{"id":21285,"date":"2023-09-29T15:34:00","date_gmt":"2023-09-29T15:34:00","guid":{"rendered":"https:\/\/businessyield.com\/?p=21285"},"modified":"2023-10-28T16:25:28","modified_gmt":"2023-10-28T16:25:28","slug":"leveraged-buyout","status":"publish","type":"post","link":"https:\/\/businessyield.com\/business-strategies\/leveraged-buyout\/","title":{"rendered":"Leveraged Buyout Model: Definition, Types & Examples","gt_translate_keys":[{"key":"rendered","format":"text"}]},"content":{"rendered":"

Have you considered your business’s exit strategy? If this is the case, you’ve certainly examined a variety of alternatives, ranging from initial public offerings<\/a> to liquidation.
However, if you’re like many business owners, closing your doors permanently was not your intention when you established your firm. You’ve worked diligently and deserve to get a reward. If you’re ready to sell and pursue another interest, a leveraged buyout model may be an option. Let’s see how the leveraged buyout LBO works and also see some examples of successful and unsuccessful buyouts.<\/p>

What is a Leveraged Buyout (LBO)?<\/span><\/h2>

A leveraged buyout (LBO) is a transaction in which a business is acquired primarily via the use of debt. Typically, these transactions occur when private equity (PE) firm borrows the maximum amount possible from a variety of lenders (up to 70% or 80% of the purchase price) and then funds the remainder with their own equity.<\/p>

Why do private equity firms employ such a high level of leverage?<\/span><\/h3>

Simply expressed, the use of leverage (debt) increases the private equity firm’s expected returns. PE businesses can obtain a high return on equity (ROE) and internal rate of return (IRR<\/a>) by investing as little of their own money as feasible. Given that private equity firms are compensated on the basis of financial returns, the use of leverage in an LBO is important to obtaining the IRRs required by the PE firm (typically 20-30 percent or higher).<\/p>

While leverage boosts equity returns, it does so at the expense of risk. By securing numerous tranches of financing to a running company, the private equity firm dramatically increases the transaction’s risk (which is why LBOs typically pick stable companies). If cash flow is constrained and the company’s economy suffers a downturn, they may be unable to service the debt and may be forced to restructure, thus eliminating all returns to the equity sponsor.<\/p>

What type of business is a good candidate for a leveraged buyout?<\/span><\/h2>

Generally, established, stable, non-cyclical, and predictable businesses are suitable candidates for leveraged buyouts.<\/p>

Given the amount of debt that the corporation would incur, it is critical that cash flows are predictable, with strong margins and relatively minimal capital expenditures. This consistent cash flow helps the business to readily service its debt. <\/p>

How does a Leveraged Buyout Model (LBO) work?<\/span><\/h2>

The leveraged buyout study begins by developing a standalone financial model<\/a> for the operating firm. This entails forecasting five years into the future (on average) and computing the final period’s terminal value.<\/p>

The research will be presented to banks and other lenders in order to get the maximum amount of debt possible in order to optimize returns on equity. After determining the amount and rate of debt financing, the leveraged buyout model is updated and the final terms of the contract are established.<\/p>

After they complete the acquisition, the task of adding value to the business begins, as the PE firm and management must expand the top line, reduce costs, pay down debt, and finally realize their return.<\/p>

Steps Involved in a Leveraged Buyout:<\/span><\/h3>
  1. Create a financial forecast for the prospective client’s business.<\/li>\n\n
  2. Connect the three financial statements and compute the business’s free cash flow.<\/li>\n\n
  3. Create schedules for interest and debt.<\/li>\n\n
  4. Calculate the credit metrics to determine the transaction’s leverage capacity.<\/li>\n\n
  5. Calculate the Sponsor’s free cash flow (typically a private equity firm)<\/li>\n\n
  6. Then calculate the Sponsor’s Internal Rate of Return (IRR).<\/li>\n\n
  7. Analyze for sensitivity<\/li><\/ol>

    Financial Model of Leveraged Buyout LBO<\/span><\/h2>

    The financial model can become pretty complicated when it comes to leveraged buyout transactions. The additional complexity stems from the following distinct characteristics of leveraged buyouts:<\/p>