Wha t is a Leveraged Buyout

(LBO)?

In corpo rate finance, a leveraged buyo ut (LBO)

is a trans action where a comp any is acquired
using debt as the main source of
consideration. These trans action s typically
occur when a private equit y (PE) firm borro ws
as much as they can from a variet y of lenders
(up to 70 or 80 perce nt of the purchase price)
and funds the balance with their own equity.

Why LBO?

Five to Ten Years

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Why Do PE Firms Use So Much
Leverage?

Simply put, the use of leverage (debt)

enhances expected returns to the private
equity firm. By putting in as little of their own
money as possible, PE firms can achieve a
large return on equity (ROE) and internal rate
of return (IRR), assuming all goes according to
plan. Since PE firms are compensa ted based
on their financial returns, the use of leverage
in an LBO is critical in achieving their targeted
IRRs (typically 20-30% or higher).

While leverage increases equity returns, the

drawback is that it also increases risk. By
strapping multiple tranches of debt onto an
operating company the PE firm is significan tly
increasing the risk of the transactio n (which is
why LBOs typically pick stable companies). If
cash flow is tight and the economy of the
company experienc es a downturn they may
not be able to service the debt and will have to
restructur e, most likely wiping out all returns
to the equity sponsor.
What Type of Company is a Good
Candidate for an LBO?

Generally speaking, companies that are

mature, stable, non-cyclical, predictable, etc.
are good candidates for a leveraged buyout.

Given the amount of debt that will be strapped

onto the business, it's important that cash
flows are predictable, with high margins and
relatively low capital expenditures required.
This steady cash flow is what enables the
company to easily service its debt. In the
example below you can see in the charts how
all available cash flow goes towards repaying
debt and the total debt balance (far right
chart) steadily decreases over time.
What are the Steps in a Leveraged
Buyout (LBO)?

The LBO analysis starts with building a

financial model for the operating company on
a standalone basis. This means building a
forecast five years into the future (on average)
and calculating a terminal value for the final
period.

The analysis will be taken to banks and other

lenders in order to try and secure as much
debt as possible to maximize the returns on
equity. Once the amount and rate of debt
financing are determined, then the model is
updated and final terms of the deal are put
into place.

After the transaction closes, the work has just

begun, as the PE firm and management have
to add value to the business by growing the
top line, reducing costs, paying down d~
and finally realizing their return.
 Summary of Steps in a Leveraged Buyout:

1. Build a financial forecast for the target

company

2. Link the three financial statements and

calculate the free cash flow of the business

3. Create the interest and debt schedules

4. Model the credit metrics to see how much

leverage the transaction can handle

5. Calculate the free cash flow to the Sponsor

(typically a private equity firm)

6. Determine the Internal Rate of Return (IRR)

for the Sponsor

7. Perform sensitivity analysis

LBO Financial Modeling

When it comes to a leveraged buyout

transaction, the financial modeling that's
required can get quite complicated. The
added complexity arises from the following
unique elements of a leveraged buyout:

• A high degree of leverage

• Multiple tranches of debt financing

• Complex bank covenants

• Issuing of Preferred shares

• Management equity compensation

• Operational improvements targeted in the

business

Below is a screenshot of an LBO model in

Excel. This is one of many financial modeling
templates offered in CFI courses.
Understanding
Leveraged Buyout
Scenarios

Leveraged buY.outs (LBOs) have probably had

more bad publicity than good because they
make great stories for the press. However, not
all LBOs are regarded as predatory. They can
have both positive and negative effects,
depending on which side of the deal you're on.

A leveraged buyout is a generic term for the

use of leverag~ to buy out a company. The
buyer can be the current management, the
employees, or a P-rivate eg.Y..i!Y. firm. It's
important to examine the scenarios that drive
LBOs to understand their possible effects.
Here, we look at four examples: the
repackaging plan, the split-up, the portfolio
plan, and the savior plan.
Ad
Leveraged Buyout
(LBO)
-
What Is a Leveraged Buyout?
A leveraged buyout (LBO) is the acquisition of
another company using a significant amount
of borrowed money (bonds or loans) to meet
the cost of acguisition. The assets of the
company being acquired are often used as
collateral for the loans, along with the assets
of the acquiring company.

