A Primer on Leveraged Buyouts

Overview
A Leveraged Buyout (LBO) is an acquisition of a business by a private equity firm or financial sposnor which is
funded using a significant amount of debt (bank (maturity of 5 – 7 years) and bonds (maturity of 7 – 10 years) with
the balance of the purchase price funded with an equity contribution from a financial sponsor. Historically, the
purchase price has been funded with 60% - 70% debt with balance contributed by the financial sponsor. These
investments are held for a medium term (i.e. 5 years).

LBO Math
An important valuation concept to understand when seeking to derive a levered value is that LBO transactions are
financed and purchased on a multiple of EBITDA. For example, if the purchase price (i.e. transaction value)
multiple for a business is 9.0x EBITDA and the banks determine that their maximum financing level is 5.0x Total
debt / EBITDA, it means that the balance of 4.0x EBITDA would be contributed in the form of equity. The return
(IRR) threshold on these types of investments is typically in excess of 20% over a 5-year period. In other words,
the equity invested grows annually at an average rate of 20% each year until year 5 which is the typical time
period for exiting the investment.

When evaluating a potential LBO on a target company, one of the main areas of focus for a financial sponsor is
the amount of projected free cash flows generated during the investment period of three to five years. This is
important as the cash flows generated will be used to service debt (interest and repayment of principal) created in
connection with the transaction and fund ongoing working capital requirements. Below are some common
calculations to arrive at the potential free cash flow (refer to Private Equity 2) that can be generated by the target
company. The amount of free cash flow would then be used to service interest, principal and possibly pay
dividends, if permitted.

Free Cash Flow Calculations

Investment Banking Private Equity 1 Private Equity 2

Tax-effected EBIT Net Income EBITDA

+ D&A + D&A - Cash Taxes
- CapEx - CapEx - Cash Interest Expense
-/+ ∆ Working Capital -/+ ∆ Working Capital - CapEx
= Unlevered FCF = FCF -/+ ∆ Working Capital

= FCF

What Makes A Good LBO Candidate?

There are multiple factors used by private equity firms when evaluating investment opportunities. Many
successful LBOs in the past have had some or all the following attributes:
1) Strong, predictable operating cash flow to service the debt while continuing to fund the business
2) Mature, steady, defensive industry characteristics
3) Leading market position and or strong brands
4) Limited capital expenditure and product development requirements
5) Undervalued (low valuation statistics relative to peers; e.g., P/E or EV/EBITDA multiples)
6) Owned by a motivated seller
7) Opportunities for an immediate rationalization for the financial sponsor (e.g., margins improvements,
working capital improvements, synergies with other portfolio companies)
8) Viable exit strategies (e.g., IPO or strategic sale)

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 General Limited Partners
(Fund Investors)
Partner
(Private Equity Firm)

Stock of Newco Cash

Pledge /
Cash Security
Equity

Target Assets Lender(s)

Debt
Assets or Cash
Stock Newco
A LBO transaction has three constituents that need to come to an agreement:
1) Target shareholders
2) Private Equity firm / Financial sponsor
3) Lender
Answers to the following questions need to be considered.
1) What is the fair value of the target company?
2) What offer price will the target shareholders accept?
3) What is the maximum amount of debt that can be supported by the cash flow?
4) What are the financial sponsor’s return rate thresholds on the investment?
The answers to the above questions must deliver acceptable outcomes for each of the three constituents for the
LBO transaction to occur. It is because of these varied interests, LBO structuring can be complex.

Overview of Transaction Constituents

1) Target Company
The primary concern of the board of directors, acting on behalf of the target’s shareholders, is agreeing to an
acceptable offer price. Typical valuation methods used to support an acceptable offer price include a
combination of analyzing public comparables and acquisition comparables, as well as a discounted cash flow
analysis (note that some valuation methodologies may not be applicable based on the availability of relevant
comparable companies or other specific business characteristics). There are many factors that may influence
an offer price including, but not limited to, market conditions, the level of comfort with the operating
assumptions and the target’s management’s willingness to “rollover” their existing equity and remain involved
in the business.

