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A Beginner’s Guide to a Leveraged Buyout


A Beginner’s Guide to a Leveraged Buyout

What is 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.


Why go through a leveraged buyout?

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?


Find a “financial sponsor”

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.


What is the price of the leverage?

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.


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Principal Partner

Miro Parizek

Miro Parizek established Hampleton in 2013 with a group of fellow deal makers and technology industry entrepreneurs, uniting hands-on industry expertise and seasoned transaction experience together for the optimal M&A advisory. Miro has been providing M&A advisory services to the technology industry since the pre-dot.com era and has managed scores of transactions supporting privately-held sellers and publicly-traded companies, ranging from 20 to over 2,000 employees.Miro has 30 years of experience in the software and IT industry.

Prior to his M&A career, which began in 1998, Miro founded and ran three software and IT related firms in the ’80s and ’90s, including a leading international software vendor, North American Software. He was a founding member and, for over a decade, treasurer of the German Software Association, which was merged with the country’s multi-media association, creating today’s national association for digital economy (BVDW).

Miro’s experience spans virtually the entire information technology industry. He has managed and closed transactions in sectors as diverse as 3D-imaging, asset management, business intelligence, business performance management, compiler software, CRM, customer services, design collaboration, content and document management, data center automation, e-Learning, enterprise systems management, ERP, GIS sub-systems, human capital management, Internet commerce, IT services, logistics, SaaS, simulation, storage solutions, supply chain management, telecom products, unified messaging, video editing, workforce management and various other verticals. Miro is an avid skier, hiker and enjoys time with his wife and young twins.

Miro has degrees in International Finance from the Wharton School of Business and in Computer Science from the Moore School of Engineering. In addition to his English mother tongue, Miro speaks fluent German after having lived in Germany for over twenty years.