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Home > Mergers and Acquisitions Best Practice > Leveraged Buyouts: What, Why, When, and How

Mergers and Acquisitions Best Practice

Leveraged Buyouts: What, Why, When, and How

by Scott S. Johnson

Table of contents

Executive Summary

  • A leveraged buyout (LBO) is the acquisition of a company financed by debt.

  • The use of debt multiplies both the potential return and risk.

  • LBOs require active and liquid credit markets.

  • Stable, mature businesses with predictable—and ideally recurring—revenues are generally the best LBO targets.

  • LBO returns are maximized by buying low and selling high, properly capitalizing the buyout, and maximizing profitable and high-quality growth during the hold period.

What

A leveraged buyout (LBO) is the acquisition of a company financed by debt. It is not unlike the typical purchase of a residence where the majority of financing is derived from a mortgage, and the balance from cash (equity) contributed by the buyer.

The use of debt in an LBO leverages the equity return, providing the equity holder with the possibility of higher returns at the cost of higher risk. From 2000 to 2013, debt levels by financial sponsors of US leverage buyouts have averaged 64% with a high of 70% in both 2005 and 2013, and a low of 54% in 2009, according to Standard & Poor’s. Debt levels vary due to numerous factors, including the vibrancy of credit markets, and the overall macroeconomic conditions (key contributors to 2009’s low leverage levels), the ability of the acquired company to support debt, and the strategy of the given LBO.

Although select transactions that could be considered LBOs occurred prior to the 1980s, this acquisition strategy grew in popularity in the 1980s when ample debt financing became available, in particular with the rise of the sub-investment grade, or “junk” debt market. Over the past decade, the strategy has seen even more activity with more than US$100 billion raised by private equity funds, which primarily engage in LBOs. Buyouts have, in fact, become a material element in mergers and acquisitions. Over the past ten years, US buyout volume exceeded US$1 trillion, according to Standard & Poor’s.

LBOs can involve the acquisition of an entire company or a division of a company. In some cases, management, usually with the financial backing and transactional expertise of a private equity group, buys out its own entity, which is then more specifically referred to as a management buyout (MBO). Yet another permutation is leveraged recapitalization, whereby some equity plus debt are used to provide liquidity to shareholders, either to buy their shares outright, or provide cash to them (not unlike a residential mortgage refinancing).

Why

Although the leveraged buyout entails risk, given the challenges of servicing debt, significant returns are possible without the need for material growth.

Furthermore, the need to generate sufficient cash flow for debt service imposes discipline. Companies that, pre-LBO, were inefficient, or overloaded with expenses are forced to streamline their operations and cost structure to succeed. At the same time, the need to service debt can generate short-term decision-making that may not always be in the best long-term interest of the business.

However, the World Economic Forum’s “Global impact of private equity report 2009”1 reported that private equity backed companies are generally better managed than their peers, with average productivity growth in the first two years after acquisition about two percent higher than comparable firms.

Case Study

How Debt Can Magnify Both Returns and Risk

Let’s take a company with $10 in profit and assume it is acquired for six times profit, or $60. In the LBO of this company, $40 of the purchase price is financed with debt and $20 is an equity investment, so equity is one-third of the total capital. In the unleveraged scenario, $60 of equity—100% of the consideration—is used to acquire the company.

If the company is sold at the end of five years, and profits have grown at a compound annual growth rate of 10% to $16 (a cumulative growth of 60%), and the purchase price multiple remains six times, the business is sold for $97. In the unleveraged scenario, the annual return is equal to the profit growth, i.e., 10% per annum and 60% on a cumulative basis.

On the other hand, the LBO equity return is much higher. In the LBO, the company sale price value (its enterprise value, or EV) is still $97. Of the $97, the first $40 is returned to the debt holders to pay off their principal, leaving $57 for the equity. Unlike the unleveraged case, where the sale price is 60% greater than the investment, here the $57 is 183% greater than the $20 investment.

The annual return in the LBO is more than double the unleveraged deal: 23% vs 10% (see Figure 1). Please note that this scenario is an oversimplification, with numerous factors such as transaction costs, working capital, and annual cash flow generation excluded (even when those factors are included, the LBO continues to outperform the unleveraged deal approximately 2:1).

Our case study also illustrates the risks of the leveraged buyout strategy. Without any interest expense or debt principal due, the unleveraged company in our simplified example can weather substantial declines in operating profit, and still maintain positive cash flow. Conversely, if the leveraged company sees a decline of profits of just 25%, its profits after interest expense fall three times that level, or 75%. If the leveraged company had material levels of capital expenditures, or debt principal repayments (which are both post-tax items), it may not be able to service its cash needs. The likely result would be a cash squeeze, which would have negative or potentially disastrous implications (see Figure 2).

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