the large deal market as well as the middle market. Private equity funds pioneered the leveraged buyout as a deal structure and have been responsible for the large growth in the field.
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More about LBO
A Leveraged Buyout (LBO) is the acquisition of a company, division, business, or collection of assets (“target”) using a significant amount of borrowed money/ debt (“leverage”) to meet the cost of acquisition. The remaining portion of the purchase price is funded with an equity contribution by the buyer or financial sponsor (“sponsor”). LBOs are used by sponsors to acquire the control of a broad range of businesses, including both public and private companies, as well as their divisions and subsidiaries. The sponsor’s ultimate goal is to realize an acceptable return on its equity investments upon exit, typically through a sale or IPO of the target.
The expectation with leveraged buyouts is that the return generated on the acquisition will more than outweigh the interest paid on the debt, hence making it a very good way to experience high returns whilst only risking a small amount of capital. During the time from which the sponsor acquires the target until its exit (“investment horizon”), cash flow is used primarily to service and repay the principal amount of debt, thereby increasing the equity portion of the capital structure. At the same time, the sponsor aims to improve the financial performance of the target and grow the existing business (including through future “bolt-on” acquisitions), thereby increasing enterprise value and further enhancing potential returns.
LBO investment is often substantial. Additional incentives to engage in LBO transactions are related to leverage-induced tax savings (as interest payments are often tax deductible) and the resolution of agency problems (improved managerial incentives, a more active monitoring by shareholders and the elimination of free cash flows). At the same time, LBO activity involves a risk of financial distress and eventual bankruptcy if the company’s future cash flows turn out to be too low to cover the payments of the debt.
A Strong LBO Candidate
Considering that the buyer will put a large amount of debt on the company, it is critical that the company be stable and able to pay off its future debts otherwise it will likely default and go into bankruptcy. Free cash flow is needed to service periodic interest payments and reduce the principal amount of dent over the life of the investment. With that in mind, below are some types of companies that make good targets:
- Stable, strong and periodical cash flow business
- Leading and defensible market position
- Efficiency enhancement opportunities
- Company with low debt levels
- Low Capex requirements
- Non-cyclical businesses
- Companies with large economic moats
- Companies with good existing management teams
- Companies with a large asset base that can be used for collateral
- Distressed companies in good industries
Some private equity firms look to “turn around” troubled assets or may just look to buy an asset with the hopes of selling it for a better price in the future.
How leverage is used to enhance equity value
LBOs generate returns through a combination of debt repayments and growth in enterprise value. Internal Rate of Return (IRR) is the primary metric by which sponsors gauge the attractiveness of a potential LBO. In addition to IRR, sponsors also examine returns on the basis of a multiple of their cash investments (“cash returns”).
The overall return for the sponsor or consortium in an LBO is determined by a number of factors:
- Growth in the operating profit/cash flow of the company (EBIT or EBITDA) over the life of the investment;
- The exit multiple on EBIT/EBITDA relative to the entry or acquisition multiple; and
- The amount of debt that is paid off over the time horizon of the investment.
The following scenarios will help to understand on how LBOs increase equity value of financial sponsors through adding leverage to capital structure.
Assuming the cumulative free cash flow generated by the target is used to repay the debt principal amount during the investment horizon and the sponsor sells the target for $ 100 million at exit. Here the value of the sponsor’s equity investment increases from $30 million at purchase to $ 80 million even though there is no growth in the company’s enterprise value. This scenario produces an IRR of 21.7% (assuming 5 year investment horizon) with a cash return of 2.7x
Assuming all the cash generated by the target is not used to repay the debt principal amount during the investment horizon, rather all cash generated is reinvested into the business and realizes 50% growth in enterprise value by selling the target at $150 million at exit after 5 years. Here the value of the sponsor’s equity investment increases from $30 million at purchase to $ 80 million even though there is no growth in the company’s enterprise value. This enterprise value growth can be achieved through EBITDA growth and/or achieving EBITDA multiple expansion.
In this scenario, the value of the sponsor’s equity investment increases from $30 million at purchase to $ 80 million without any debt repayment. This scenario also produces an IRR of 21.7% (assuming 5 year investment horizon) with a cash return of 2.7x.
