LEVERAGED BUYOUTS (LBO), A KEY DRIVER OF THE M&A LANDSCAPE

Leveraged Buyouts

What are Leveraged Buyouts (LBO)?

Due to the proliferation of private investment vehicles (e.g., private equity firms and hedge funds) and their considerable pool of capital, Leveraged Buyouts (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, particularly leveraged buyouts (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.

Definition of LBO

A Leveraged Buyouts (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”). Leveraged Buyouts (LBOs) are used by sponsors to acquire 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.

What are the LBO expectations?

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 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.

Leveraged Buyouts (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, more active monitoring by shareholders and the elimination of free cash flows). At the same time, Leveraged Buyouts (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.

Who is 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 debt 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
• Companies with low debt levels
• Low Capex requirements
• Non-cyclical businesses
• Companies with large economic moats
• Companies with good existing management teams
• Entities 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.  The Internal Rate of Return (IRR) is the primary metric by which sponsors gauge the attractiveness of a potential Leveraged Buyouts (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 a Leveraged Buyout (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 how LBOs increase the equity value of financial sponsors by adding leverage to the capital structure.

How are the returns generated in LBO transactions?

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 the 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 a 5-year investment horizon) with a cash return of 2.7x

Return Generated

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 the 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 a 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 centres on fundamental company-specific cash flow, returns, and credit statistics analysis, as well as market conditions. 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 risk management and growth perspective.

Structuring an LBO is predicated on analyzing the target cash flows and credit statistics, including leverage and coverage ratios. This emphasises the need of crafting a financial structure that provides high leverage while maintaining sufficient cushion and room to manoeuvre in a downside scenario.

What are the Exit Strategies?

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 target 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:

1. Sale of business to strategic buyers or another financial sponsor
2. Initial Public Offer (IPO)
3. Dividend Recapitalizations
4. Below Par Debt Repurchase

What are the 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

What is LBO Analysis?

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 modelling, leveraged debt capital markets, M&A, valuation, business planning and deal structuring. At the centre of an LBO, analysis is a financial model (the “LBO model”), which is constructed with the flexibility to analyse the performance of a given target 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 modelling, due diligence and financing of the transactions with our comprehensive service strategies.

Visit us: http://unifinn.com/ to know more.

LBO Valuation

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.

What are the steps in LBO?

1. Build a financial forecast for the target company
2. Link the three financial statements and calculate the free cash flow of the business
3. Create the interest and debt schedules
4. Model the credit metrics to see how much leverage the transaction can handle
5. Calculate the free cash flow to the Sponsor (typically a private equity firm)
6. Determine the Internal Rate of Return (IRR) for the Sponsor
7. Perform sensitivity analysis

Suggested reading (curtsy): A handbook on ‘Investment Banking’ (Valuation, LBOs and M&A), second edition, by Joshua Rosenbaum and Joshua Pearl)

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