The key mechanics of Leveraged Buyouts

Author: Joris Kersten MSc

Source used: Leveraged Buyouts: A practical introductory guide to LBOs (2012). Author: David Pilger. Publisher: Harriman House Great Britain.

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Leveraged Buyouts: Key mechanics

A Leveraged Buyout (LBO) is basically one company buying another company with using a lot of “debt” in the process.

The debt used in the acquisition is often secured by the assets of the target.

So the target company needs to have enough available “collateral”. And this in the form of “assets” to allow the buyer to attract the debt capital for the acquisition.

Concerning the debt of the LBO, this can be done with “bonds” and “bank loans”.

(Source used: David Pilger, 2012)

Bonds and bank loans in LBOs

In the case of “bonds” this means that the debt is issued and sold to investors in the “capital markets”.

The buyers pay on the bonds a “fixed coupon” rate (interest) to the creditors.

Bonds in LBOs are often rated below “investment grade” (“junk bonds”), because of the high levels of debt in LBOs and corresponding large risk.

In the case of bank loans, financing comes directly from banks, rather than from investors in the capital markets.

The interest expense on the bank loans is often at a “variable rate”.

And here it is common for banks to charge the borrower an interest rate of LIBOR + an additional amount.

This additional amount is called “spread”, and it corresponds to the risk involved, and the level of “seniority” of the loan in case of a “default” (bankruptcy).

LIBOR is the “London Inter Bank Offered Rate”, and this is the daily rate that banks charge to borrow unsecured funds from each other for a given period of time.

(Source used: David Pilger, 2012)

Loan syndication

Concerning the bank loans in LBOs, these are often “syndicated” amongst different banks.

So here banks share the risk of borrowing money for an LBO.

In general bank loans are more complicated than bonds, for example because of the syndication.

But there are also a lot of different bank loans like: Term loans, revolving credit facilities and payment in kind (PIK) loans for example.

The interest rates with banks are “floating”, so variable. But with bonds, the interest rates (coupon) is fixed and these are sold in the capital markets. I have mentioned this before.

More on the topic “debt” will follow in later blogs since we need to take a look at this in great detail.

But now let’s first take a look at the goals of LBOs.

(Source used: David Pilger, 2012)

Goals of LBOs

The goal of an LBO transaction is to achieve relative high returns on the initial equity investment.

For example, when you buy a company for 100 million euro, and when you then sell it one year later for 110 million euro, then you make 10 million euro in a year.

This is a 10% return when it is financed with all equity (10/ 100 = 10%).

But when you buy the company with 10 million euro equity and 90 million euro debt, then you make a higher return.

Let’s assume you pay on average 7% interest on the debt, this is then:

· 6.3 million euro interest (0.07 * 90 million).

When you sell the company also in 1 year you make again 10 million (110 – 100).

And after the interest this then is: 10 profit – 6.3 interest = 3.7 million euro profit.

But then the return on your equity is: 37% (3.7 profit/ 10 initial equity outlay).

So here the returns are much higher since you use debt which is (relatively) cheap!!

In other words, the company makes more returns than you need to pay the debt holders.

And this increases the return on equity (the famous “LEVERAGE”)!

(Source used: David Pilger, 2012)

Advantages of LBOs

With a smaller initial equity investment you can buy a relative big company with an LBO due to the large debt component.

In the extreme, and simple, example above you buy a 100 million euro company with only 10 million in equity.

This is the first advantage.

The second advantage is that the potential loss (of equity put in yourself) is limited and relative small.

This again due to the little initial equity outlay. So you basically you use other’s people’s money for the LBO (money of the debt holders).

Although no need to feel sorry for the debt holders (bond investors and banks), these people are professionals and they know how to research an LBO deal upfront.

A third advantage is that the interest payment on the debt involved in LBOs is tax deductible (in many countries), or at least for a part of the interest.

This saves money on the tax bill.

(Source used: David Pilger, 2012)

Disadvantage of LBOs

As there are quite some advantages, there is one big disadvantage:

· The high leverage in the capital structure of LBOs brings along risk!

And the main risk is default risk.

In times of trouble, when the company is not making profits, leverage can kill the company.

This since in times of trouble still interest (and in LBOs, this is a lot) needs to be paid.

When they can not pay the interest anymore, so in case of a bankruptcy, the creditors will stand in line (ahead of the equity partners) in order to get their money back.

And very (very very very) likely in the end nothing will be left for the equity holders.

(Source used: David Pilger, 2012)

Intro to LBOs: Wrapped up

So in this first blog on LBOs I have explained what an LBO is, and what the goal is.

Concerning the bid price for an LBO, an investor will look at:

1. The market prices for similar companies as an EBITDA multiple;

2. Purchase prices in previous transactions of similar companies as an EBITDA multiple;

3. Discounted cash flow valuation.

Herewith the LBO investor will get an idea of current market prices for specific companies.

After that they “model” the LBO.

This is basically to check whether they can make a certain return when they buy the company for a certain price.

I will get in to this process of “LBO modelling” in way more detail in subsequent blogs.

But after the deal is done, the game that is played, is about:

· Focusing on “operating efficiency” to increase EBITDA;

· Identifying additional revenue generating opportunities to increase EBITDA;

· Paying back the debt;

· (making the company more “special” in the holding period to increase the EBITDA multiplier at the moment of the exit).

So when the company is sold again in 5 years, this is called the “exit”.

When the company was bought for 8 times EBITDA, then even when it’s sold for (only) 8 times EBITDA, then the “enterprise value” gets higher when the EBITDA was increased.

On top of that the debt is reduced, so the final equity received is a lot higher than the initial equity outlay.

And this most likely will result in a good return, also called “internal rate of return” (IRR) with LBOs.

This blog was just to give you an impression on what LBOs are.

In the next ones I will look (and explain) all the concepts in detail.

(Source used: David Pilger, 2012)

Thanks for reading, happy weekend, best regards Joris Kersten (Kersten Corporate Finance)