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Leveraged Buyout: Definition, Examples, Pros & Cons of the LBO model
In a leveraged buyout (LBO), one company purchases another with leveraged funds; the majority is borrowed to meet the cost of the purchase.
QUOTE
The worth of a business is not measured by what has been put into it, but by what can be taken out of it.
Big ideas
- The defining characteristic of a leveraged buyout is that the money used for the purchase comes from debt (such as bonds or a private note), typically using the acquired company's assets as collateral for the loan.
- Through an LBO, a relatively small company can take over a much larger entity, as it relies nearly exclusively (typically about 70% to 80%) on borrowed funds. The debt can be paid down through cash flow generated from the acquired company.
- The leveraged buyout has a reputation as a predatory practice, using the assets of the soon-to-be acquired firm against it. The debt-to-equity ratio will be as high as possible.
What is a leveraged buyout?
DEFINITION
The leveraged buyout is a debt-funded acquisition, usually undertaken by a private equity firm. The idea is that the new owners can then improve on existing processes and/or add new revenue streams to more than cover the extra debt burden incurred during purchase.
The LBO is a purchasing strategy that went into decline after the 2008 financial crisis, but has recently seen a resurgence since around 2020.
The LBO is a purchasing strategy that went into decline after the 2008 financial crisis, but has recently seen a resurgence since around 2020.
Leveraged Buyout Financing
The assets of the to-be-acquired company are used as collateral for the loan, and the debt is typically paid off using revenue generated from the purchasing company.
Leveraged buyouts can be seen as predatory practices because they can be very advantageous to the purchasing company, with the to-be-acquired company taking on most of the risk.
Once the purchasing debt is paid down, the income streams return to the investors. It can be a very lucrative investment structure for investors, without requiring upfront cash to take a majority stake in the newly acquired business.
At the same time, it is worth remembering that some leveraged buyouts can be complete and utter catastrophes; taking on huge debt levels is only a good idea with excellent planning and execution. If the company is not profitably managed, then the debt may not be paid back, and there will be little to no revenue streams from the new company.
Two well-known examples are:
1. Toys "R" Us (2005): Bain Capital and KKR's acquisition led to overwhelming debt, preventing necessary modernisation. The retailer filed for bankruptcy in 2017, unable to compete with online stores while servicing its debt obligations.
2. Reader's Digest (2007): Ripplewood Holdings' $2.4 billion buyout collapsed into bankruptcy in 2009. The print magazine's declining readership in the digital age made debt payments unsustainable, showing how market shifts can doom leveraged companies.
Leveraged buyouts can be seen as predatory practices because they can be very advantageous to the purchasing company, with the to-be-acquired company taking on most of the risk.
Once the purchasing debt is paid down, the income streams return to the investors. It can be a very lucrative investment structure for investors, without requiring upfront cash to take a majority stake in the newly acquired business.
At the same time, it is worth remembering that some leveraged buyouts can be complete and utter catastrophes; taking on huge debt levels is only a good idea with excellent planning and execution. If the company is not profitably managed, then the debt may not be paid back, and there will be little to no revenue streams from the new company.
Two well-known examples are:
1. Toys "R" Us (2005): Bain Capital and KKR's acquisition led to overwhelming debt, preventing necessary modernisation. The retailer filed for bankruptcy in 2017, unable to compete with online stores while servicing its debt obligations.
2. Reader's Digest (2007): Ripplewood Holdings' $2.4 billion buyout collapsed into bankruptcy in 2009. The print magazine's declining readership in the digital age made debt payments unsustainable, showing how market shifts can doom leveraged companies.
How does a leveraged buyout work?
The LBO works by purchasing a new company mainly with debt, typically in the region of ~70% debt to ~30% equity. The assets of the new company are used as collateral for the debt taken on.
EXAMPLE
One notable (and successful) UK-based leveraged buyout was the 2007 acquisition of Alliance Boots, the owner of high street pharmacy chain Boots, by private equity firm Kohlberg Kravis Roberts (KKR). Alliance Boots, a major pharmacy and health retail group, was taken private in the transaction.
