Leveraged Buyouts – An Overview
Leveraged Buyout, often referred to as LBO, is one of the channels through which a company, a division, a business, or a collection of assets (all termed as “target/s”) is/are acquired. Unlike a regular acquisition where the acquirer directly pays the purchase price of the company with its own money, in an LBO, the acquirer (called the financial sponsor) uses debt (outside loans) to finance a relatively large portion of the purchase price of the company.
In simple words, the financial sponsor does not provide the entire purchase price from his pocket. He provides only 30%-40% of the price from his pocket. The remaining 60%-70% of the price is raised through loans by the financial sponsor for completing the transaction. Hence, the financial sponsor creates leverage for himself. The ultimate aim of the financial sponsor is to exit the investment either through a sale or through an IPO process. Since the disproportionately high level of debt is involved, financial sponsors carefully look for the best LBO candidate. The best LBO candidate is selected based on the acquiring company’s Projected Free Cash Flow and Asset Base. On average, 20%+ returns are sought through LBOs.
Parties Involved in LBO
The acquirers are called financial sponsors in LBOs simply because their main aim is to exit at some point in the future and rarely to retain their ownership. Financial Sponsors could be Private Equity (PE) firms, Merchant Bankers, Hedge Funds, Venture Capital (VC) Funds, etc.
Investment Banks provide M&A advisory services to either or both the target and the financial sponsors. Some of them also act as lenders for financial sponsors through underwriting high yield bonds or mezzanine debt. Their underwriting facility provides bridge loans to the financial sponsors assuring the timely execution of the transaction.
Banks and Institutional Lenders
Financial Sponsors can easily raise debt for their LBOs through banks and institutional lenders.
Since the financial sponsor raises debt to pay the purchase price, the debt forms a part of the target, and hence, the target issues debt instruments in the form of high yield bonds. Bond investors are those who purchase these bond instruments from the target.
the management team of the target also plays a crucial role in marketing the target to potential buyers and lenders. A strong management team is also one of the major factors considered for selecting an LBO candidate.
Considerations for a strong LBO candidate
Strong Cash Flow
Since a high amount of debt is involved in LBOs, a favorable cash flow generated by the target is essential in order to, first, make interest payments and second, gauge the growth potential of the target.
Leading Market Position
A leading market position with a good brand name enables the financial sponsor to trust the company’s growth stability and predictability.
A target with high growth potential in the market is the main advantage because that assures returns to the financial sponsor during exit.
Strong Asset Base
A strong asset base reduces the risk of loss in case of bankruptcy of the target.
Strong management team
A strong management team ensures that the target will be able to pull off the projected growth till the exit.
Low capital expenditure (CapEx)
Low CapEx enhances the Cash Flow of the target. However, a higher CapEx may be considered in case the target is able to project and assure the achievement of a strong growth profile and higher margins.
Economics of LBOs
Internal Rate of Return (IRR)
IRR is one of the primary parameters considered for analyzing an LBO’s attractiveness. IRR refers to the discount rate that must be applied to the financial sponsor’s cash flows in order to make the Net Present Value (NPV) equal to zero. IRR measures the total return a financial sponsor will get at the end of its investment horizon.
Cash Return is typically the multiplication made by the financial sponsor’s initial investment at the end of the investment horizon. Cash Return does not consider the time value of money, unlike IRR.
After forming a customized financial model, the financial sponsor tests a number of scenarios i.e. a number of equity-to-debt proportions. Based on the IRR and the Cash Return generated, the best scenario is selected for the transaction. Read more about Returns Analysis here: Leveraged Buyouts – Returns Analysis.
Basic Exit Strategies
Sale of business
The financial sponsor may choose to sell off the entire business or one of the divisions, subsidiary, etc. of the target to potential strategic buyers at a higher price.
Initial Public Offering (IPO)
An IPO exit enables the financial sponsor can sell off a portion of its share to the general public in the market. At the same time, the sponsor can hold a large equity stake in the target with an aim to exit the target slowly through equity offerings in the future. This helps the financial sponsor gain more returns.
The financial sponsor can also go for Dividend Recapitalisation. In this method, the target raises more debt to pay substantial dividend to the shareholders. However, it comes with high risk since the debt of the target keeps going high.
Hence, we may conclude that Leverages Buyouts (LBOs) are a viable option for companies wanting to go for some quick expansion. On the other hand, LBO investors invest in high growth potential targets and exit with substantially high returns.