Leveraged Buyout (LBO): Everything you need to know

Shouvik Das Gupta
Jun 13, 2021
7 min read

In the financial world, LBOs are considered as one of the trickiest deals, however, most of the time, they are not all that complicated. In this section, we will dive deep into its working and see what’s the hype all about.

What & Why?

An LBO is conceptually a very simple transaction in which an undervalued or underappreciated company or a division of a company is purchased by a private equity or another sponsor firm. The purchased company is then transformed from being publicly traded to one that is privately held by a much smaller group of investors.

The goal of nearly all LBO sponsors is to purchase a company, make some significant changes in the company’s operations, thus improving the profitability of the firm. Then, in a few years, the private equity firm can sell the new and improved company at a premium in the public markets or to another strategic buyer.

Players involved in an LBO

Investment banks: they play a number of roles in an LBO. Firstly, they advise the firms when the firms either have been identified as the target of an LBO or when they want to position themselves to be an attractive candidate for an LBO. Additionally, Investment banks utilize their extensive networks of contacts to gauge the interest of potential purchasers for firms who may be interested in being the target of an LBO.

Secondly, when the private equity sponsor wants to sell off the company, Investment bankers are called upon for the valuation on the shares of the company and lining up investors for an IPO.

Finally, investment bankers could also be called upon to find a strategic buyer or to counsel the firm through a secondary leveraged buyout.

Big Institutions: Private equity firms and leveraged buyout firms pool investors’ assets and invest in a variety of companies. Some of the major investment banking firms are also major sponsors of LBOs and have private equity partnerships that their clients can invest in. Investors generally don’t invest directly in LBOs, but they’ll invest through one of these LBO sponsors who set up specific funds. These specific funds invest in a variety of LBOs so that the risk for the investor is effectively spread out over several deals. Most of the LBO and private equity sponsors set up their funds as limited partnerships. Partnership typically has many limited partners who are entitled to the cash flow but are legally liable for debts only to the extent of their original investments.

Management: Here the management refers to the management of the target firm. This involvement of the management refers that in most cases, there are no takeovers or hostile treatments with the management. In fact, many LBOs are initiated by the management team and are referred to as management buyouts (MBOs). MBOs often happens when the founder of a company is looking to exit and the management team is interested in buying the company because they believe in the future prospects of the company and want to retain their positions in the firm. Private equity sponsors often help bring additional management expertise to the firm and are actively involved in taking some fundamental decisions.

Stock and Bond Investors: This refers to the investors who put their money through the private equity investors in the form of stocks and bonds. A private equity company’s track record is extremely important in this case. Sometimes, the private equity sponsors who develop a strong track record of success often find that they don’t have to actively market their new funds because previous investors buy up the limited partnership interests of any new funds that they sponsor. Many institutional investors invest in private equity through fund of funds, a pool of money that invests in a wide variety of private equity limited partnerships. That way, the institutional investor doesn’t have to concern itself with the detailed due diligence involved in the selection of the specific private equity fund. However, the downside of investing in a fund of funds is the additional layer of fees that the fund of funds sponsor extracts.

Which firms make the cut for the LBOs

The characteristics that make the firm an attractive target for an LBO include :

Strong management: The firm should have high-quality management who is willing to work closely with the LBO sponsor.
Low leverage: The sponsor wants to effectively replace equity with debt in an LBO, so firms that make good targets for LBOs should have little or no debt.
Strong asset base: To induce lenders to lend money with the firm’s assets as the collateral for the loan, the quality of assets must be strong and marketable.
Low business risk: Firms that are seen as attractive LBO candidates tend to be in relatively sedate, low-tech businesses that have minimal business risk.
Stable cash flows: As the target firm has to carry a huge amount of debt, the target firm should have predictable revenues and stable cash flows that will allow it to service the debt.
Out of favor: Private equity sponsors look to buy undervalued or out-of-favor companies. One of the best ways to identify undervalued companies is to look at their P/E ratios.
Divisions that don’t fit the firm: Many LBO targets are not entire firms but are divisions of firms that really don’t fit within the larger firm and may not be receiving the care and feeding necessary to maximize their potential.