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 2) Financial Sponsor Value Creation Themes
The private equity firm seeks to create value (IRR) in the target company through (1) deleveraging, (2)
operating improvements and (3) possible “multiple expansion”. Deleveraging refers to the use of excess
cash flow to repay the transaction debt. Assuming the value of the company hasn’t changed since going
private, as the debt is reduced, the equity value will increase. Most operating improvements are the result
of productivity and efficiency gains resulting in enhanced operating cash flows that are used to repay debt.
Typically, these improvements include growing sales, increasing operating margins and instituting more
efficient working capital programs. If these operating improvements are made, there is a possibility of selling
the company at a higher multiple then what it was acquired for. This is referred to as “multiple expansion”.
Financial sponsors typically look to exit an investment between three and five years. Exit strategies include
selling the business to a strategic buyer who views the target as complimentary to an existing business line,
an initial public offering (IPO) or a sale to another financial sponsor. When calculating sponsor IRRs, we
assume that the entry and exit multiples (8.0x) are the same. While exiting the investment at a multiple higher
than the purchase price multiple will help boost a sponsor's IRR, it is often difficult to justify a higher multiple
in the initial IRR analysis. Returns sought by sponsors often depend on the perceived risk of their investment
and the health of the sector but are typically in excess of 20%.
Calculating returns to the sponsor assuming
Future: Sold for 8.0x's
LTM EBITDA of $137.5 they exit in 5 and 3 years…
Initial: Acquired for 8.0x's
LTM EBITDA of $125.0. Future PV = $300, FV = $725, N = 5, IRR = 19.3%
$1,100
Initial PV = $300, FV = $725, N = 3, IRR = 34.2%
$1,000

Equity  1

$300
  FV  N 
Equity IRR =   −1
$725  PV  
 

 1

$700
Debt   Equity Value exit  Holding period 
IRR =  
 −1
 Equity Value 
 entry 
Debt $375
 

3) Lender
The funding sources for the LBO include excess cash from the target’s balance sheet, leveraged loans
(secured bank debt), subordinated debt (high yield bonds), mezzanine financing and sponsor equity.
Because the use of financial leverage (or debt) allows for acceptable returns to the sponsor, the lenders play
a pivotal role in a LBO transaction. Debt capacity refers to the amount of leverage that the target company
can support based on the projected cash flow stream. Debt capacity is usually expressed as a multiple of
EBITDA. Determining the debt capacity is a function of assessing the following risks: (i) industry (ii) company,
(iii) structural and (iv) market. Also important is the management track record and the stability of the cash
flows to service the debt. Some of the key factors that
impact debt capacity are: Excess Cash
• Determining “financeable” EBITDA
• Maintenance versus growth CapEx Leveraged • Revolving credit facilities
• Average versus peak working capital requirements Loans • Term loans
• 2nd lien loans
• Historical performance 2.0x – 3.0x

• Achievability of projections
High yield • Senior secured notes
• Depth and quality of management bonds • Senior unsecured notes
• Growth capability given leverage constraints up to 5.0x • Subordinated notes
• Structural risk Mezzanine • PIKs
– Size capital • Warrants
• Convertible securities
– Leverage (e.g., Total and senior debt / EBITDA) up to 6.5x
– Coverage (e.g., EBITDA / Interest coverage) Equity Note: These parameters will
• Precedent LBO transaction debt structures 40% - 50% change with market conditions.

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 TTS Modeling Summary
A TTS LBO model is essentially a financing model layered on top of cash flow projections.
1) Transaction assumptions:
Because the level of debt lenders will provide is critical to the success of a LBO, it is important to understand
what the capital markets will support in terms of capital structure (e.g., total debt / EBITDA and debt/equity
mix) and then work backwards to derive an offer price that will allow for all three constituents to reach an
agreement.
In the model, total funding sources, including all levels of debt and equity, must be set equal to the uses of
funds including the actual purchase price to acquire the business, refinance existing debt and pay any
associated fees. The sponsor’s equity should be “the plug”, representing the remainder of the funds required
to fund the transaction after all debt levels and any other sources of funding have been exhausted.
2) Operating assumptions:
The cash flow portion of the model needs to take into consideration any changes in operating performance
and capital investments. After the operating model for the target company is completed, you can reference
the transaction assumptions in order to illustrate its impact on the pro forma balance sheet, post-transaction
capital structure and more importantly the cash flows. It is important to analyze how the new debt levels will
impact the credit quality of the business and to make sure higher interest expense will not damage the
company’s underlying ability to operate.

3) Sponsor Returns (IRR) or Multiple of Money (M-o-M):

Sponsors typically hold onto an investment in the target company for five years and look to exit via either a
trade sale (sold to another financial sporsor or corporate) or Initial Public Offering (aka IPO). The return
thresholds on the equity is typically in excess of 20%. This calculation is based on the initial equity
investment and the implied future value of the equity in five years. Another expression used is the multiple of
money defined as: Implied Future Value of Equity / Initial Equity Investment.

The remaining steps to complete in the model include the calculation of all the relevant ratios and credit
metrics which are usually summarized on one page.

