Leveraged Buyout (LBO) : Buy A Company - Fix It Up - Sell It

Leveraged Buyout (LBO)
A leveraged buyout is the acquisition of another company using a significant

amount of borrowed money (bonds or loans) to meet the cost of acquisition.
The concept of a leveraged buyout is simple:
Buy a company –> Fix it up –> Sell it
The assets of the company acquired are often used as collateral for the loans,
along with the assets of the acquiring company. Generally, In a leveraged buyout
(LBO), there is usually a ratio of 90% debt to 10% equity. As leveraged buyout has
a high debt/equity ratio so the bonds issued in the buyout are usually are not
investment grade.
The reason for the leveraged buyout is to allow companies to make large
acquisitions without having to commit a lot of capital. LBOs are conducted for
three main purposes:
 To take a public company private.
 To spin-off a portion of an existing business by selling it.
 To transfer private property
Mostly, the entire plan is, a private equity firm targets a company, buys it, fixes it
up, pays down the debt, and then sells it for large profits.
How does LBO Financing Work?
LBO is the analysis of how a change in the capital structure along with other
parameters will affect the returns that a Private Equity firm can generate from its
investment in the target company. Therefore the purpose of this analysis is to
come up with a range of prices that the PE can negotiate and pay to acquire the
controlling interest.
The main factors that are considered in the analysis are as follows:
 Expected Cash flows of the target company of which the PE investor will
receive the shares proportionate to the percentage of his investment.
These are calculated and provided by the target company’s management
and are vetted for many different tests to establish reliability. This is
important because these form the way of repaying the debt that the PE
investor has to take up and also for the calculation of the return on
investment. Generally, a predetermined investment horizon is considered
while conducting such analysis.
 Expected Return of the Capital Providers: Once the CFs is established, it

needs to be compared with the expected returns of the various capital
providers to analyze whether the CF is sufficient to meet the return
requirement. Without this, there is no meaning to the calculation of
expected CFs because they won’t imply anything.
 Availability of Financing: Further, once it is determined how much is

required, it is also required to figure out how much debt can actually be
raised. At times the lenders may refuse to provide the required amount and
thus the transaction might not take place at all.
Strategies of LBO Financing
 At times the seller of the company provides the debt capital to the buyer
for making the purchase of the target company. This gives the buyer the
opportunity to negotiate the term of the payback and therefore provides
him some flexibility. Further, the seller gets a little bit of surety of the
amount she will receive, and also the responsibility of the company is
transferred to the buyer.
 In most cases, the PE firm borrows a massive portion of the buyout price.
Almost as much as 90% while puts in only 10% equity. However, if the
equity percentage increases to 30% or more, it is called and own fund LBO
however, for it to stay an LBO, the debt must be at least 50%
 In the case of LBO, the debt issued might get the priority in payment over
other existing debts, which is the case of LBO through a senior debt issue.
 At times the PE firms might not want to give the debt the seniority right,
then it may use subordinated debt but here it will have to pay a higher
interest rate.
Advantages and Disadvantages of LBO financing
Advantages
Increased Efficiency: The LBO is conducted for the purpose of creating more
efficiency. In the case of the Heinz deal, right after the deal culminated, several
employees were laid off and several austerity measures were taken by the new
owners to make the company more efficient.
Managing Competition: LBO takes place also among competitors, wherein a

bigger company that sees the target company as a threat makes an attempt to
acquire the competitor and capture the market share which it feels can be eaten
out by the target company. LBO is helpful because it speeds up the process
otherwise there might not always be equity capital that is easily available.
Diversification: Like in other M&A activities, the LBO is also used to diversify the
portfolio of a company wherein it is able to invest in a new product to get
exposure in this new domain and gain the advantage when this new product picks
up.
Disadvantages
Debt Costs: As LBOs are heavily financed by debt, the interest burden is very high
and even though a lot of due diligence goes into the CF forecast, a forecast is after
all a forecast and may not always come true. Therefore it is a high-risk high
reward scenario and no matter if the company is stable enough, the debt burden
might be too high to cover up.
Resistance: As is the case with any M&A activity, the smooth amalgamation of the
company and the owners is not always easy to acquire, and therefore there might
be challenges as to the coming together of the cultures and values of both.
Conclusion
So, LBO is a format in which the Private equity firm takes over a controlling
interest in a company that is large enough and has stable cash flows. The process
involves a high level of debt financing. The cash flows from the company are used
to pay off the debt and over time the debt component is reduced to generate
greater returns.
Usually, the investment horizon is not too long nor too short and the exit from the
investment is also an integral part of the investment decision but is not
completely drafted before-hand because until and unless the control is shifted,
the exit strategy might not get the required validation

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Leveraged Buyout (LBO)

A leveraged buyout is the acquisition of another company using a significant

Buy a company –> Fix it up –> Sell it

How does LBO Financing Work?

 Expected Return of the Capital Providers: Once the CFs is established, it

 Availability of Financing: Further, once it is determined how much is

Advantages and Disadvantages of LBO financing

Managing Competition: LBO takes place also among competitors, wherein a

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