KKR acquired the company in a £11.1 billion LBO, contributing around £1.22 billion in equity. The deal was highly leveraged, with nearly 70% of the debt financed from a consortium of banks. The remaining portion of the financing came from other equity partners and cash flows from the business itself.
Walgreens initially acquired a 45% stake in 2012 and later completed the full acquisition in 2014. The LBO aimed to improve operational efficiency and expand the company’s footprint. KKR's investment in Alliance Boots generated an estimated 2.7x return, primarily through the gradual sale of its stake to Walgreens.
KKR acquired the company in a £11.1 billion LBO, contributing around £1.22 billion in equity. The deal was highly leveraged, with nearly 70% of the debt financed from a consortium of banks. The remaining portion of the financing came from other equity partners and cash flows from the business itself.
Walgreens initially acquired a 45% stake in 2012 and later completed the full acquisition in 2014. The LBO aimed to improve operational efficiency and expand the company’s footprint. KKR's investment in Alliance Boots generated an estimated 2.7x return, primarily through the gradual sale of its stake to Walgreens.
The skill of the acquiring management team is crucial to a successful leveraged buyout. If the newly acquired company cannot be run more effectively than it is currently, then there is no tangible reason for the buyout. Usually, the company to be acquired is in difficulty for some reason, thus the reason for the sale. This problem area needs to be specific, with a clear roadmap to resolution.
The mechanics of an LBO
Despite their predatory reputation, the logic behind leveraged buyouts is strong. A strong management team skilled in a specific area can acquire a struggling company, without having to come up with much equity stake. Broadly speaking, there are four steps leading up to a buyout:
- Management team - A strong management team (industry analysts, investment bankers, etc.) comes together and identifies struggling companies.
- Business plan - A business plan outlines how the revenue streams will be improved and how the debt will be paid off, including the (often high) interest rate.
- Funding – This is often the most challenging part. Funds now have to be acquired, typically in private notes or bonds. Occasionally, it can also be mezzanine financing, bank financing, or seller financing.
- Due diligence - Due diligence procedures are often very intensive due to the reputation and style of LBOs, as compared to other purchasing methods.
There are typically three parties within the leveraged buyout - the private equity firm, the target company, and the lenders.
Financing options for leveraged buyouts
While the typical form of funding in an LBO is about 70% to 80% debt, there are multiple subcategories. The main financing options for LBOs are as follows:
- Debt financing - This refers to borrowing money to fund a significant portion of the acquisition. The debt is repaid using the acquired company’s future cash flows, reducing the buyers' equity contribution.
- Senior debt - This has the highest priority in repayment during liquidation. It offers lower interest rates due to its secured status, backed by the company’s assets, and typically forms the largest part of LBO financing.
- Subordinated debt - This ranks below senior debt in repayment priority. It carries higher interest rates to compensate for increased risk since it is repaid only after senior obligations are fulfilled.
- Mezzanine financing - A hybrid of debt and equity, offering lenders the right to convert into equity if the loan is not repaid. It fills the gap between senior debt and equity, carrying higher interest rates.
- High-yield bonds - These are unsecured bonds with higher interest rates, reflecting their increased risk. They are often referred to as junk bonds.
Along with debt, equity financing in LBOs comes from the buyer's own capital, as well as from private equity firms. This constitutes a much smaller part in comparison to debt financing.
Types of leveraged buyouts
There are various styles of leveraged buyouts. They can be complex arrangements that rely on third-party financing and specialised expertise. The LBO is a high-risk and high-reward manoeuvre that often involves industry insiders and seasoned investment professionals.
- Management buyouts (MBO) - With an MBO, a company’s existing management team buys out the business, using debt financing along with its own equity. This structure aligns management's interests with ownership, allowing them to control the company’s future direction.
- Buy-in management buyouts (BIMBO) - A BIMBO involves both existing managers and external executives acquiring a business together. This approach combines internal knowledge with fresh expertise.
