Leveraged Buyouts

Meaning
• A leveraged buyout (LBO) is the purchase of a
company using a large amount of debt or
borrowed cash to fund the acquisition.
• Typically, the acquiring company uses
the assets of the acquired company as
collateral for the new loan.
– Typical LBO operation
• Financial buyer purchases company using high level of
debt financing
• Financial buyer replaces top management
• New management makes operating improvements
• Financial buyer makes public offering of improved
company at higher price than originally purchased
 TYPES OF LBO’S

• LBOs are typically used for three purposes,

each in the category of corporate acquisitions
generally. These are 1) taking a public
company private, 2) financing spin-offs, and 3)
carrying out private property transfers
frequently related to ownership changes in
small business.
 Public to Private
• The first situation arises when an investor (or investment group) buys
all of the outstanding stock of a publicly traded company and thus
turns the company into a privately-held enterprise ("taking private"
in reverse of "going public").
• These deals may be friendly or hostile, the two terms related to
management's point of view.
• Friendly cases typically involve the management buying the
company for itself with plans to operate it thereafter as a privately-
held entity.
• Hostile cases involve an investor or investor group intent on buying,
reorganizing, and then reselling the company again to realize a high
return.
• The sale of the company may be to another company or may be to
the public in a stock offering. In the last case the situation actually
amounts to a transaction more aptly labeled public-to-private-to-
public.
• There are other variants in the disposition or in the payback of a
third-party investor, although they tend to be rare, such as very high
dividend payments and recapitalization by other groups.
 Spin-Offs
• A spin off is public or private sale of asset that
provide a company with a valuable cash injection
or allow it to increase efficiency in focus of
operation.
• Public or private companies often wish to sell off
elements of their business to get cash. In some
cases the seller may itself have been bought in an
LBO and is spinning off assets to pay the investors
back.
• An LBO is also used to purchase the subsidiary or
division of a company.
 Private Deals
• The Private Deals concerns cases where a privately
held operation is bought by an investor group.
• Such cases often arise when a small businesses owner,
having reached retirement age, wishes to divest him-or
herself of the company and either cannot find a
corporate buyer or does not wish to sell to a company.
• The buying group itself may be the company's
employees or individuals associated in some way with
the owner. These people organize an LBO because they
only have limited equity.
 Characteristics of LBO
• Tax advantages associated with debt financing,
• Freedom from the scrutiny of being a public
company or a captive division of a larger parent,
• The ability for founders to take advantage of a
liquidity event without giving up operational
influence or sacrificing continued day-to-day
involvement
• The opportunity for managers to become
owners of a significant percentage of a firm’s
equity.
 Advantages of an LBO
• The main advantage of a leveraged buyout to the company
that is buying the business is the return on equity. Using a
capital structure that has a substantial amount of debt
allows them to increase returns by leveraging the seller’s
assets.
• From the seller’s perspective, there are advantages to using
an LBO. First and foremost, it is one of the many ways that
an owner can sell a business. Most sellers will go through
with the LBO process as long as it allows them to exit the
business at their desired price.
• Leveraged buyouts also allow for the sale of companies that
are in distress or going through a turnaround. They provide
a viable exit to the seller while also allowing the business to
continue operating while the problems are fixed.
 Disadvantages of an LBO
• From a buyer’s perspective, LBOs have some risks. The
main disadvantage is that, once the deal is completed,
the target business is very leveraged. This scenario
allows for little margin of error. A problem with
liquidity, such as the loss of a few key customers, could
put the business in serious distress.
• From a seller’s perspective as well, executing a
leveraged buyout has some disadvantages. Buyers
usually undertake an extensive due diligence process.
This process can consume time and resources which
could be spent managing the business. Furthermore,
their lenders may also want to do their own due
diligence, adding to the disruption. Lastly, even after all
this effort, the transaction could fall through if a key
lender is not comfortable with its findings.
 How is the purchase financed?
• Most small and midsize company leveraged buyouts usually
require two types of financing. The buyer needs funds to
acquire the company. They also need some financing to
operate and expand the business.
• The type of debt that is used to purchase the company
depends on a number of variables such as the financial
health of the buyer and the seller, their reputations, and
the size of the transaction.
• Larger transactions that involve well-known companies
commonly use a mix of bonds, senior and mezzanine
financing, and conventional bank lending.
• On the other hand, smaller transactions, or those involving
companies that are not well known, tend to use alternative
financing options.
 Options of Financing LBO
Private Equity: typically funds 25% of the total
transaction. This is also the most expensive source of
financing. Sources of this equity can include the target
company's management team, a pool of funds held by LBO
firms, as well as investment banks. Equity structures may
include preferred stock held by the LBO firm, while employees
and management teams receive common stock.
Mezzanine Financing: typically funding 25% of the total
transaction, this type of financing fills the gap between equity
and senior debt. Mezzanine financing is junior to all other
debt. For this reason, it carries a higher level of risk and
interest rate to compensate investors for that risk.
Senior Debt: also known as term debt, this will usually fund
approximately 50% of the total transaction. This debt is
frequently secured by assets of the acquired company, and is
the least costly way to fund the buyout.
 Identifying LBO Candidates
At a high level, potential LBO candidates would be
undervalued stocks with strong cash flows, and
relatively low debt. Other characteristics of target
companies include:
• Large asset base
• Low future capital requirements
• Potential for process improvements or cost
reductions
• Strong market position
• Relatively low enterprise value
• Finally, the ideal candidate would be a company that
can be easily separated into logical subdivisions and /
or presents the acquirer with a clear exit strategy.
 Valuing LBOs: Cost of Capital Method1

