What is a leveraged buyout?
A leveraged buyout is an acquisition of a company using a significant amount of debt to meet the cost of the acquisition.
Name three core components that contribute to the success of a leveraged buyout.
- 1. Cash availability, interest, and debt pay-down
- 2. Operation (EBITDA) improvements
- 3. Multiple expansion
Name four exit strategies to a leveraged buyout.
- 1. Strategic sale
- 2. Sale to another financial sponsor
- 3. IPO
- 4. Dividend recapitalization
What are some characteristics of a company that make a good LBO candidate?
- 1. Steady cash flows
- 2. Opportunities for earnings growth or cost reductions
- 3. A high asset base—collateral to raise more debt
What are the three main steps to conducting a leveraged buyout analysis?
- Step 1: Obtaining a purchase price
- Step 2: Estimating sources and uses of funds
- Step 3: Calculating investor rate of return (IRR)
What is the purpose of a leveraged buyout analysis?
A leveraged buyout analysis helps determine the annualized returns (IRRs) of an investor’s equity investment in a business after a specific time horizon.
Walk me through a leveraged buyout analysis.
- In order to determine the IRR of a particular investment after a certain number of years, one first needs to establish the purchase price of the business. After estimating purchase price, one needs to determine the entire uses of funds (purchase price, net debt, and transaction fees) and the sources used to fund the acquisition (some combination of term loans, high yield debts, mezzanine, and equity). One can then construct a simple unlevered free cash flow analysis that will provide a projected EBITDA for estimating an exit and total cash produced for paying down debt. The projected EBITDA is multiplied by a multiple to get an estimated exit value. Often
- the purchase multiple is used as an estimated exit multiple. In order to establish return, one needs to calculate the final debt. The original debt raised to fund the acquisition plus the total interest incurred is calculated. One can estimate total
- interest by taking each annual interest expense multiplied by the number of years and multiplied by 1 – tax%. The sum of the original debt raised and the total interest expense less the sum of the unlevered free cash flow is the final debt balance.
- The return is the exit value (from the EBITDA times the multiple) less this final debt number. One can then compare the return with the equity originally invested in the
- business to calculate the IRR.
What are some major differences between a basic LBO analysis and full-scale LBO model?
- There are many differences between a basic and full-scale LBO model. One major difference is that simple analysis would just contain a simple cash flow build-up, whereas a full-scale model would contain complete projections. This would include
- the income statement, cash flow statement, balance sheet, as well as the supporting schedules. A full-scale analysis would also include balance sheet adjustments—a more detailed look at the balance sheet post-transaction adjustments. Another major difference to highlight is the simple analysis estimates interest in one year and multiplies by the number of transaction years to estimate total interest obligations. In
- reality, if a company is paying down debt each year, the interest expense should also be reducing. Because a full-scale model contains a debt schedule, it will more associate declining interest in line with debt paydown.
What are some common types of debts raised in a leveraged buyout?
Although there is a vast range of possible securities utilized in funding a particular LBO transaction, they can come in several major categories: bank debt, high yield debt, and mezzanine debt. Bank debt, or a term loan, is the most fundamental type of debt. It usually carries 5 percent to 12 percent interest and can be backed by the core assets of the business. Such debt can be a revolving line of credit, a term loan, and other subordinated loans or notes. High yield debt is a more aggressive type of debt borrowed at much higher interest rates to compensate for additional risk of defaulting on such debts. Interest in such debt can be upwards of 15 percent, but it varies depending on the situation at hand. Mezzanine (or convertible) lending is a hybrid between debt and equity. The general concept of a mezzanine security is that it is initially considered debt that will convert to equity after a certain amount of time or after certain hurdles are met.
What are the most common variables in an LBO analysis?
- a. Purchase price. The higher the purchase price, the more costly the investment may be to the investor, and therefore the lower the IRR.
- b. Sources of cash. The amount of debt that can be raised to make such an investment will also affect the IRR. The more debt we can raise, the less equity we have to put in, and so the higher our expected returns will be.
- c. Interest rate. A lower interest rate would lower our costs, which would increase our cash, which would allow us to pay down debt faster and increase the IRR.
- d. Time frame. Typically, a shorter time frame would produce a higher IRR.
- e. Operations performance (EBITDA projections). The more we can improve EBITDA, the higher our potential sale value, which would increase IRR. Also, a higher EBITDA would improve our cash flow.
- f. Cash flow (UFCF projections). Improved cash flow performance will allow us to pay down debt faster and will improve our IRR.
