LBOs are associated with very advanced financial modelling and students sometimes get scared when the concept comes up.
In reality, while investment bankers do run LBO models on a very regular basis, it is one of the simplest concepts and easiest things to model in high finance.(1)
Leveraged Buyout Walkthrough
A leveraged buyout means that you are using leverage to buy out a company. In simpler terms, it means you are purchasing a company partially funded with debt. In a private equity context, the company will start to pay down debt using free cash flows before being sold in a reasonable time horizon (the base case is 5 years, this is called the “exit”).
The idea is that due to the lower cost of capital of debt (especially on an after-tax basis owing to interest deductibility), you will elect to use debt as much as you can as long as it is below your cost of equity. That is one way to look at it.(2)
The simpler way to look at it is that you reap the rewards of ownership despite using Other People’s Money – a very powerful financial concept.
Example Leverage Case Study Using Residential Real Estate
For the layman, let’s look at a house.
You put $100,000 down on a $400,000 condo. It goes up 10% to $440,000 in one year. The asset is up 10%.
If you bought the condo with all cash, your return on investment and return on equity is 10%.
Now if you bought the condo only putting down a $100,000 down payment and covering the rest with mortgage (75% loan-to-value or LTV), you owe the bank $300,000 but you own the property.
If the condo goes up 10% in one year, the property is worth $440,000. What you owe the bank remains the same $300,000 (ignoring principal repayments and assuming that your rent just covers your interest and principal). So your equity value is now worth $440,000 – $300,000 = $140,000.
Your return on equity is $40,000/$100,000 or 40%. Same asset, markedly different returns on the money you invested. This is how leverage works.
Leverage juices returns. Leverage is how people get rich – whether financial or operational. However, leverage is a knife that cuts both ways.
If your house was purchased for $1 million and your down payment was $200,000 before the housing market crashes, devaluing your house that now trades at $800,000, your equity has been wiped out to zero.
Good Leveraged Buyout Candidates
Moving on from a simple house to a business that generates cash flows, the old LBO model (and the one that is easy to put down on paper) is for a private equity firm/corporate raider to find a company that has strong, stable cash flows, low capital expenditure requirments, with a decent return on equity and low levels of debt. Basically, an underlevered cash cow.(3)
Then you secure financing from banks for a loan, a bridge loan for high yield bond takeout and provide some of your own equity from a fund that you just raised, pay a large premium for the stock if it is publicly traded and then boost the return on your equity via cheap debt.
The stable cash flows make sure that you will comfortably service your lofty interest payments after relevering the company and the equity cheque you have to cut is low because the debt as a % of the LBO in terms of a funding source is huge.
Unfortunately, LBOs have become commoditized now and do not return the same as they used to. Banks and debt investors do not allow the same level of leverage (debt as a number of turns of EBITDA) anymore and also require a larger equity cheque (think of this as the down payment on the house – instead of a 10% down payment they may expect 25 or 50%). A higher equity cheque means a lower IRR.
Sources and Uses: Modelling the LBO and IRR Triggers
First, the private equity firm will purchase a company at a valuation that can also be communicated as a purchase multiple of EBITDA (a crude proxy for cash flow). For example, if EBITDA is $100 million and the multiple contemplated is 7x, the purchase price will be $700 million.
Next, the sources and uses for funding have to be determined. On the uses side, we look at the $700 million value of the contemplated transaction and see whether that means just the equity or the assumption of some outstanding debt on that balance sheet. You also need to set aside 1 or 2% of the purchase price to pay investment banking fees, lawyer fees, debt issuance fees and accounting fees. (in buying a house – same thing, the house sells for $1 million, you need to pay real estate agent fees of 3% so the uses are $1.03 million – the sources are the mortgage and your equity cheque).
On the sources side, you are raising debt from a variety of stakeholders, from the banks (the most senior) to the subordinated debtholders. Then you will have preferred shares and equity.
Assuming that you have EBITDA and capex lines, the LBO really just takes a stream of levered free cash flows before an exit – LBOs and private equity firms generally will see a sale of the business in the end.
Every year, operating cash flows will be reduced by capital expenditures (the CFO line in the statement of cash flows already accounts for changes in net working capital and interest) to get to a levered free cash flow number. This levered free cash flow number will either be used to pay down debt or be kicked out to the financial sponsor/private equity firm via a dividend.
Usually, the EBITDA is expected to grow while debt is paid down. Inflation works well for LBOs because cash flows will rise while the cost of debt is eroded owing to the time value of money (a dollar today is worth more than a dollar tomorrow).
During the exit year, we again assume an exit multiple where the company is sold off.
So what affects your return on equity or IRR? If you lower the purchase multiple, you will increase your IRR and vice versa. If you lower the exit multiple, you will lower your IRR and vice versa. If you increase the amount of debt as part of the uses, you increase your IRR. If you lower the interest rates, you will increase your IRR.
1. Operational modeling and three statement modelling are actually more difficult and require better accounting and algebra skills – an LBO is a simple IRR formula that you can build easily with an EBITDA line and a few debt tranches.
2. Theoretically, the more debt you layer on, the more expensive the incremental debt costs. This is because as the risk of default increases (as meeting interest obligations becomes more difficult), debtholders must be compensated for the additional risk with a higher promised return (higher interest). Also, different debt investors will have different risk profiles – banks need to be paid back and are the most senior, secured debt. High yield bonds and subordinated debt rank lower in the capital structure and must be compensated for their subordinated claims. Bank debt might fund 30% of a transaction where junior debt may make up an incremental 40%, all of which demands a higher coupon than the bank debt.
3. Following this logic, companies with unstable cash flows, such as cyclical stocks or commodity producers (oil and gas companies are at the mercy of macroeconomics and regional egress dynamics) will not be able to lever as much as an infrastructure asset with secure cash flows. An oil and gas LBO may only be levered up to 2x or 3x, accordingly. The more utility like the cash flows, the higher the leverage it can support. A telecommunications company with a steady customer base has historically been able to hold plenty of debt on the balance sheet, although this is slowly changing if you look at firms such as Frontier Communications.