Leveraged Buyouts (LBOs): Key mechanics of LBOs

Leveraged Buyouts (LBOs): Key mechanics of LBOs

May 18th 2020, Uden/ The Netherlands

www.joriskersten.nl

Consultant & Trainer: Joris Kersten

Joris (1980) is an independent Corporate Finance consultant with his firm “Kersten Corporate Finance” at Uden (The Netherlands).

He provides consulting and deal making in Mergers & Acquisitions (M&As) of medium sized companies in The Netherlands.

Moreover, he provides training in “Business Valuation” and “Financial Modelling” at leading “bulge bracket” investment banks in New York, London and Hong Kong.

In addition, he provides training in Corporate Finance at Universities and at Corporations all over the world (e.g. Mongolia, Surinam, Kuwait, Peru, Luxembourg, Saudi Arabia, Dubai, The Netherlands, Belgium etc.).

At last, he writes blogs on LinkedIn on Corporate Finance, almost 60 of his (free) blogs can be found at the end of this one (and on his LinkedIn page under “articles”).

NEW: 100% Online training “Certificate Investment Management”

On September 1st 2020 you can start (100% online) with obtaining your “Certificate Investment Management” given out by “Kersten Corporate Finance” in The Netherlands.

In 19 webinars (19 topics) of about 3 hours each, I will teach you the key elements of “investment management”. And this in 6 main themes.

After the webinars you practice with cases and exercises yourself, including questions from past CFA exams (level 1, 2 and 3). In the cases and exercises I will also teach you to actively use “Microsoft Excel” since this is an important tool in Corporate Finance.

The correct answers of the cases and exercises are also presented to you by webinars, worked out in detail. This in order to check your own work.

When you have finished the 19 webinars and have practised with the exercises and cases (all online), then there is an online exam to take (whenever you feel ready).

And when you pass the exam then you will receive the “Certificate Investment Management” of “Kersten Corporate Finance”. (pass = grade above 5.5 on a scale of 10)

Your name, and certificate number, will then be mentioned in the register on www.joriskersten.nl.

So for example your employer can then verify that you obtained the “Certificate Investment Management” of “Kersten Corporate Finance”.

Level training:

Participants get from a "foundation" level to "intermediate" level. This takes about 1 month to 3 months, depending on your own speed.

Foreknowledge needed for the training: A basic understanding of the Profit & Loss statement, cash flow statement and balance sheet. Moreover, a basic understanding of Microsoft excel.

The “course manual” with all info and conditions of the training will be available in the week of June 8th 2020.

And registration & subscription will also start in the week of June 8th 2020.

The 19 topics of the webinars, divided over 6 main themes are:

Theme 1: Key elements of investments

1) Asset classes and financial instruments. 2) Securities markets. 3) Mutual funds and other investment companies.

Theme 2: Portfolio theory

4) Risk, return and the historical record. 5) Efficient diversification. 6) Capital asset pricing model and arbitrage pricing theory. 7) Efficient market hypothesis.

Theme 3: Debt securities

8) Bond prices and yields. 9) Managing bond portfolios.

Theme 4: Security analysis

10) Macroeconomic and industry analysis. 11) Equity valuation. 12) Financial Statement Analysis.

Theme 5: Derivative markets

13) Option markets. 14) Option valuation. 15) Future markets and risk management.

Theme 6: Active investment management.

16) Evaluating investment performance. 17) International diversification. 18) Hedge funds. 19) Taxes, inflation and investment strategy.

The “course manual” with all info and conditions of the training will be available in the week of June 8th 2020.

Open (real life) training programs

The open training programs of Joris Kersten in The Netherlands take place at the dates below.

And for registration just write an email ([email protected]) or look at www.joriskersten.nl.

·       17, 18, 19, 20 and 22, 23 June 2020: 6 days - Business Valuation & Deal Structuring. Location: Uden/ The Netherlands;

·       24, 25, 26, 27 and 29, 30 June 2020: 6 days - Business Valuation & Deal Structuring. Location: Uden/ The Netherlands;

·       19, 20, 21, 22 and 23 July 2020: 5 days – Training with Certificate in Investment Banking. Location: Dubai/ United Arab Emirates;

·       16, 17, 18, 19 and 20 August 2020: 5 days – Training Master Financial Modelling Specialist. Location: Riyadh/ Saudi Arabia;

·       28, 29, 30, 31 October 2020 + 2, 3 November 2020: 6 days - Business Valuation & Deal Structuring. Location: Amsterdam Zuidas/ The Netherlands;

·       16, 17, 18, 19 November 2020: 4 days - Financial Modelling in Excel. Location: Amsterdam Zuidas/ The Netherlands.

