In the business world, it seems that the only constant is change. Companies are spun off, divided, merged, bought and sold, and all of these transactions fall under one of the definitions of mergers and acquisitions.
Mergers and acquisitions (M&As) is a blanket term that describes the takeover of one company by another. There are many flavors of M&As that include both mergers and acquisitions, but there are other types of transactions as well, including consolidations, tender offers, purchase of assets and leveraged buyouts (commonly abbreviated as LBOs), among others.
What Is a Leveraged Buyout?
A leveraged buyout is a financial transaction that is commonly used in mergers and acquisitions. In a standard leveraged buyout model, the company that is performing it (the acquiring company) uses a large amount of borrowed capital (the cost of acquisition) to take over another company (the target company). The borrowed capital can be in the form of bonds and/or loans, which is then used to handle the cost associated with the LBO transaction and the target company’s assets are often used for collateral.
The goal of an LBO transaction is to enable the acquiring company to perform a large acquisition without having to expose too much of its assets. In a standard LBO model, the ratio is usually around 90% bank debt to 10% equity invested by the acquiring firm. Many top-tier companies have been involved in leveraged buyouts, including RJR Nabisco (1989), Clear Channel (2006), Hilton Hotels (2007) and PetSmart, Inc. (2014), among many others.
How LBOs Differ from Other M&As
As mentioned earlier, there are several types of M&As, but the leveraged buyout model is its own breed of animal. An LBO model is most commonly employed by a private equity firm to acquire a company using bank debt financing to fund the purchase. As opposed to a standard M&A transaction, where the acquiring company is operating strategically, an LBO tends to be more return-driven, with the private equity firm focused on the internal rate of return (IRR), which is a metric used to determine the future profitability of an investment.
In other words, an LBO looks to become profitable down the road from the free cash flow derived from the acquired business. LBO modeling typically involves a much greater debt-to-equity ratio and equity value than standard M&As, and an LBO secures the acquisition debt with the company that was acquired, which is a major differentiating factor.
Why Are LBOs Performed?
The biggest reason leveraged buyouts are a popular financial model with private equity investors is because very little capital is required up-front in order to conduct the transaction, thereby protecting investors from a large amount of financial exposure. If things go bad in the future with the financial modeling transaction, it is the target company that is stuck with the debt. Of course, that doesn’t mean that the acquiring company is shielded from loss; there is the possibility of lawsuits from shareholders, which is not an entirely uncommon outcome in the dog-eat-dog business world.
When Is an LBO Employed?
There are several scenarios when a leveraged buyout financial modeling is performed, including the following.
- To take a public company private: Taking a company private means consolidating the target company’s public shares into the investment firm that will take those shares out of circulation.” And now that the investor (or investors) owns all or the majority of the shares of the target company, it is possible to have the company take on the debt liability for the transaction, as described above.
- To split a large company or spin off a division: Companies grow and change focus, and sometimes that’s not for the better. Larger companies often become conglomerates (a corporation that contains multiple subsidiaries or divisions, quite often in unrelated industries), and the goal is to split the larger company into two (or more) smaller companies.
- To boost performance of an underperforming company: If an investor sees a company that looks to be performing below its potential or if the purchase price is determined to be less than what the company could ultimately be worth, then it is a candidate for an LBO.
- To create wealth for shareholders: In the business world, companies are typically managed to create as much wealth as possible. With that in mind, when a company is acquired or purchased, its stock price generally goes up. In the case of an LBO, the investors are the beneficiaries of those capital gains.
The LBO Process
A typical LBO involves several steps. These include the following:
- Making assumptions on purchase price: This includes researching the price, checking interest rates, reviewing the balance sheet and income statement, and determining other financial factors involving enterprise value.
- Creating sources and uses of investment funds: A table of sources and uses is created in LBO modeling. Sources tell exactly where the money and free cash flow is coming from; uses indicate the amount of money required to complete the transaction.
- Conducting financial projections: Here, future performance is projected in a financial model, including the income statement, balance sheet and other financial documentations.
- Adjusting the balance sheets: The balance sheets are adjusted, reflecting the new debt, debt financing, and equity value.
- Tracking the private equity firm’s exit: Once all financial projections (and associated enterprise value adjustments) are completed, the private equity firm’s exit from its investment can occur.
- Calculating the internal rate of return (IRR): In short, IRR is used to spell out how much return is going to come from the initial investment.
One More Step for a Successful LBO
Another important step in the LBO process, and in all M&As, is to employ a virtual data room (VDR). A VDR is a critical tool in all these types of transactions. It’s an online location where all parties can securely store and share (with proper credentials) the documentation required for the transaction.
Having a trusted VDR solution like CapLinked is mandatory for your LBO transactions to remain secure, stay on schedule, and stay within budget. Click here to start your free trial today.
Chris Capelle is a technology expert, writer and instructor. For over 25 years, he has worked in the publishing, advertising and consumer products industries.
Investopedia – Leveraged Buyout (LBO)
Quora – What is the Difference Between an MA and an LBO
TheStreet.com – Leveraged Buyout: Definition, Examples and Uses
Wall Street Mojo – Leverage Buyout (LBO)