A Beginner’s Guide to a Leveraged Buyout

For those of you wondering, in layman’s terms, a leveraged buyout is the acquisition of another company using a significant amount of borrowed money to meet the cost of the acquisition.

For a Private Equity (PE – i.e. financial investor) to optimise the Internal Rate of Return (IRR) on their equity investment, they use leverage when it is available. (More links to definitions for PE, IRR, etc. can be found at the end of the blog). It took over three years after the great recession for banks and other institutions to make debt more readily available. And now, it is once again easier to organize debt financing for acquisitions. Currently, financial buyers are accounting for about one-quarter of mid-sized acquisitions and most are leveraged.

Using leverage does not reduce the purchase price of the target. So how does leverage lead to a better IRR for the investor?

PE investors measure the IRR on their deployed capital. Using leverage reduces the amount of their equity invested (i.e. “deployed capital”). But of course, leverage is not for free; there is both an interest charge and there are other costs in addition. Let’s say a company generates EBITDA of €6.25m, has no debt and no excess cash, and is valued at €50 million (i.e. a valuation equal to 8x EBITDA).

The business plan calls for doubling the bottom line growing to €12.5m in year 4. If the company is valued again at 8x EBITDA at the time of the PE investor’s exit four years later, that would translate to an Equity Value of roughly €100 million (8x €12.5m = €90 million of enterprise value plus the excess cash of ~€30m produced from the following four years of profits). The €130 million exit valuation represents a 2.6x return on the invested capital of €50 million and calculates to an IRR of 27% p.a. This is not bad, but may not be sufficient enough to investors in order to justify their cost of capital and to account properly for the downside risk or the fact that it might take 5 years instead of 4 to achieve the forecasted growth.

So, what is an investor to do to increase their IRR and absolute return in such an investment case?

The PE will try to get a financial sponsor (i.e. a bank or other financing institution such as a government backed organization or a specialist debt investment fund) in order to complete a successful leveraged buyout.

Let’s assume the PE investor can organize a financial sponsor willing to provide €25 million of debt to NewCo to finance half the purchase price of the company. Given the €50 million price tag as in the example above, the PE needs to invest only €25 million of equity to finance the purchase on top of the €25 million loan.

The loan conditions would be negotiated such that the company’s profits in the following 4 years are sufficient for paying off the debt as well as paying the interest. As opposed to the “unleveraged” example above, the company ends up with less or no excess cash on the balance sheet at the time of exit as most, if not all, of the company’s profits are used to pay the interest charges and the principle of the debt at or prior to exit.

If the company is valued once again at 8x EBITDA at the exit, that would result in an Equity Value four years after the LBO equal to €100 million (8x €12.5m = €100 million). There is no excess cash added to the valuation in this leveraged case as the accumulated cash in our LBO example would be used to pay the principle of the loan leaving no net cash and no net debt at exit.

The €100 million Equity Value represents a 4.0x return on the invested capital of €25 million. This ends up calculating to a significantly higher IRR of 41% p.a. versus the IRR of 29% in the example above without leverage.

And if it should take 5 years to double the company’s profits and to exit then for €100 million, the IRR is still a very respectable 32% p.a.

Outside of interest, what other “costs” are associated with using leverage?

The other costs are related to the covenants of the loan. Banks’ require certain KPIs to be maintained throughout the term of a loan.

They add expense, reduce flexibility and can be very burdensome. Sometimes it is even possible to lose control of a company if the investors agree to onerous covenants.

Nevertheless, most acquisitions where a PE firm can organize leverage will have some leverage. In fact, almost as much as is doable. Sometimes, 50% of the EV may be financed with debt.

Here is a link http://www.loanuniverse.com/covenant.php to an article describing a number of typical covenants a loan may require a company to commit to.

Deployed capital – http://www.investopedia.com/terms/c/capitalemployed.asp
EBITDA – http://www.investopedia.com/terms/e/ebitda.asp
Equity Value and Enterprise Value – http://www.financewalk.com/2011/calculate-equity-enterprise/
IRR – http://www.investopedia.com/terms/i/irr.asp
Leverage – http://bizfinance.about.com/od/pricingyourproduct/qt/what-is-leverage-and-business-financial-risk.htm
LBO – http://www.investopedia.com/terms/l/leveragedbuyout.asp
PE – http://www.interviewprivateequity.com/what-do-pe-investment-professionals-do/