Leveraged Buyouts (LBOs)

This is a sequence of blog on so called “Leveraged Buyouts” (LBOs).

In a number of blogs I will describe what LBOs are and how they are structured.

Topics that will come back are:

·       The advantage of leverage;

·       The parties involved in LBOs;

·       Financial modelling of LBOs;

·       Building the LBO analysis;

·       What price can you pay for the target in an acquisition;

·       Debt analysis;

·       Returns analysis and sensitivity analysis.

I have written a blog in the past already on the “financial modelling” of LBOs.

In case you have not read it yet, and when you are interested, I will give you the link here:

Leveraged Buyout (LBO) Analysis (older blog):

https://www.dhirubhai.net/pulse/leveraged-buyouts-lbos-joris-kersten-msc-bsc-rab/

For this sequence of blogs, I have used the book below as a source.

I really recommend you to read to book when you are interested in this topic, since it discusses LBOs within a practical setting and in a very clear way! ??

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

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)

The upcoming blog on LBOs will be on:

·       The players in the LBO market;

·       Financial modelling of an LBO;

·       Making the LBO analysis.

Stay tuned!

Source

For this sequence of blogs, I have used the book below as a source.

I really recommend you to read to book when you are interested in this topic, since it discusses LBOs within a practical setting and in a very clear way! ??

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

Under here you can find the links to my previous free articles (almost 60) on business valuation.

Earlier blogs on “net debt” (cash & debt free)

Article 1: Valuation: Introduction to "net debt" (cash & debt free)

https://www.dhirubhai.net/pulse/valuation-introduction-net-debt-cash-free-joris-kersten-msc-bsc-rab/

Article 2: Valuation: Net debt (cash & debt free)

https://www.dhirubhai.net/pulse/valuation-net-debt-cash-free-joris-kersten-msc-bsc-rab/

Article 3: Valuation: Adjusted net debt – Cash like items

https://www.dhirubhai.net/pulse/valuation-adjusted-net-debt-cash-like-items-kersten-msc-bsc-rab/

Article 4: Valuation: Adjusted net debt – Debt like items

https://www.dhirubhai.net/pulse/valuation-adjusted-net-debt-like-items-joris-kersten-msc-bsc-rab/

Earlier blogs on “valuation of banks”

Article 1: Valuation of Banks: Business models of Banks

https://www.dhirubhai.net/pulse/valuation-banks-business-models-joris-kersten-msc-bsc-rab/

Article 2: Bank Valuation: Financial Statements of Banks (part 1)

https://www.dhirubhai.net/pulse/bank-valuation-financial-statements-banks-part-1-joris/

Earlier blog on “Valuation of Oil & Gas Companies”

Article 1: Valuating Oil & Gas Companies: The Oil Industry

https://www.dhirubhai.net/pulse/valuating-oil-gas-companies-industry-joris-kersten-msc-bsc-rab/

Article 2: Valuating Oil & Gas Companies: The Oil Industry – Part 2

https://www.dhirubhai.net/pulse/valuating-oil-gas-companies-industry-part-2-kersten-msc-bsc-rab/

Earlier blogs on “Debt & Leverage”

Article 1: Debt: Ratio “debt/ GDP” in the US, The Netherlands, Germany and Japan

https://www.dhirubhai.net/pulse/debt-ratio-gdp-us-netherlands-germany-japan-kersten-msc-bsc-rab/

Article 2: Debt: Why global debt increased over the last 100 years

https://www.dhirubhai.net/pulse/debt-why-global-increased-over-last-100-years-kersten-msc-bsc-rab/

Article 3: Debt of companies: Leverage, Private Equity, Solvency and Bankruptcy

https://www.dhirubhai.net/pulse/debt-companies-leverage-private-equity-solvency-kersten-msc-bsc-rab/

Earlier blogs on “Weighted Average Cost of Capital (WACC) – step by step”

Article 1: Capital Market History Lessons – Corporate Finance (part 1)

https://www.dhirubhai.net/pulse/capital-market-history-lessons-corporate-finance-part-joris/

Earlier blogs on Financial Modelling

Article 1: Financial Modelling in Excel: Circular references, interest calculations and iterations

https://www.dhirubhai.net/pulse/financial-modelling-excel-circular-references-kersten-msc-bsc-rab/

Article 2: Excel basics for Finance: SUM, MAX, MIN, AVERAGE, IF, cell referencing, named ranges

https://www.dhirubhai.net/pulse/excel-basics-finance-sum-max-min-average-cell-named-joris/

Article 3: Excel for Valuation: COUNTIF, VLOOKUP, INDEX and MATCH

https://www.dhirubhai.net/pulse/excel-valuation-countif-vlookup-index-match-kersten-msc-bsc-rab/

