Leveraged Buyout (LBO) Mechanics
- Understanding LBOs: A Leveraged Buyout (LBO) is an acquisition strategy employed by Private Equity (PE) firms.
- Definition: An LBO is the acquisition of a company primarily using debt as the means of funding.
- Key Variables: The success of an LBO transaction depends significantly on purchase and exit multiples, and the degree of leverage (debt) used. Lesser purchase price or a higher exit price, along with more leverage, typically result in higher returns.
- Applying the LBO Process: An LBO transaction process consists of several essential steps:
- Deal and Operational Assumptions: Establish the key financials of the target company. Predict the target company growth and deal price using estimates such as EBITDA Multiple, Marginal Growth Rate, and Tax rate.
- Sources and Uses of Capital: Determine the components that constitute the capital used for purchasing the company (sources), and where that capital is invested (uses).
- Project Finances: Project the financial performance of the company over a selected holding period and estimate the rate of debt paydown.
- Exit Value and Internal Rate of Return (IRR): Find the future value of the company at the end of the holding period (Exit Value), and calculate the IRR to gauge the profitability of the investment.
- Deal & Operational Assumptions: These assumptions are the core to the LBO model.
- Entry Equity Value: This will be for the deal and is determined based on Due Diligence (DD), Compound Annual Growth Rate (CAGR), and comparable companies.
- Cost of Debt: The cost of the debt utilized within the deal is also outlined in this phase.
- Sources & Uses of Capital: Understanding the flow of capital is crucial in an LBO.
- Sources: This is essentially the capital required to execute the LBO. It's the sum of bank & senior debt and sponsor equity.
- Uses: This is where the capital is allocated and includes fees & expenses, retiring existing debt, and equity payment.
- Projecting Finances: This involves constructing financial projections over the holding period.
- Operating Model: Use Last Twelve Months (LTM) margins to forecast future margins, with forecasting ending when the PE firm plans to exit.
- Debt Schedule: Using Levered Free Cash Flow (LFCF), create a schedule to understand how much cash is available to pay down debt.
- Finding Exit Value & Return Multiples: The Exit Value is the future worth of the company at the end of the holding period.
- Enterprise Value (EV) at Exit: EV is calculated as the EBITDA at the final holding year multiplied by the Exit Multiple.
- Money Over Invested Capital (MOIC): MOIC is the ratio of EV at Exit to EV at Entry, indicating the multiple received on the initial invested capital.
- Internal Rate of Return (IRR): IRR is calculated using MOIC and the holding period, providing a measure of the annualized effective compounded return rate.
- Why Use LBOs?: LBOs allow PE firms to acquire companies with minimal equity, optimizing returns.
- Financial Improvement: This could involve working capital management analysis, capital structure optimization, and identification of cost reduction & revenue enhancement opportunities.
- Operational Improvement: Working closely with the management team to develop and execute a robust strategic plan.
- LBO as a "Floor" Valuation: LBO analysis can establish a minimum valuation for a company.
- Valuation Range: The range between the LBO valuation and the valuation from a discounted cash flow (DCF) analysis can give bankers a fair value range.