What is Leveraged Buyout and how does it works?

September 28, 2020
Posted by Keval Shah

28 Sep

LEVERAGED BUYOUT

A leveraged buyout (LBO) is the acquisition of a company, division, business, or collection of assets (“target”) using debt to finance a large portion of the purchase price. The remaining part of the purchase price is financed by a financial sponsor (“Sponsor”) with an equity contribution.

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In the traditional LBO model, debt usually comprised between 70 and 90 percent of the funding structure, with the remaining 10 to 30 percent of equity.
Normally, the assets of the business that are being purchased are held up as collateral to protect the debt.
The primary aim of the sponsor is to achieve an adequate return on its equity investment upon exit, usually by a secondary sale or target IPO.
The primary aim of a sponsor in an LBO transaction involves-

WHY LEVERAGED BUYOUT MODEL?

Suppose that XYZ Corp. wishes to acquire ABC Corp without investing a lot of capital.
The value of ABC Corp. is INR 100,000 /-
Let’s say 20 percent tax rate, 15 percent IRR, and 8 percent interest rate p.a.

OBSERVATIONS:

Returns on leveraged buyouts are far higher than usual transactions. If the entire investment is funded by equity, returns would have been mere 15%.
The higher the leverage (debt) in the LBO model, the higher would be the returns.
The use of leverage also provides the additional benefit of tax savings due to the tax-deductibility of interest expense.

STEPS INVOLVED IN BUILDING A LBO MODEL:

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CHARACTERISTICS OF AN IDEAL LBO CANDIDATE:

HOW LBO IS USED FOR DIFFERENT PURPOSES:

1. To Privatize a Public Company

Taking a publicly-traded company private means acquiring the majority of the shares trading in the market by private investors.
This requires high capital to purchase all or most of the company’s shares which is substantially funded by debt.

2. To Break Up a Large Company

Sometimes the sponsor may purchase the company and split it off, selling it as a series of smaller companies.
In this case, the sponsor would buy the company through a leveraged buyout in the belief that these individual sales will result in higher profits than selling as an entire company

3. To Improve an Underperforming Company

The sponsor may conclude that the company is substantially underperforming its ability.
Under this scenario, the purchase price of the company would be significantly cheaper than what the company will potentially be worth, making a leveraged buying a good choice.