- Secondary and tertiary buyouts - These refer to businesses being acquired by new private equity firms after an initial round of buyouts. Secondary buyouts involve a second buyer. Tertiary buyouts occur when the company changes hands for a third time.
- Owner buyout - An owner buyout happens when a current owner uses debt to acquire the remaining shares/ownership stakes. This allows the owner to control the business fully without bringing in new external investors.
- Leveraged buildup - In a leveraged buildup, multiple small companies are acquired to form a larger entity. The goal is to improve value by combining operations, leveraging debt to fund each acquisition.
- Public-to-Private (P2P) - A public company is taken private through an LBO. This is common when investors believe that the company can be restructured or repositioned away from the public market's pressures. Elon Musk's takeover of Twitter (now rebranded as X) can be classified as a public-to-private (P2P) leveraged buyout.
Beyond these main categories, other specialized LBO types exist. One notable example is the split up – a hostile takeover strategy where the buyer acquires a company to sell its assets separately and reduce the workforce, famously depicted by Michael Douglas as Gordon Gekko in Wall Street.
The other scenario would be the saviour plan – the existing management team borrows money, adjusts and upgrades the company processes, and all existing parties will benefit. This is what Charlie Sheen’s character was aiming to do in the same movie before being double-crossed by Gekko. This is the rarest type of leveraged buyout.
The other scenario would be the saviour plan – the existing management team borrows money, adjusts and upgrades the company processes, and all existing parties will benefit. This is what Charlie Sheen’s character was aiming to do in the same movie before being double-crossed by Gekko. This is the rarest type of leveraged buyout.
Risks and challenges of leveraged buyouts
LBOs offer growth potential but also bring significant risks. High debt levels can threaten cash flows, while operational disruptions and market instability can impact profitability. These risks demand careful planning to maintain long-term financial health and stability.
Financial risks: Cash flow pressure
Leveraged buyouts rely heavily on borrowed funds, creating large debt obligations. Companies must generate consistent cash flow to meet interest and principal payments. If revenue falls short, liquidity issues arise, forcing cost cuts or asset sales.
Even a small drop in cash flow can disrupt operations. Managing cash flow becomes more difficult when debt terms are strict or business conditions change, increasing the risk of default.
Even a small drop in cash flow can disrupt operations. Managing cash flow becomes more difficult when debt terms are strict or business conditions change, increasing the risk of default.
Operational risks: Management changes
Leadership changes often occur after an LBO, bringing challenges. New managers may need time to understand the business, which can slow decision-making. Existing employees might resist changes to processes or culture, leading to inefficiencies.
If management teams fail to deliver improvements quickly, the company may struggle to meet its financial targets. Balancing operational continuity with fresh leadership vision is a common issue in these scenarios.
If management teams fail to deliver improvements quickly, the company may struggle to meet its financial targets. Balancing operational continuity with fresh leadership vision is a common issue in these scenarios.
Market risks: Economic downturns
Market conditions directly affect LBO performance. During an economic downturn, revenue can shrink while costs remain fixed, making it harder to cover debt payments. Market volatility also impacts valuations, complicating asset sales or refinancing efforts.
A tight credit environment may reduce access to capital, leaving businesses without financial flexibility. LBO companies are particularly vulnerable when consumer demand or sector performance declines.
A tight credit environment may reduce access to capital, leaving businesses without financial flexibility. LBO companies are particularly vulnerable when consumer demand or sector performance declines.
Evaluating potential candidates for LBOs
Selecting the right company for an LBO requires looking at business fundamentals, financial stability, and market trends. Successful LBOs target companies that can sustain debt while offering room for growth and operational improvements over time.
Characteristics of attractive LBO targets
Ideal candidates have strong cash flow, stable demand, and predictable revenue streams. Mature companies with limited growth but low capital needs are attractive since they generate steady profits. Firms with high margins or the potential for operational efficiencies make good targets.
How Leveraged Buyouts create value
Market leaders with defensible positions, loyal customer bases, and minimal competition reduce risk. Companies undergoing ownership transitions, like family-owned businesses, often present opportunities for buyouts.