KEY TAKEAWAYS
• A leveraged buyout occurs when the
acquisition of another company is
completed almost entirely with
borrowed funds.

• Leveraged buyouts declined in

popularity after the 2008 financial
crisis, but they are once again on the
rise.

• In a leveraged buyout (LBO), there is

usually a ratio of 90% debt to 10%
equity.

• LBOs have acquired a reputation as a

ruthless and predatory business
tactic, especially since the target
company's assets can be used as
leverage against it.
Understanding Leveraged Buyouts
{LBOs)
In a leveraged buyout (LBO), there is usually a
ratio of 90°/o debt to 10% equity. Because of
this high debt/equity ratio, the bonds issued in
the buyout are usually not investment grade
and are referred to as junk bonds. LBOs have
garnered a reputation for being an especially
ruthless and predatory tactic as the target
company doesn't usually sanction the
acquisition. Aside from being a hostile move,
there is a bit of irony to the process in that the
target company's success, in terms of assets
on the balance sheet, can be used against it as
collateral by the acquiring company.
 , Important: The purpose of
leveraged buyouts is to allow
companies to make large
acquisition s without having to
commit a lot of capital.

LBOs are conducted for three main reasons:

1. To take a public company private

2. To spin off a portion of an existing business
by selling it
3. To transfer private property, as is the case
with a change in small business ownership

However, it is usually a requireme nt that the

acquired company or entity, in each scenario,
is profitable and growing.

Leveraged buyouts have had a notorious

history, especially in the 1980s, when several
prominent buyouts led to the eventual
bankruptc y of the acquired companies. This
was mainly due to the fact that the leverage Ad

ratio was nearly 100% and the interest

payments were so large that the company's
LBOs are conducted for three main reasons:

1. To take a public company private

2. To spin off a portion of an existing business
by selling it
3. To transfer private property, as is the case
with a change in small business ownership

However, it is usually a requirement that the

acquired company or entity, in each scenario,
is profitable and growing.

Leveraged buyouts have had a notorious

history, especially in the 1980s, when several
prominent buyouts led to the eventual
Ad
bankruptcy of the acquired companies. This
was mainly due to the fact that the leverage
1. To take a public company private
2. To spin off a portion of an existing business
by selling it
3. To transfer private property, as is the case
with a change in small business ownership

However, it is usually a requirement that the

acquired company or entity, in each scenario,
is profitable and growing.

Leveraged buyouts have had a notorious

history, especially in the 1980s, when several
prominent buyouts led to the eventual
bankruptcy of the acquired companies. This
was mainly due to the fact that the leverage
ratio was nearly 100% and the interest
payments were so large that the company's
QP-erating cash flows were unable to meet the
obligation.
Example of Leveraged Buyouts
One of the largest LBOs on record was the
acquisition of Hospital Corporation of America
(HCA) by Kohlberg Kravis Roberts & Co. (KKR),
Bain & Co., and Merrill Lynch in 2006. The
three companies valued HCA at around $33
billion. [l]

Although the number of such large

acquisitions has declined following the 2008
financial crisis, large-scale LBOs began to rise
during the COVID-19 pandemic. In 2021, a
group of financiers led by Blackstone Group
announced a leveraged buyout of Med line that
valued the medical equipment manufacturer
at $34 billion. [ 2 J [ 3 ]
How Does a Leveraged Buyout
Work?
A leveraged buyout (LBO) is when one
company attempts to buy another company,
borrowing a large amount of money in order
to finance the acquisition. The acquiring
company issues bonds against the combined
assets of the two companies, meaning that the
assets of the acquired company can actually
be used as collateral against it. Although often
viewed as a predatory or hostile action, large-
scale LBOs experienced a resurgence in the
early 2020s.

Why Do Leveraged Buyouts

Happen?
Leveraged buyouts (LBOs) are commonly used
to make a public company private, or to spin
off a portion of an existing business by selling
it. They can also be used to transfer private
property, such as a change in small business
ownership. The main advantage of a leveraged
buyout is that the acquiring company can
purchase a much larger company, leveraging a
relatively small portion of their own assets.
What Type of Companies Are
Attractive for LBOs?
Equity firms will typically target companies in
established industries and mature for
leveraged buyouts, rather than fledgeling or
more speculative industries. [4 J The best
candidates for LBOs typically have strong,
dependable operating cash flows, well-
established product lines, strong management
teams, and viable exit strategies so that the
acquirer can realize gains.
What is Leveraged
Buyout (LBO)?
A leveraged buyout, or LBO for short, is
the process of buying another
company using money from outside
sources, such as loans and/or bonds,
rather than from corporate earnings.
Sometimes the assets of the company
being acquired are also used as
collateral for the loans (rather than, or
in addition to, assets of the company
doing the acquiring).