Article 4: Excel for Business Valuation: OFFSET, FORECAST and CHOOSE

https://www.dhirubhai.net/pulse/excel-business-valuation-offset-forecast-choose/

Article 5: Excel for Business Valuation: NPV, IRR, PMT and EOMONTH

https://www.dhirubhai.net/pulse/excel-business-valuation-npv-irr-pmt-eomonth-kersten-msc-bsc-rab/

Article 6: Excel for Business Valuation: Custom Formatting, Conditional Formatting and Sparklines

https://www.dhirubhai.net/pulse/excel-business-valuation-custom-formatting-sparklines-joris/

Earlier blogs on “various topics”

Article 1: Financing a M&A transaction: An introduction

https://www.dhirubhai.net/pulse/financing-ma-transaction-introduction-joris-kersten-msc-bsc-rab/

Article 2: Valuation: How to adjust for “Operating Lease” (under Dutch GAAP)

https://www.dhirubhai.net/pulse/valuation-how-adjust-operating-lease-under-dutch-gaap-joris/

Article 3: M&A closing mechanisms: Locked Box & Completion Accounts

https://www.dhirubhai.net/pulse/ma-closing-mechanisms-locked-box-completion-accounts-joris/

Article 4: Scoping a financial model built primarily for business valuation:

https://www.dhirubhai.net/pulse/scoping-financial-model-built-primarily-business-joris/

Article 5: Consolidation of M&A targets and Purchase Price Allocation (PPA)

https://www.dhirubhai.net/pulse/consolidation-ma-targets-purchase-price-allocation-joris/

Article 6: Economics: Do economies have to grow to maintain the same level of prosperity ???

https://www.dhirubhai.net/pulse/economics-do-economies-have-grow-maintain-same-level-joris/

Earlier blogs on “bonds”

Article 1: Bonds - An introduction

https://www.dhirubhai.net/pulse/corporate-finance-bonds-introduction-joris-kersten-msc-bsc-rab/

Article 2: Bonds & Bond Markets

https://www.dhirubhai.net/pulse/bonds-bond-markets-corporate-finance-joris-kersten-msc-bsc-rab/

Article 3: Bonds, Rating Agencies and Credit Ratings

https://www.dhirubhai.net/pulse/bonds-rating-agencies-credit-ratings-joris-kersten-msc-bsc-rab/

Earlier blogs on “Valuation & funding of start-ups”

Article 1: Valuation & funding of start-ups - Funding rounds

https://www.dhirubhai.net/pulse/valuation-funding-startups-rounds-joris-kersten-msc-bsc-rab/

Article 2: Startup valuation: Pre-money and post-money valuation

https://www.dhirubhai.net/pulse/startup-valuation-pre-money-post-money-joris-kersten-msc-bsc-rab/

Article 3: Valuation methods for Startups (early stage) – Part 1

https://www.dhirubhai.net/pulse/valuation-methods-startups-early-stage-part-1-kersten-msc-bsc-rab/

Article 4: Valuation methods for Startups (early stage) – Part 2

https://www.dhirubhai.net/pulse/valuation-methods-startups-early-stage-part-2-kersten-msc-bsc-rab/

Article 5: Startups in Silicon Valley: The beginning – Part 1

https://www.dhirubhai.net/pulse/startups-silicon-valley-beginning-part-1-joris-kersten-msc-bsc-rab/

Article 6: Startup Funding & Convertible Debt (part 1)

https://www.dhirubhai.net/pulse/startup-funding-convertible-debt-part-1-joris-kersten-msc-bsc-rab/

Earlier blogs on “Mergers & Acquisitions (M&As)” and “M&A transactions”

Article 1: M&A Transactions: Share Deals, Asset Deals and Legal Mergers and Divisions

https://www.dhirubhai.net/pulse/ma-transactions-share-deals-asset-legal-mergers-kersten-msc-bsc-rab/

Earlier blogs on “Business valuation to Enterprise Value”

From June until August I have written the following blogs on valuation:

1)    Leveraged Buyout (LBO) Analysis:

https://www.dhirubhai.net/pulse/leveraged-buyouts-lbos-joris-kersten-msc-bsc-rab/

2)    M&A Analysis – Accretion/ Dilution:

https://www.dhirubhai.net/pulse/ma-model-accretion-dilution-joris-kersten-msc-bsc-rab/

3)    Discounted Cash Flow Valuation:

https://www.dhirubhai.net/pulse/discounted-cash-flow-valuation-dcf-joris-kersten-msc-bsc-rab/

