An art, not a science.
Structure
A leveraged buyout (“LBO”) is a typical way for PE funds to acquire companies. To understand what an LBO is we must first understand each term. Buyout is pretty self-explanatory and leverage just means debt.
So what does this mean? It means that the PE fund raises debt to help it acquire target companies, thereby limiting its equity check (the money it invests itself).
How Do They Work?
If the transaction is $100 million and the PE firm can raise $70 million of debt, that means they only have to write a $30 million equity check.
The bonds that are issued are usually high-yield in nature and well below investment grade. The junk bond revolution started by Mike Milken at Drexel is often credited as seminal point in finance history because of the impact it has had on LBOs.
The reduced equity check allows PE firms to take on more investments in individual funds. Additionally it allows for higher returns to PE funds. It may be hard to conceptualize this, so here’s a quick example:
Purchase
EBITDA: $20 million
Purchase multiple: 5.0x
Purchase Price: $100 million
Debt Raise: $70 million
Sponsor Equity: $30 million
Exit
EBITDA: $20 million
Exit Multiple: 5.0x
Sales Price: $100 million
Net Debt at Exit: $20 million
Sponsor equity value: $80 million
Sponsor return: 2.7x
In the above example, the financial sponsor can make 2.7x its money by literally just paying down debt, assuming nothing else in the business changes. In an ideal world, EBITDA would grow through operational improvements and hopefully there would be some multiple expansion as well. As you can see, this has the potential to be pretty lucrative for the sponsors.
What Makes a Good Target
A good LBO target really is a company that is able to support a healthy amount of debt. Such companies are typically well-established, possess a strong cash flow profile to facilitate debt repayment, and operate in stable, established industries.
For example, say you have two different targets:
(1) A widget making firm in Ohio that has consistently generated $30 million of FCF every year.
OR:
(2) A revolutionary tech company that has had EBITDA of -$50 million for the past 4 years and won’t be cashflow positive for another 3 years but has the potential to be worth $1 billion.
While (2) may sound like the next Uber, there is a reason why venture capital funds rarely use leverage. The odds of that company requiring additional funding are high and the ability to raise debt for that company is limited; however, a PE fund can take less risk, put capital to work in the widget maker and see a nice return assuming business remains as usual. The credit risk for the tech bet remains significantly higher until it matures, at which point a financial sponsor may want to take it over through an LBO.
How to Model an LBO
LBO modeling can be complicated. It involves all three financial statements, pro forma adjustments, goodwill adjustments, and many more confusing pieces. That being said, we have a template to help you get started building your first LBO model.
The best way to practice is to take the 10K for a public company and work through the LBO model that way, which will be grueling at first, but will eventually become a lot easier. Additionally, you can find steps on how to do that in our Excel Course for Investment Bankers and our Financial Modeling Course.
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