Financial metrics to consider
Key metrics include EBITDA, free cash flow, and debt-to-equity ratio. A healthy EBITDA margin ensures the business can support debt repayments. Free cash flow is essential for servicing debt and funding growth.
Moderate leverage is preferred, as excessive debt increases the chance of default. Valuation multiples, such as EV/EBITDA or EV/Sales, help assess if the target is priced reasonably. Consistent past earnings performance adds confidence in future projections.
Moderate leverage is preferred, as excessive debt increases the chance of default. Valuation multiples, such as EV/EBITDA or EV/Sales, help assess if the target is priced reasonably. Consistent past earnings performance adds confidence in future projections.
Industry trends impacting LBO viability
Based on market dynamics, certain industries are more suited for LBOs. Sectors with low volatility, like healthcare or consumer staples, provide stability. Industries with fragmented markets offer consolidation opportunities, adding value through acquisitions.
Regulatory shifts or technological advancements can make some sectors less viable for LBOs. Economic cycles also influence viability. Consumer-driven businesses may face higher risk during downturns, while industrial sectors tend to perform well when demand picks up.
Regulatory shifts or technological advancements can make some sectors less viable for LBOs. Economic cycles also influence viability. Consumer-driven businesses may face higher risk during downturns, while industrial sectors tend to perform well when demand picks up.
Recap
The LBO is a complex, high-risk, operation that might work for a group of specialists, often industry insiders, who know precisely what they are getting into.
Thus, even with the best of planning, systematic risks and outside events are big risks for any LBO; potentially disturbing cash flow and making it difficult or impossible to pay off debt, as well as the high levels of interest.
Thus, even with the best of planning, systematic risks and outside events are big risks for any LBO; potentially disturbing cash flow and making it difficult or impossible to pay off debt, as well as the high levels of interest.
FAQ
Q: What are the steps of an LBO?
The process starts with identifying a target company, followed by structuring debt and equity financing. After acquiring the company, operational improvements and cost efficiencies are implemented. The goal is to repay the debt over time and eventually exit through a sale or IPO, generating returns.
Q: What are the key assumptions in an LBO model?
Key assumptions include purchase price, leverage ratio, interest rates, and exit multiple. Projected EBITDA, free cash flow, and revenue growth are critical to estimating debt repayment. The holding period and expected valuation at exit also play an essential role in the model.
Q: What are the factors necessary to a successful LBO?
Strong cash flow generation, stable operations, and a reasonable purchase price are critical. A manageable debt load ensures the company can meet obligations. Operational improvements, favourable market conditions, and a well-timed exit contribute to success. Experienced management also plays a crucial role.
Q: What is a 3-statement LBO model?
A 3-statement LBO model integrates the income statement, balance sheet, and cash flow statement. It forecasts the company’s performance under the LBO structure, showing how cash flow is used to repay debt. It also tracks changes in equity and debt over time.
Q: What are the key risks in LBO?
Key risks include excessive leverage, interest rate increases, and operational setbacks. If cash flow weakens, meeting debt payments becomes challenging. External risks, such as economic downturns or regulatory changes, can affect profitability. A poor exit strategy may reduce returns.
Q: Are LBO models difficult?
LBO models require precision and solid financial knowledge. They involve building detailed projections and balancing assumptions around cash flow, debt, and valuation. While complex, the models become manageable with experience, especially for those comfortable working with financial statements and forecasts.
- Collateral: Valuable assets pledged by a borrower to secure a loan. In leveraged buyouts, the target company’s assets often serve as collateral for the financing.
- Hostile takeover: An acquisition attempt carried out against the wishes of a target company’s board, usually involving direct appeals to shareholders or other tactics.
- Junk bond (high-yield bond): A bond offering above-average interest rates to compensate for its higher risk of default. Such bonds are frequently used to fund leveraged buyouts.
- Equity stake: The portion of a company’s shares owned by an individual or group, signifying a claim on the firm’s profits and assets.
- Private note: A form of loan agreement not sold to the public on a market. It’s negotiated privately, often used to fund a portion of a company’s acquisition.