Financial Structuring of LBO Transactions
As with valuation, determining the appropriate LBO financing structure involves a mix of art and science. The structuring exercise centers on fundamental company specific cash flow, returns, and credit statistics analysis, as well as market conditions. The fundamental analysis is akin to the DCF approach to intrinsic valuation, while market conditions and precedent LBO deals are similar to comparable companies and precedent transactions.
The ultimate LBO financing structure must balance the needs of the financial sponsor, debt investors, the company, and the management, which are not necessarily aligned. For example, the sponsor often seeks to maximize the leverage so as to generate the highest IRR. Lenders and Debt Investors, on the other hand, have an interest in limiting leverage as well as introducing convents and other provisions to protect their principal. The company’s best interests often reside with more moderate leverage from both a risk management and growth perspectives.
Structuring an LBO is predicated on analyzing the targets cash flows and credit statistics, including leverage and coverage ratios. This emphasis on the need of crafting a financial structure that provides high leverage while maintaining sufficient cushion and room to maneuver in a downside scenario.
Most sponsors aim to exit or monetize the target investment within a period of 5 years holding in order to provide timely returns to their LPs. These returns are typically realized via sale to another company (“strategic sale”), sale to another sponsor, or an IPO. Sponsors may also extract a return prior to exit through a dividend recapitalization, which is the issuance of additional debt to pay shareholders a dividend.
By the end of the investment horizon, ideally the sponsor has increased the targets EBITDA, through organic or inorganic growth, acquisitions, expansions, diversifications, and/or increased profitability) and reduced its debt, thereby substantially increasing the target’s equity value. The primary exit/ monetization strategies for sponsors are:
- Sale of business to strategic buyers or another financial sponsor
- Initial Public Offer (IPO)
- Dividend Recapitalizations
- Below Par Debt Repurchase
LBO Financing Sources
- Bank debts
- Revolving credit facilities
- Assets Based Lending Facility
- Term Loan and other Senior Lending Facilities
- Amortizing Term Loans
- Institutional Term Loans
- Second Lien Term Loans
- High Yield Debt Instruments
- Bridge Loans
- Mezzanine Debt
- Equity Capital
- Preferred Stocks
LBO analysis is the core technical tool used to assess financing structure, investment returns and valuation in leveraged buyout scenarios. The same technique can also be used to assess refinancing opportunities and restructuring alternatives for corporate issuers. An LBO analysis essentially requires specialized knowledge of financial modeling, leveraged debt capital markets, M&A, valuation, business planning and deal structuring. At the center of an LBO analysis is a financial model (the “LBO model”), which is constructed with the flexibility to analyze a given targets performance under multiple financing structures and operating scenarios.
The team of Unifinn has diversified experience in structuring LBO transactions and with our extensive network of capital sources, we can structure any LBO transactions, assist in valuations, financial modeling, due diligence and financing of the transactions with our comprehensive service strategies.
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The goal of analyzing LBO financing structure is typically to present a financial sponsor with tailored financing options that maximizes returns while remaining marketable to investors. The financing structure must also provide the target with sufficient flexibility and cushion to run its business according to plan.
LBO analysis is an essential component of M&A. Its used by sponsors, lenders and other financial professionals to determine an implied valuation range for a given target in a potential LBO based on achieving acceptable returns. The valuation output is premised on key variables such as financial projections, purchase price, and financing structure, as well as exit multiple and year. Therefore, sensitivity analysis is performed on these key value drivers to produce a range of IRRs used to frame valuation for the target.
Steps in LBO
- 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
- Calculate the free cash flow to the Sponsor (typically a private equity firm)
- Determine the Internal Rate of Return (IRR) for the Sponsor
- Perform sensitivity analysis
Dileep K Nair
(Investment Banker, Capital Advisory and Corporate Finance expert)
Unifinn Global Capital
Suggested reading (curtsy): A hand book on ‘Investment Banking’ (Valuation, LBOs and M&A), second edition, by Joshua Rosenbaum and Joshua Pearl)