- g. Exit multiple. The higher our exit multiple (exit value), the higher our return.
Name four sources of funds in a leveraged buyout from least to most risky.
- 1. Bank debt (term loan, notes)
- 2. High-yield debt
- 3. Mezzanine funding (convertible securities)
- 4. Equity
Name the three methods of acquiring a business.
- 1. Asset acquisition
- 2. Stock acquisition
- 3. 338(h)10 election
Name the core uses of funds categories.
- 1. Purchase price
- 2. Net debt
- 3. Transaction fees
What is one way to conservatively estimate an exit multiple?
Often, one can conservatively assume the purchase multiple will be the exit multiple.
Name one way to calculate IRR.
IRR can be calculated as: (Exit Equity Value/Equity Invested) ^ (1/Years) − 1
What are the major variables to an LBO analysis? Name at least four.
- 1. Purchase price
- 2. Sources of cash
- 3. Interest rate
- 4. Time frame
- 5. Operations performance (EBITDA projections)
- 6. Cash flow (UFCF projections)
- 7. Exit multiple
What are some advantages of LBO financing?
- a. The more debt used to make the purchase, the less equity needed, which can
- maximize potential returns.
- b. Interest payments on debt are tax deductible.
What is the advantage to using leverage when making an acquisition?
The more leverage used to fund an acquisition, the less equity needed. Less equity invested will maximize your return
How can one determine the amount of debt raised?
One can use debt multiples as comparable metrics to other similar leveraged buyouts.
Would you rather have an extra dollar of debt paydown or an extra dollar of EBITDA?
You would rather have the extra dollar of EBITDA because of the multiple. At exit, the sale price is dependent on the EBITDA times the exit multiple. So, an extra dollar of debt paydown increases your equity value by only one dollar; an extra dollar of EBITDA is multiplied by the exit multiple.
Name several strategies to maximize returns in an LBO.
- 1. Minimize equity invested (this can be done by increasing the debt used).
- 2. Reduce the purchase price.
- 3. Increase the sale price (exit).
- 4. Increase EBITDA (cutting costs or boosting revenue).
- 5. Maximize cash flow.
What is a dividend recapitalization?
In a dividend recap, the company re-levers (raises debt on) the balance sheet. The new money raised is often paid out as a dividend.
What is the advantage of performing a dividend recap?
A dividend recap could have several advantages in maximizing returns. One common advantage is to extend the holding period of the company while still raising cash to expend for the fund’s needs. If the market environment is not the best for target company exit, a dividend recap would allow the fund more time to look for the right exit opportunity
What cost of equity discount rate would you use to value a target company in a leveraged buyout using a discounted cash flow analysis?
You would often use a rate that reflects the expected equity return of the fund. If the fund is expecting a 25% return, this could be the rate to use
What is a PIK security?
A PIK security is a paid-in-kind security. The periodic interest obligations are satisfied “in kind,” meaning in something other than currency. Typically, when the interest obligation comes due, more debt is raised to meet that obligation. This results in interest-on-interest, which can get costly. On the other hand, it reserves cash for other beneficial uses.
What is the purpose of a seller note in a leveraged buyout?
A seller note is a loan to the purchased business from the seller. If a certain purchase price is negotiated in an acquisition, a certain amount is of course paid immediately, and the rest can be deferred as a seller note payable in certain terms. This can be used to prevent the seller from starting a competing business or can incentivize the seller to continue to support the business.
What does an LBO Model contain?
- Purchase Price Assumptions
- Sources and Uses of Cash Schedule
- Capital Structure Alternatives
- Pro Forma Balance Sheet
- Integrated Financial Model
- IRR Analyses
Causes of Acquirer's Stock Price Dilution
- The target has a negative net income
- Acquirer borrows the cash to fund the purchase of the stock, resulting in increased interest expense
- Acquirer uses balance sheet cash to fund a portion purchase price
- A large amount of new amortization intangibles
- Target has a higher P/E multiple than the acquirer
Required information for both the acquirer and target
- Fully-diluted shares
- Current share prices
- Current balance sheets
- LTM and forward earnings per share
- Additional information on the offer
What items are sensitized in an M&A Model?
- Range of share price paid / premium to current share price
- Range of considerations (cash/ equity) for acquisition
- Range of options for how cash portion is financed (new debt, b/s cash)
- Price/Earnings Ratios
- Accretion/ Dilution to EPS
- Proforma Ownership of Acquirer and Target Shareholders
- Pre-tac synergies to breakeven