What is a Leveraged Buyout (LBO)?

//What is a Leveraged Buyout (LBO)?
What is a Leveraged Buyout (LBO)? 2017-10-05T06:07:36+00:00

Definition: A leveraged buyout (LBO) is the purchase of a company using a large amount of debt or borrowed cash to fund the acquisition. In other words, it’s when a company used a large amount of borrowed funds to purchase another company instead of using its own money or raising capital from investors.

What Does Leveraged Buyout Mean?

What is the definition of leveraged buyout? An LBO occurs when a company purchases another by taking out a loan. Typically, the acquiring company uses the assetsof the acquired company as collateral for the new loan.

Before this process can take place a leveraged buyout model is performed to evaluate the acquired company and determine the floor price that delivers an equity return, which meets the buyer’s hurdle rate. Financial analysts use operating and valuation assumptions in Excel and create the model to calculate the purchase price that can generate an expected equity return.

Furthermore, a LBO model includes projections for the target’s expected cash flows to ensure that the target will be able to cover the principal and interest payments of the loan. To proceed with a buyout, private equity funds ensure that the assets of the target company can be used as warranty (collateral) for the loan required for the buyout.

Let’s look at an example.

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.

Summary Definition

Define Leveraged Buyout: A LBO occurs when the purchase of a company is financed with a significant about of borrowed funds. A model is then used to determine the maximum price that a financial buyer should pay for a leveraged buyout given specific debt levels and equity return requirements.