When the companies being acquired

are against the transaction, it is often
referred to as a "hostile takeover."

Following a LBO, the new owners often

take the company private, rather than
continuing to operate as a public
entity.
LBOs by the Numbers
To be considered an LBO, the debt-to-
equity ratio on an acquisition is
typically between 70% to 30% to as
much as 90% to 10%. That means the
acquiring company invests 10-30% of
the cost and borrows the remaining
70-90% to be able to make the
purchase. That's a risky deal, mainly
because the cost of the monthly loan
payments, called debt service, on such
a deal can be huge. Because of that, it
can be difficult for some buyers to stay
current.

Enormous loan payments are what

caused the downfall of many firms
engaged in LOBOs in the 1980s. Back
then, LBOs were becoming so popular
that in some cases, the debt-to-equity
ratio was 100% to 0%, meaning
companies were putting no money
down and financing the entire deal.
Yes, car dealers also offer those "no
money down" opportunities, which can
get buyers in trouble because the
monthly payment is quite large.
LBOs by the Numbers
To be considered an LBO, the debt-to-
equity ratio on an acquisition is
typically between 70% to 30% to as
much as 90% to 10%. That means the
acquiring company invests 10-30% of
the cost and borrows the remaining
70-90% to be able to make the
purchase. That's a risky deal, mainly
because the cost of the monthly loan
payments, called debt service, on such
a deal can be huge. Because of that, it
can be difficult for some buyers to stay
current.

Enormous loan payments are what

caused the downfall of many firms
engaged in LOBOs in the 1980s. Back
then, LBOs were becoming so popular
that in some cases, the debt-to-equity
ratio was 100% to 0%, meaning
companies were putting no money
down and financing the entire deal.
Yes, car dealers also offer those "no
money down" opportunities, which can
get buyers in trouble because the
monthly payment is quite large.

These no-money-down offers also

became popular in the mortgage
industry and are what caused many
homeowners to go bankrupt, many
homes to be foreclosed on, and many
banks to go under, after having
financed too many homes that
borrowers simply couldn't afford,
thanks to the huge monthly payments.
Advantages of an
LBO
Despite their risky nature, there are
some pros to LBOs:

• More control. Once the

acquisition is converted to
private ownership from public,
the new owners can completely
overhaul to company's
operations and cost structure,
making it easier for the venture
to succeed.
• Financial upside. Since, by
definition, LBOs require acquiring
companies to put up little to
nothing of their own money, as
long as the company being
acquired can generate more than
enough cash to fund its
purchase, investors win.
• Continued operation. Sometimes
a company's financial situation
becomes so dire that it is at risk
of being shuttered altogether.
When a buyer comes in, whether
internal management or
outsiders, the company at least
has the opportunity to keep its
doors open.
Disadvantages of an
LBO
Of course, for every upside there is a
downside. Here are some related to
LBOs:

• Poor morale. Especially in cases

of a hostile takeover, where the
company has no interest in being
acquired, unhappy workers can
convey their disappointment by
slowing down or stopping work,
further hampering the company's
efforts to succeed.
• Bankruptcy a big risk. If the
acquired company's finances
cannot, on their own, cover the
cost of the loan payments
needed to buy the company in
the first place, it's possible the
company will end up declaring
bankruptcy. Weak finances are
extremely risky.
• Deeper cuts. While employees
may hope that a new owner will
help turn the acquired company
around, in many cases, the cost-
cutting required to return a
company to profitability may
involve serious job cuts and
other unpopular measures. That
means many employees will lose
their jobs and the result could
have a negative impact on the
surrounding region.

Due to stricter banking laws

introduced after the wild 1980s, LBOs
are not nearly as popular as they once
were, simply because it's very difficult
to obtain financing.