Financing options we have for an LBO

Bank debt: LBOs are generally financed with two different kinds of bank debt - revolving credit and traditional term loans.

Revolving credit: a company’s revolving credit is not to be a permanent source of funds, but is a source of funds for temporary working capital needs. One common use for revolving credit is to purchase inventories or raw materials. The revolving credit line is accessed when the funds are needed and then is paid down when cash is available.
Traditional term loans: here the money is loaned to the company for a specific time period - the term, and the loan is paid back over the term of the loan in equal payments on a periodic basis (generally quarterly). This includes the interest on the loan and repayment of the principal. The process whereby a term loan is paid down via equal payments is called amortization.

Junk bonds: these are bonds of lesser quality than the typical class of bonds that investors like to invest in, referred to as investment-grade bonds. The difference between junk bonds and investment-grade bonds is their quality, measured in part by the bonds’ ratings. The purpose of bond ratings is to provide investors with an idea of the creditworthiness, or the risk of the bond. Here, creditworthiness refers to how likely the lender is to receive his promised interest and principal payments.

Mezzanine debt: it is a form of financing that is between traditional debt and equity. Mezzanine debt has attributes of both debt and equity and is often referred to as a hybrid form of financing. Here, the bonds usually come with warrants attached in order to make them more attractive to the purchaser. A warrant is simply the right to buy a specific number of shares of the company’s stock at a predetermined price for a specified period of time. Mezzanine debt is typically structured as intermediate-term debt — perhaps three to five years.

Equity: these individuals own the company and are entitled to the returns of the company only after all the debt holders’ claims have been satisfied in full. Typically, the majority of the equity is held by the private equity partnership — the firm that sponsored the LBO and put the deal together. A minority portion of the equity may be held by the management of the firm.

Key points to remember

Seniority is where the provider of funds stands in the line of priority with regards to being paid. The more senior the claim of the form of financing, the lower the expected return. That is why, for instance, revolving bank debt has the lowest expected return of all the types of financing and why equity has the highest expected return.

Maturity refers to when the debt comes due and needs to be paid back. A revolving credit line never matures, but it’s expected that it will be periodically paid down. Term loans issued in LBO transactions typically have maturities between four and eight years. Junk bonds typically have maturities between five and ten years, whereas investment-grade bonds are typically issued with maturities up to 30 years. Equity has no maturity.

How much debt the LBO will finally get?

The level of debt that the market will likely support for an LBO is a function of both the risk of the particular LBO and current market conditions -

Risk of the LBO: refers to the variability or volatility of the EBITDA projections and how likely they are to be reached. EBITDA refers to the “Earnings Before Interest, Taxes, Depreciation, and Amortization” and the total debt the LBO will support is depicted as the multiple of it. The less variability in the EBITDA projections — that is, the more certain the analyst is that there won’t be negative surprises in EBITDA in the foreseeable future — the higher the multiples of EBITDA that the LBO will support. That is why simple businesses with stable cash flows are the best targets for LBOs because their cash flows are more stable and less vulnerable to surprises due to downturns in the economy or technological innovations.
Market conditions: some markets are simply better for LBOs than others. When credit conditions are loose and the risk appetite of market participants is strong, the multiples of EBITDA that an LBO will support expand and it’s an opportune time for private equity sponsors to participate in the LBO market. Alternatively, when credit conditions tighten and the risk appetite of market participants is weak, it’s a poor time for private equity sponsors to participate in the LBO market.

Finding the exit

Private equity LBO sponsor firms generally have a relatively short timetable in mind when they purchase a firm through an LBO transaction. There are three primary methods for LBO sponsors to exit their positions and realize the ultimate return on their investment-

IPO: this is the case only if the resulting organization is seen by investors as a desirable individual company whose future prospects are bright and the firm can command a premium price in the financial markets.
Sale to a strategic buyer: This exit strategy is the most common, and the one that is most preferred in the private equity industry because it’s quick and simple. A strategic buyer is an entity that believes that the target company offers synergy to its existing business line. Synergy is the concept that one plus one can equal three, that some businesses are worth much more in the hands of one entity than another.
Another leveraged buyout: The exit strategy for a minority of private equity deals involves simply selling the company to another private equity firm that will essentially put the firm through a secondary LBO.