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 Leveraged Buyout of Sample Company Target shareholders
(USD in millions, except per share data)
look for a reasonable Cumulative
premium
Pro Forma
Transaction Assumptions Sources Amount % of Total EBITDA
Current share price 20.00 Cash 303.8 4.5% 0.4x
Offer price premium 30.0% Bank debt 2,355.0 34.7% 3.4x
Offer price per share 26.00 Subordinated debt 1,570.0 23.1% 5.4x
Target diluted shares outstanding 200.000 Sponsor's equity 2,565.2 37.8% 8.7x
Offer Value 5,200.0 Total sources 6,794.0 100.0% 8.7x
+ Debt 1,542.0
+ Preferred 0.0 Uses Amount % of Total
+ Noncontrolling interest 20.0 Purchase of equity 5,200.0 76.5%
- Cash & equivalents (303.8) Refinancing of existing debt 1,542.0 22.7%
Transaction Value 6,458.2 Transaction expenses @ 1.0% 52.0 0.8%
Total uses 6,794.0 100.0%

Transaction Multiples Pro Forma IRR Returns Year 4 Year 5 Year 6

Transaction Value / Sales 1.67x 7.7x 19.1% 19.2% 18.9%
Transaction Value / EBITDA 8.2x EBITDA Exit 8.2x 21.9% 21.1% 20.4%
Transaction Value / EBIT 12.8x 8.7x 24.5% 23.0% 21.8%
Pro Forma EBITDA 785.0 Purchase Price Potential IRR to the
multiple Financial Sponsor

Pro Forma Projected year ending December 31,

Credit stats FYE FYE+1 FYE+2 FYE+3 FYE+4 FYE+5 FYE+6 FYE+7 FYE+8
Senior Debt / EBITDA 3.0x 2.5x 2.0x 1.4x 0.9x 0.4x 0.0x 0.0x 0.0x
Total Debt / EBITDA 5.0x 4.4x 3.8x 3.1x 2.5x 1.9x 1.4x 1.3x 1.2x
EBITDA / Interest 2.6x 2.8x 3.1x 3.6x 4.2x 5.0x 6.2x 7.6x 8.1x
EBITDA - CapEx / Interest 2.3x 2.5x 2.8x 3.2x 3.7x 4.5x 5.6x 6.8x 7.3x
Historical year ending December 31, Projected year ending December 31,
FYE-2 FYE-1 FYE FYE+1 FYE+2 FYE+3 FYE+4 FYE+5 FYE+6 FYE+7 FYE+8
Operating Assumptions
Sales growth NA 3.0% 5.0% 5.0% 5.1% 5.2% 5.3% 5.4% 5.5% 5.6% 5.7%
Cost of goods sold (as a % sales) 64.3% 62.7% 63.2% 63.2% 63.0% 62.8% 62.6% 62.4% 62.2% 62.0% 61.8%
SG&A (as a % sales) 14.2% 15.8% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5%
Capital Expenditures Assumptions
CapEx (as a % sales) NA 2.5% 1.9% 2.2% 2.2% 2.2% 2.2%
Operating 2.2% 2.2% 2.2% 2.2%
Depreciation (as a % of CapEx) NA 123.9% 154.2% 147.4% 140.6% 133.9% 127.1% 120.3% 113.5% 106.8% 100.0%
improvements
Additions to intangibles (amount) NA 170.0 180.0 175.0 175.0 175.0
driving 175.0
cash flow 175.0 175.0 175.0 175.0
Amortization (amount) NA 161.0 168.0 164.5 164.5 164.5 164.5 164.5 164.5 164.5 164.5

Working Capital Assumptions

Accounts receivable (days collection period) 95.0 84.1 85.1 85.1 85.1 85.1 85.1 85.1 85.1 85.1 85.1
Accounts payable (days outstanding) 12.9 15.8 14.2 14.2 14.2 14.2 14.2 14.2 14.2 14.2 14.2

Other current assets (as % of sales) 13.3% 10.4% 9.6% 9.6% 9.6% 9.6% 9.6% 9.6% 9.6% 9.6% 9.6%
Accrued liabilities (as % of sales) 24.4% 20.3% 18.5% 18.5% 18.5% 18.5% 18.5% 18.5% 18.5% 18.5% 18.5%
Other current liabilities (as % of sales) 72.9% 76.1% 72.0% 72.0% 72.0% 72.0% 72.0% 72.0% 72.0% 72.0% 72.0%

Conclusion
The LBO analysis will result in the practitioner arriving at a “levered” value for the target company.

This resultant value is determined by focusing on key variables such as purchase price multiple, debt financing
parameters, cash flow generation, debt reduction and IRR. Therefore, the LBO model allows a practitioner to
analyze and balance the trade-off between the purchase price multiple, leverage, equity contribution, and IRR in
order to establish what the company is worth to a financial sponsor.

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