MAY 19th, 2022
It’s time for new M&A ideas to bloom, register for the M&A Science Spring Summit on May 19th!
Register Now!

The Ultimate Guide to Leveraged Buyouts (LBOs)

Leveraged buyouts (LBOs) have gained a largely unwarranted association for excess.

While there have been several high profile failures - notably the bankruptcy of Energy Future Holdings in 2014 - this overlooks the successes, of which there are many.

And while debt combined with hubris is a recipe for disaster, debt combined with solid strategic planning has the potential to generate huge shareholder value.

This article, prepared by our DealRoom team, aims to give you a primer on some of the issues surrounding LBOs and why they’re likely to generate even more headlines in the coming years.

What is Leveraged Buyout?

A leveraged buyout is an acquisition whereby the consideration paid by the buyer is primarily composed of third-party debt. The buyer, typically a private equity firm or the company’s current management team, believes that they can extract value from  the deal that outweighs the risk taken on to fund the acquisition.

The amount of debt used in LBOs varies, but usually constitutes 70-80% of the total consideration paid. The remainder is paid with the buyer’s equity.

What is Leveraged Buyout?

How Does a Leveraged Buyout Work?

In a leveraged buyout, the acquirer uses significant amounts of leverage (debt) to fund the deal. The target company’s assets – rather than those of the buyer - are used as collateral to acquire the capital, with the target company’s future cashflows then used to repay the debt over an agreed period.

LBOs are typically funded by bonds and private notes, which can be issued by public or private investment companies. Other methods of funding LBOs include mezzanine financing – usually offered at higher rates of interest – bank financing, and even seller financing, where the seller of the company offers financing to the buyer to acquire the business

Why do Leveraged Buyouts Happen?

Although LBOs have often taken on a reputation as being a reckless form of financing transactions, the logic behind them is sound. They enable competent management teams with strong industry experience and convincing business plans to takeover companies without having the financial resources to do so.

How LBOs create value:

How LBOs create value

Higher ROI: With less money upfront, in theory the LBO leads to a higher return on income than investments where they use their own capital.

Access to more deals: More capital, means more access to deals for the buyout team proposing the LBO.

Tax advantages: Because the deal involves the company itself taking on more debt, there are usually considerable tax advantages associated with LBOs.

Improved business plan: In theory, if not always in practice, the LBO should put expert managers with excellent business plans in charge of companies for better results.

Critical Success Factors for Leveraged Buyouts

Like any acquisition, the success of an LBO depends on a combination of internal and external factors. For LBOs, these success factors tend to fall into one of the following: 

Critical Success Factors for Leveraged Buyouts

1. Market growth

The case of Energy Future Holdings shows that even an LBO with a world-class management team at the helm is hostage to what happens in the wider market. Most of the high profile failures in LBOs have been a result of markets significantly underperforming the projections inherent in the buyers’ calculations.

2. Cash generating ability

The larger the debt, the larger the interest payments. The aim of an LBO is to generate enough cash to turn debt into equity. Hence, the reason that cash generative businesses such as FMCGs tend to be so popular with private equity companies undertaking LBOs.

3. Operational Improvements

A thread running through all LBOs is that the buyers believe they can make operational improvements to the target company that will generate more cash flow and ultimately, increase the company’s value. This is already a specialty of private equity companies, explaining why LBOs are so popular with them.

4. Management Expertise

Binding all of the critical success factors together is a strong management team. They are firstly responsible for putting together a strategic plan that shows creditors where value will be extracted from the deal. Then, once funds are secured, they will then be responsible for implementing that plan.

Steps involved in an LBO

Details of the steps involved in an LBO will vary on a company by company and industry by industry basis but will typically follow a pattern similar to that outlined below:

Step 1 - The buyer identifies a company that it believes generates enough cash to warrant an LBO. Cash is a key component here. If the business isn’t generating cash, it is unlikely to be targeted by LBO buyers.

Step 2 - The buyer conducts a thorough valuation of the company, typically using conservative growth figures, to show its funders, as well as providing it with a reference value when making a bid for the company.

Step 3 - A crucial differentiator of the valuation for LBOs is that the creditor (usually referred to as the ‘deal sponsor’) will be provided with an IRR for their debt - the expected return on the capital that they provide to fund the deal.

Step 4 - Most buyers will create a strategic plan - showing where operational improvements can be made - before approaching funders. Doing this now rather than later strengthens the pitch with funders, clearly showing them where value will be extracted.

Step 5 - Funds secured, the buyer makes a bid for the company. This can sometimes be hostile - i.e. the current company leadership does not want to sell - a possible issue that buyers like to anticipate in advance and include in their calculations.

Exit opportunities in an LBO

The intention for buyers undertaking LBOs is not value creation for the sake of it.

Rather, they aim to exit the target company at a higher value multiple than that at which they entered within a predefined period of time.

Exit opportunities in an LBO

The exit opportunities open to them will depend on how well they have implemented their strategic plan, and as always, the condition of the market at the time of the sale.

Exit strategies in LBOs include:

An IPO

Listing the company on a public index and exiting through the sale of equity may be possible depending on where equity markets are in their cycle.

Strategic sale

A common exit route for companies is through finding a comparable company in the same industry and selling the business to them.

Financial sale

The company could be sold to another private equity company who believes that it can extract even more value from a new strategic plan.

Advantages of LBOs

  • Allows competent managers to take control and generate value for companies they otherwise could not afford.
  • The high debt used in LBOs usually endows them with tax advantages over cash acquisitions.
  • For buyers (i.e., those using third-party debt), there is huge value generation potential on the equity invested in the deal.

Disadvantages of LBOs

  • Saddling the target company with a significant debt pile has the potential to hinder its growth rather than turbocharge it
  • Connected to the above point, the focus on repaying interest may encourage the company to underinvest in capital, R&D, etc.
  • The fact that the management team have so little financial exposure to the downside risks may create an agency problem for deal sponsors.

Examples of Leveraged Buyouts (LBOs)

Blackstone’s acquisition of Hilton Hotels in 2007

Sometimes good management can mitigate unprecedented market turbulence. Just before the global financial crisis kicked in, Blackstone Group paid $26 billion for Hilton Hotels, using just $5.5 billion (i.e. about 21%) of its own funds. Blackstone eventually yielded $14 billion on the deal from a staged exit, almost tripling its initial investment. 

KKR’s acquisition of Safeway in 1986

KKR implemented a strategic plan for the takeover of Safeway in 1986 that involved the closure of underperforming stores and divesting others. They paid just $129 million in a deal valued at $5.5 billion. Value creation in the deal was aided by the fact that Safeway’s management agreed to the deal, ensuring KKR did not have to overpay. Just four years later, in 1990, they exited, yielding a profit of $7.2 billion.

Malcolm Glazer’s acquisition of Manchester United in 2003

Tampa Bay Buccaneers owner Malcolm Glazer spotted the value in English football club Manchester United in 2003 well before its then owners. Glazer acquired the club using £275 million (approximately $400 million), using the club’s assets as collateral. A financial master stroke, albeit one that didn’t endear Gladwell to the club’s fanbase. In 2012, the club listed on the NYSE. In June 2021, its market capitalisation stands at $2.25 billion.

Conclusion

Leveraged buyouts are an excellent way for competent management teams with strong strategic plans to take over underperforming companies.

Although they have gained a negative press due to a number of high profile failures, this overlooks the value created for buyers and sponsors through ensuring that cash generative companies fulfil their potential.

demo

Join 2,000+ forward-thinking M&A practitioners

Get weekly updates about M&A Science upcoming webinars, podcasts and events!

7
Subscribe for free
Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.