What is Leveraged Buyout and how does it works?

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.

SOME OF THE BIGGEST LBOs IN THE PAST:

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RECAP OF LBO:

Author: Keval Shah

About the Author: Keval Shah is a Chartered Accountant and FRM 2 Candidate. He is passionate about financial markets and loves to play Chess.

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