4)    Valuation Multiples 1 – Comparable Companies Analysis:

https://www.dhirubhai.net/pulse/valuation-multiples-1-comparable-companies-analysis-joris

5)    Excel Shortcuts & Business Valuation:

https://www.dhirubhai.net/pulse/excel-shortcuts-business-valuation-joris-kersten-msc-bsc-rab

6)    Valuation Multiples 2 – Precedent Transaction Analysis:

https://www.dhirubhai.net/pulse/valuation-multiples-2-precedent-transaction-kersten-msc-bsc-rab

Earlier blogs on “Investment Management”

Article 1: Investment Management: Securitization, Subprime Loans and Collateralised Debt Obligations

https://www.dhirubhai.net/pulse/investment-management-securitization-subprime-loans-joris/

Earlier blogs on “Energy Transition”

Article 1: Energy transition: Introduction to Sustainable/ Renewable Energy

https://www.dhirubhai.net/pulse/energy-transition-introduction-sustainable-joris-kersten-msc-bsc-rab/

Article 2: Energy transition: Energy mix of The Netherlands & Goals for co2 reduction

https://www.dhirubhai.net/pulse/energy-transition-mix-netherlands-goals-co2-reduction-joris/

Earlier blogs on Wall Street

Article 1: Wall Street – A general introduction

https://www.dhirubhai.net/pulse/wall-street-general-introduction-joris-kersten-msc-bsc-rab/

Article 2: Wall Street – The Federal Reserve banking system

https://www.dhirubhai.net/pulse/wall-street-federal-reserve-banking-system-kersten-msc-bsc-rab/

Earlier blogs on the “cost of capital”

Article 1: Valuation & Betas (CAPM)

https://www.dhirubhai.net/pulse/valuation-betas-capm-joris-kersten-msc-bsc-rab/

Article 2: Valuation & Equity Market Risk Premium (CAPM)

https://www.dhirubhai.net/pulse/valuation-equity-market-risk-premium-capm-joris-kersten-msc-bsc-rab/

Article 3: Is the Capital Asset Pricing Model dead ? (CAPM)

https://www.dhirubhai.net/pulse/capital-asset-pricing-model-dead-capm-joris-kersten-msc-bsc-rab/

Article 4: Valuation & the cost of debt (WACC)

https://www.dhirubhai.net/pulse/valuation-cost-debt-wacc-joris-kersten-msc-bsc-rab/

Article 5: Valuation & Capital Structure (WACC)

https://www.dhirubhai.net/pulse/valuation-capital-structure-wacc-joris-kersten-msc-bsc-rab/

Article 6: International WACC & Country Risk – Part 1

https://www.dhirubhai.net/pulse/valuation-international-wacc-country-risk-part-1-joris/

Article 7: International WACC – Part 2

https://www.dhirubhai.net/pulse/valuation-international-wacc-part-2-joris-kersten-msc-bsc-rab/

Article 8: Present Values, Real Options, the Dot.com Bubble

https://www.dhirubhai.net/pulse/valuation-present-values-real-options-dotcom-bubble-joris/

Article 9: Valuation: Different DCF & WACC techniques

https://www.dhirubhai.net/pulse/valuation-different-dcf-wacc-techniques-joris-kersten-msc-bsc-rab/

Article 10: Valuation of a company abroad

https://www.dhirubhai.net/pulse/valuation-company-abroad-joris-kersten-msc-bsc-rab/

Article 11: Valuation: Illiquidity discounts, control premiums and minority discounts

https://www.dhirubhai.net/pulse/valuation-illiquidity-discounts-control-premiums-joris/

Article 12: Valuation: Small firm premiums

https://www.dhirubhai.net/pulse/valuation-small-firm-premiums-joris-kersten-msc-bsc-rab/

Earlier blogs on Financial Due Diligence

Blogs on this topic coming soon

Earlier blogs on Derivatives

Blogs on this topic coming soon

Earlier blogs on Distressed M&A and distressed Valuation

Blogs on this topic coming soon

Earlier blogs on Debt crises

Blogs on this topic coming soon

Earlier blogs on How inflation works

Blogs on this topic coming soon

Earlier blogs on Tax and tax evasion

Blogs on this topic coming soon

Earlier blogs on Financial modelling in excel: step by step model building

Blogs on this topic coming soon

Earlier blogs on Hedge funds

Blogs on this topic coming soon

Earlier blogs on Central banking and the supply of money (quantitative easing)

Blogs on this topic coming soon

Earlier blogs on Advanced Valuation

Blogs on this topic coming soon

Earlier blogs on Finance for Non Financials

Blogs on this topic coming soon

In case you like to see back certain topics within my blogs, please email your suggestions and I will take them into account: [email protected]