What is an LBO?
A Leveraged Buyout (LBO) is an acquisition of a company that is financed mostly through debt, with the assets of the target company used as collateral. The buyers in an LBO are often private equity firms, and financing the buyout through debt allows these firms to acquire companies without contributing a large amount of capital. The end goal for private equity firms in an LBO is to increase the value of the target company and eventually resell it a higher price than it was acquired for, turning a profit in the process.
For example, say a private equity firm is looking to conduct a leveraged buyout of a target company worth $20M. The private equity firm puts up $4M of its own money and borrows the remaining $16M through a leveraged loan, which is arranged by a commercial or investment bank. Leveraged loans are different from most loans in that their interest rates are much higher, which accounts for the relatively high risk of default. The risk of default arises from the fact that the entirety of the debt ($16M in this case) is assumed by the target company, and the possibility of bankruptcy increases because of this. Immediately after a leveraged buyout, the target company has an extremely high debt to equity ratio.
Now that the target company has been acquired, the private equity firm will use its expertise and human capital to restructure the target and make it more profitable (a completely new management team is often brought in to replace the old management, and LBOs are sometimes referred to as “hostile takeovers” because of this). During this period, the target will pay off debt until the full amount of the original $16M loan is repaid, plus interest. When the loan is finally repaid and the company restructured, the private equity firm will resell the company for more than it was purchased. In this example, the private equity firm was able to resell the target company for $30M. Assuming the total cost of the leveraged loan was $22M ($16M principal + $6M interest) and accounting for the original $4M investment, the private equity firm makes a profit of $4M, doubling their investment.
What Kind of Companies are Good Targets for LBOs?
An ideal candidate for a leveraged buyout is a company that has a stable cash flow, has low outstanding debt, and is undervalued. Companies that display these traits are most likely to avoid bankruptcy and maximize profitability for their buyers.
Perhaps the most important characteristic that an LBO target company needs to display is a stable cash flow. Strong and stable cash flows will allow the business to survive while it pays off the incredible amount of debt it incurred during the acquisition. If the company can’t handle its debts, it will be forced into bankruptcy and the PE firm will lose its entire investment as the bank seizes the company’s assets as collateral.
Another key feature of LBO target companies is that they have low outstanding debt at the time of acquisition. If a large amount of debt already exists when the buyout occurs, the company almost certainly will not be able to handle the payments associated with its pre-existing debts in addition to those associated with the leveraged loan. The leveraged loan would demand even higher rates in this situation, creating a nightmare scenario for the business.
Because the money to be made in an LBO is in the margins, an undervalued company can save buyers money by reducing the total cost of the acquisition, which therefore reduces the total size and cost of the loan. When the target company is resold, its newly restructured management and greater efficiency make for a higher valuation, increasing profits considerably.
· First Data Corp
· RJR Nabisco