Adjusts for the varying level of risk as the firm’s total

debt is repaid.
• Step 1: Project annual cash flows until
target D/E achieved
• Step 2: Project debt-to-equity ratios
• Step 3: Calculate terminal value
• Step 4: Adjust discount rate to reflect
changing risk
• Step 5: Determine if deal makes sense
1Also known as the variable risk method.
 Cost of Capital Method: Step 1
• Project annual cash flows until target D/E ratio
achieved
• Target D/E is the level of debt relative to equity at
which
– The firm will have to resume payment of taxes and
– The amount of leverage is likely to be acceptable
to IPO investors or strategic buyers (often the
prevailing industry average)
 Cost of Capital Method: Step 2

• Project annual debt-to-equity ratios

• The decline in D/E reflects
– the known debt repayment schedule and
– The projected growth in the market value of
the shareholders’ equity (assumed to grow
at the same rate as net income)
 Cost of Capital Method: Step 3

• Calculate terminal value of projected cash

flow to equity investors (TVE) at time t, (i.e.,
the year in which the initial investors choose
to exit the business).
• TVE represents PV of the dollar proceeds
available to the firm through an IPO or sale to
a strategic buyer at time t.
 Cost of Capital Method: Step 4
• Adjust the discount rate to reflect changing risk.
• The firm’s cost of equity will decline over time as debt is repaid and equity grows,
thereby reducing the leveraged ß. Estimate the firm’s ß as follows:

ßFL1 = ßIUL1(1 + (D/E)F1(1-tF))

where ßFL1 = Firm’s levered beta in period 1

ßIUL1 = Industry’s unlevered beta in period 1
= ßIL1/(1+(D/E)I1(1- tI))
ßIL1 = Industry’s levered beta in period 1
(D/E)I1 = Industry’s debt-to-equity ratio in period 1
tI = Industry’s marginal tax rate in period 1
(D/E)F1 = Firm’s debt-to-equity ratio in period 1
tF = Firm’s marginal tax rate in period 1

• Recalculate each successive period’s ß with the D/E ratio for that period, and using
that period’s ß, recalculate the firm’s cost of equity for that period.
 Cost of Capital Method: Step 5

• Determine if deal makes sense

– Does the PV of free cash flows to equity
investors (including the terminal value)
equal or exceed the equity investment
including transaction-related fees?
 Evaluating the Cost of Capital Method

