Leveraged Buyout Primer

Leveraged Buyout Overview

A leveraged buyout (“LBO”) is an acquisition of a company (the “Target”) by an investor or group of investors (the “Buyout Investors”), who use debt to fund a significant portion of the purchase price. The assets of the Target are used as collateral, and the cash flow of the Target is used to pay interest and principal on the debt.  Buyout Investors typically borrow between 50-75% of the total purchase price and invest 25-50% of equity to finance the remaining portion of the purchase price. 

Buyout Investors target public companies (a type of going private transaction), private companies, family owned businesses, and divisions of public and private companies that generally share the following characteristics: steady cash flows, strong market positions, good growth prospects, a proven management team, and a viable exit strategy in three to five years, among others.

Buyout Investors rely on the combination of debt reduction and earnings growth to boost the value of their equity investment in the Target during their holding period which is typically three to five years.  Buyout Investors generally pursue whole or partial monetization of their investments during the holding period through a sale transaction, dividend recapitalization(s), or through an initial public offering (“IPO”) and subsequent secondary share sales. Buyout Investors typically target an 18+ percent compound annual return or internal rate of return (“IRR”) and 2.0+ times cash-on-cash return.

Buyout Investors compete against corporations and other Buyout Investors for acquisition opportunities.  Typically corporations have a lower cost of borrowing and much lower cost of equity capital. As a result, Buyout Investors are best positioned to deploy capital when interest rates are low, the lending environment is favorable (higher leverage, less restrictive covenants, etc.), and valuations are moderate.  2007 was the most active year for LBOs in U.S. history.

U.S. Buyside Financial Sponsor Activity

Source: Thomson Reuters Note: A financial sponsor is another term for a Buyout Investor

Source: Thomson Reuters

Note: A financial sponsor is another term for a Buyout Investor

Increased leverage from LBO transactions can add significant financial risk to a Target. Debt typically includes financial covenants that place constraints on the Targets operations, and high interest costs that divert operating cash flow from investments to fund the Targets operations and future growth initiatives.  In some cases, increased leverage can lead to a balance sheet restructuring and / or bankruptcy. 

 

Leveraged Buyout Investors

Private Equity Firms

Private equity firms form specific fixed-life limited partnerships (“Funds”) and invest pools of committed capital from group(s) of limited partners. These limited partners include pension funds, high net worth individuals, family offices, endowments, and other institutional investors. Funds typically have a 10 year term. In the first four to six years of the fund, private equity firms acquire Target companies (the “Investment Period”) and for the next four or five years, private equity firms monetize their investments through recapitalizations, sale transactions and initial public offerings or secondary share sales (the “Harvest Period”). Proceeds are typically returned to limited partners as soon as they are received. Private equity firms are typically compensated with an annual fee based on total assets under management during the Investment Period and based on invested capital during the Harvest Period (typically 2% in both cases); a percentage of profits gained from the sale of portfolio companies (typically 20%); and transaction fees and portfolio company monitoring fees paid by the Targets.  Funds often have specific mandates about the size of investments they can pursue and the industries in which they can invest. Private equity firms often also develop specific areas of focus (company size, company stage, turnaround, etc.) and industry expertise.  

Private Equity Fundraising

Source: Pitchbook

Source: Pitchbook

Source: McNally Capital

Source: McNally Capital

Family Offices (Direct Investing)

Single-family and multi-family offices are often limited partners in private equity funds, but are becoming increasingly active in investing in leveraged buyouts directly. When participating as direct investors in leveraged buyout transactions, family offices often do not have defined guidelines on the timing to return capital allowing a longer-term investment horizon on direct investments. Family offices often specialize in specific industries where the family has deep industry knowledge. Family offices have also been among the early adopters of investing in mission-driven and impact-focused businesses.

 

Ideal Characteristics of a Leveraged Buyout Candidate

Characteristics1.png

 

Illustrative Leveraged Buyout Mechanics

The following is an illustration of a leveraged buyout transaction (the “Illustrative LBO”), demonstrating the typical structure and mechanics in a conventional leveraged buyout scenario. The Illustrative LBO assumes a company with $25 of earnings before interest, taxes, depreciation and amortization (“EBITDA”) is acquired for 8.0 times EBITDA, implying a total transaction value of $200.  The $200 transaction value is funded with $140 of new debt (representing 5.6 times EBITDA and 70% of the total purchase price) and $60 of new investor equity (30% of the total purchase price). Proceeds from the sale are used to repay existing debt of the target company and the remaining $180 is used to purchase all of the equity interests from existing shareholders.  Note: Buyout Investors often require management, and in some cases existing investors, to rollover a portion of their existing equity interest into a new equity investment.

The following page demonstrates the mechanics of the Illustrative LBO for the next five years after the transaction closes, culminating with a sale of the Target at the end of Year 5. During years one through five, the Target grows revenue and EBITDA and uses cash generated from operations to pay interest expense and principal on the $140 of debt that was used to fund the purchase.

In Year 5, the company, which is now generating $30.7 of EBITDA, is sold at an 8.0 times EBITDA multiple valuing the company at $245.4. After repaying $105.8 of remaining debt, the remaining equity value is $139.6. Based on an initial investment of $60, the equity holders have earned a 2.3x “cash-on-cash” return (implied equity value / initial investment) and a compound annual return or internal rate of return (“IRR”) of 18.4%.

LBO1b.png
Source: Keene Advisors estimates Note: Uses of proceeds excludes transaction-related expenses

Source: Keene Advisors estimates

Note: Uses of proceeds excludes transaction-related expenses

For more information on leveraged buyout transactions or any corporate finance-related questions, please contact Keene Advisors at info@keeneadvisors.com.

Securities related services are provided through Burch & Company, member FINRA / SIPCKeene Advisors, Inc. and Burch & Company are not affiliated entities. Keene Advisors, Inc. does not provide legal, tax, or accounting advice.