Leveraged Buyouts – Returns Analysis

When we talk about LBOs, there are two main returns widely considered – Internal Rate of Return (IRR) and Cash Return (read about the two returns in the previous article Leveraged Buyouts – An Overview).

I recommend you read the article Leveraged Buyouts – An Overview first and then move on with this article for a better understanding of the topic.

This article explains a simple method for analyzing the returns under various debt and equity contribution scenarios. Return Analysis helps the financial sponsors to select the best debt-to-equity contribution ratio that is feasible and provides maximum returns. Let us first study the returns from two simple scenarios – Scenario 1 has 75% equity and 25% debt, and Scenario 2 has 25% Equity and 75% Debt. For more clarity regarding the calculations and assumptions, download the LBO – Returns Analysis excel sheet attached at the end of this article

Scenario 1 – 75% Equity & 25% Debt

In this scenario, we assume that the target is acquired or purchased for Rs. 1000. Hence, the equity contribution made by the sponsor is Rs. 750 and the remaining Rs. 250 comes by raising debt. For simplicity, let us randomly assume the cost of debt to be at 8%, marginal tax rate at 35%, and that the target produces a constant cash flow of Rs. 50 each year (after interest payments and tax deductions). Hence, by the end of 5 years, the target will be able to pay off all the debt of Rs. 250 (i.e. 50×5). The target is sold at the end of the 5th year at Rs. 1500 (randomly assumed). The following tables represent the resultant IRR of 12.75% and 2x Cash Return.

Assumptions

Purchase Price	Rs. 1000
Equity Contribution (75%)	Rs. 750
Cost of raising Debt	8%
Marginal Tax Rate	35%
Cumulative Free Cash Flow for 5 years (i.e. 50×5)	Rs. 250
Sale Price (Year 5)	Rs. 1500

Equity Value

Equity Contribution	Rs. 750
Increase in Equity Value:
Increase in Enterprise Value (Sale Price – Purchase Price)	Rs. 500
The decrease in Debt from Repayment	Rs. 250
Equity Value at Exit (Year 5)	Rs. 1500

Returns

IRR	12.75%
Cash Return	2x

Scenario 2: 25% Equity & 75% Debt

In this scenario, we assume that the target is acquired or purchased for Rs. 1000. Hence, the equity contribution made by the sponsor is Rs. 250 and the remaining Rs. 750 comes by raising debt. For simplicity, let us randomly assume the cost of debt to be at 8% and the marginal tax rate at 35%. In this scenario, the additional Rs. 500 debt (i.e. Rs. 750 from scenario 2 – Rs. 250 from Scenario 1) required the target to pay higher interest expense than in scenario 1. This incremental interest expense is calculated by multiplying the difference between the debt beginning balances of each year with the cost of debt (i.e. Incremental Interest Expense = {Total Debt beginning balance of scenario 2 – Total Debt beginning balance of scenario 1}x8%). The target would hence also save more interest tax which is calculated by multiplying the incremental interest expense with the marginal tax rate assumed at 35%. The target is sold at the end of the 5th year at Rs. 1500 (randomly assumed). The following tables represent the resultant IRR of 15.19% and 3.57x Cash Return.

Assumptions

Purchase Price	Rs. 1000
Equity Contribution (25%)	Rs. 250
Cost of raising debt	8%
Marginal tax rate	35%
Cumulative additional Free Cash Flow for 5 years	Rs. 141.85
Sale Price	1500

Equity Value

Equity Contribution	Rs. 250
Increase in Equity Value:
Increase in Enterprise Value (Sale Price – Purchase Price)	Rs. 500
The decrease in Debt from Repayment	Rs. 141.85
Equity Value at Exit	Rs. 891.85

Returns

IRR	15.19%
Cash Return	3.57x

Comparative Analysis

Analysing the returns generated from two scenarios, Scenario 2 proves to be the best one with higher returns. One would argue that Scenario 1 is a better option with no remaining debt at the time of exit year 5 as opposed to Rs. 358.15 of still unpaid in Scenario 2. It is important to note here that financial sponsors work on leverage. It means that they prefer a higher leverage (meaning a higher risk) in order to be able to generate higher returns. And this is possible only when the target company is fundamentally a high growth potential company that has the ability to bear higher debt for a long term. Also, the financial sponsor opts for varied kinds of debts of varying sizes and time periods. This provides a breathing space for the target’s management, the financial sponsor and the eventual potential buyer at exit. Hence, Scenario 2, especially in the case of LBOs, is the best one to choose from.

In reality, the financial sponsors along with investment bankers, test multiple scenarios before taking up the best ratio. Some investment banks also provide mezzanine debts or some debt of the kind to ensure the stability and completion of the transaction (similar to the underwriting facility during an IPO). Such debts are provided only if the financial sponsor is falling short of the debt amount to be raised for the target, or if the target is unable to repay the existing debt interest during the investment horizon. In such a case, both the financial sponsors as well as the investment banks are exposed to the target’s performance. Hence, both the parties carefully evaluate the target’s growth potential and the ability to repay the debts. Accordingly, the best debt-to-equity ratio is fixed that is not overly exposed to outside debt, neither puts the financial sponsor to a disadvantage of under-utilizing leverage.

In many cases, the financial sponsors also agree to realize a part of their returns at regular intervals and re-invest the amounts realized, using more leverage in the same target. However, this is a highly risky move that was most prevalent in the US between the late 2000s up till the 2008 subprime crisis. The period was termed as the “age of mega-buyouts”. However, in 2008, multiple companies that were acquired through the LBO process filed for bankruptcies. However, post-2008, a number of policies and reforms were undertaken all across the world helping LBOs gain momentum again. And with coronavirus pandemic putting the world’s top businesses to a standstill, buyouts may tend to be the best option for survival for some of the businesses.