• Advantages:
– Adjusts the discount rate to reflect diminishing
risk as the debt-to-total capital ratio declines
– Takes into account that the deal may make sense
for common equity investors but not for lenders
or preferred shareholders
• Disadvantage: Calculations more burdensome than
Adjusted Present Value Method
 Valuing LBOs: Adjusted Present Value
Method (APV)
Separates value of the firm into (a) its value as if it were debt free and (b)
the value of tax savings due to interest expense.
• Step 1: Project annual free cash flows to equity investors and interest
tax savings
• Step 2: Value target without the effects of debt financing and discount
projected free cash flows at the firm’s estimated unlevered cost of
equity.
• Step 3: Estimate the present value of the firm’s tax savings discounted
at the firm’s estimated unlevered cost of equity.
• Step 4: Add the present value of the firm without debt and the
present value of tax savings to calculate the present value of the firm
including tax benefits.
• Step 5: Determine if the deal makes sense.
 APV Method: Step 1

• Project annual free cash flows to equity investors and interest

tax savings for the period during which the firm’s capital
structure is changing.
– Interest tax savings = INT x t, where INT and t are the firm’s
annual interest expense on new debt and the marginal tax
rate, respectively
– During the terminal period, the cash flows are expected to
grow at a constant rate and the capital structure is
expected to remain unchanged
 APV Method: Step 2

• Value target without the effects of debt financing and

discount projected cash flows at the firm’s unlevered cost of
equity.
– Apply the unlevered cost of equity for the period during
which the capital structure is changing.
– Apply the weighted average cost of capital for the terminal
period using the proportions of debt and equity that make
up the firm’s capital structure in the final year of the
period during which the structure is changing.
 APV Method: Step 3

• Estimate the present value of the firm’s annual

interest tax savings.
– Discount the tax savings at the firm’s unlevered
cost of equity
– Calculate PV for annual forecast period only,
excluding a terminal value, since the firm is sold
and any subsequent tax savings accrue to the new
owners.
 APV Method: Step 4

• Calculate the present value of the firm

including tax benefits
– Add the present value of the firm without
debt and the PV of tax savings
 APV Method: Step 5

• Determine if deal makes sense:

– Does the PV of free cash flows to equity
investors plus tax benefits equal or exceed
the initial equity investment including
transaction-related fees?
 Evaluating the Adjusted
Present Value Method
• Advantage: Simplicity.
• Disadvantages:
– Ignores the effect of changes in leverage on the
discount rate as debt is repaid,
– Implicitly ignores the potential for bankruptcy of
excessively leveraged firms, and
– Unclear whether true discount rate should be the
cost of debt, unlevered cost of equity, or
somewhere between the two.
 Example
• Stephen is an analyst at a private equity fund. He is asked to construct an LBO model
to determine the maximum price that the fund should pay for the target company.
Stephen makes several operating and valuation assumptions, and he creates an Excel
file.
• First, he estimates the total cost of the deal given that the target company has
a market cap of $3.4 billion and an outstanding debt of $1.8 billion. Therefore, the
total cost of the deal is $3.4 + $1.8 = 5.2 billion.
• Then, he defines how the deal will be financed. He estimates that the private equity
fund will fund $1.0 million, which is the 19.2% of the total cost, and the remaining
$4.2 billion will be funded by two separate debts equal to $1.7 billion at an interest
rate of 15% and $2.5 billion at an interest rate of 18%. Both loans will have a duration
of 10 years.
• Then, he defines the future growth rates of the target company. Revenues are
expected to grow by 12% until year 5 and by 7% from year 6 to 10 taking into
consideration depreciation and capital spending. Working capital is expected to grow
at a steady growth rate of 15%.
• The next steps in the model include the calculation of the expected cash flows from
the leveraged buyout, the capital structure of the costs of debt and equity and the
final conclusions. Stephen concludes that the deal should be accepted at a target
price of $125.
• Note that the LBO activity increases when interest rates are low because the cost of
borrowing is lower. Also, when an industry or a sector underperforms, the equity of
the target firm is undervalued.