Chapter 15 Leveraged

Buy out
Meaning
 When Company acquires another company using a
significant amount of borrowed funds such as
bonds or loans to pay the cost of acquistion.the
transaction is termed leverage.
 Example: HCA Inc was acquired in 2006 by

Kohleberg Kravis Roberts & Co ,Bain & Co and

Merrill lynch which paid around $33 billion for the
acquistion.
 An LBO often invloves a ratio of 70 % debts and

30% equity,although the ratio of debt as high as 90

% to 95 % of the target companys capitalization
 The Assets of the target are offered as
collateral security for the purpose of
raising loans in addition to the assets of
the acquirer.
 LBOS involves use of debts, the assets of

the company being acquired in addition to

the assets of the acquiring company are
used as collateral for security loans.
 These include cost savings, managerial

incentives, decreasing the total number of

owners, tax benefits, flexibility, and
control
Meaning of Leveraged Buy Out
 Leveraged Buy out is a” A financing technique
of purchasing a private company with the
help of borrowed or debt capital”.
 LBO Means “ the acquisition ,financed largely

by borrowing of all the stocks or assets,of

hither to public company by a small group
investors”.
 LBO Means “ the acquisition of a compnay or

divison of a company with a substantial

portion of borrowed funds.
Acquirer Target Value Status at time of Post LBO
LBO
Kohleberg Amphen $1.4 It increase the In
Kravis ol billion company’s levergae December
roberts and the corporation 1999 APH
credit rating Filled for a
declined to B+ from public
BBB- offering of
2.75 million
commonsha
res and
used the
proceeds to
pay down
debt and
reduce
leverage
leading to
Types of Levergaed Buy out.
 Sponsored LBO:
 Under Sponsored LBOs ,the private equity
firms offer to buy a controlling stake in a
company using leverage obtained from bank
based on the financial of the company.
 This strategy is simple commit very little own

money to purchase the business.

 This is secret behind the specific return for

there is very little cash invested

 Non Sponsored Lab
 This strategy is adopted in case of

financial health business where the

financing techniques are similar but the
management gains operating control with
around 85 % to 100 % ownership
depending on the situation.
 These buyout are called non sponsored

leveraged buy out.

Characteristics of LBO Candidate
1) Efficient and experienced Management
Team: In order to motivate the lenders as well
as investors for providing borrowed or loan
capital to considerable extent and with a view
to make the LBO programme succeful, a
strong management body comprsing of
experienced as wel
2) Assurance of sufficient and stable cash flow:
With a view to service the debt borrowed for the
acquisition and in order to ensure the smooth
ongoing operations of the firms, the existence of
sufficient, strong and secure cash flow is
considered indispensable for a successful
programmed.
3) Lower degree of operating risk: LBO
Programme,the financial task is very high it is
mostly based on leveraged capital or debt capital.
In order to sustain in the market, the degree of
operating risk arising out of normal business
activities
4) Limited amount of Debt: There should have
been limited amount of debt in the firms
balance sheet compared to the value of the
tangible assets of the firm that can be used
as collateral securities for raising the loan
capital required to finance the LBO
Programme
Types of Leveraged Buy out.
Source of LBO Financing
Senior Debt:
 Senior debt is borrowed money that a company must repay first if

it goes out of business.

 Each type of financing has a different priority level in being

repaid if the company decides to liquidate.

 If a company goes bankrupt, senior debtholders, who are often 
bondholders or banks that have issued revolving credit lines, are
most likely to be repaid, followed by junior debt holders, 
preferred stock holders and common stock holders, possibly by
selling collateral held for debt repayment.
 The Debt which ranks ahead of all the other debt and equity
capital in the business .
 Bank loan are typically structured in up to three trenches:A,B and
C
 Senior debt is secured by a business for a set
interest rate and time period. The company
provides regular principal and interest
payments to lenders based on a
presentschedule. 
 Senior debt in an LBO will require repayment

of the debt in equal annual investment over a

period of approximately 7 years.
Subordinated debt
 This debts ranks behind senior debt in order of priority on any
liquidation.
 The terms of the subordinated debt are usually less stringent than
senior debt.
 Repayment usually required in one bullet payment at the end of the
team .
 Subordinated debt is more risky than unsubordinated debt.
Subordinated debt is considered any type of loan that's paid after all
other corporate debts and loans are repaid, in the case of borrower
default. 
 High yield bonds can either be senior or subordinated securities that
are publicly placed with institutional investors.
 They are fixed rate, publicly traded, long term secutirities wit a
looser convenant package than senior debt though they are subject
to stringent reporting requirements.
 Mezzanine finance: This is usually high risk
subordinated debt and is regarded as a types
of intermediate financing between debt and
equity and an alternative to high yield bonds.
(Warrants, Options and shares)
 Loan Stock: This can be a form of equity

financing it convertible in to equity capital.

 Preference Shares: This forms part of
company’ share capital and usually gives
 Equity Shares
 Equity shares
 Preference Shares
Element of % Totall capital Tenuers Traditional
Capital Suppliers of
capital
Senior Debt 30%-60% 5-8 Investment
banks and
commercial
banks
Subordinated 10%-25% 7-10 Investment
debt banks-
commercial
banks and
mezzanine
funds
Building an LBO Model

The key steps in completing an LBO model are as follows

(1) Forecast Cash Flows
 Projected Cash flow should be modified in exactly the same manner
as for DCF Valuation
 The Forecast period should end no earlier than the latest date on
which an exist is expected or the latest date on which the debt is
expected to be rapid in full
 Whiled DCF valuation requires the unlevered free cash flow be
discounted to provide enterprise value, an LBO uses free cash flows
to derive IRRs.
(2) Estimate Debt Capacity:
 The next step is to estimate the amount of debt that the company can take
on. The financial statement should make provision for interest and debt
costs.
 The company can only bear debt to the extent that it has available cash flow
 When modeling consult your team about the financing assumptions to be
used.
 These will according to market conditions, industry characteristics and
company specific issues.
 Set out below are some parameters that will influence financing
considerations for the model
 Minimum interest cover (times)
 Total debt/EBITDA (times)
 Senior debt repayment (in years)
 Mezzanine debt repayment (in years)
 Senior debt interest rate
 Subordinated interest rate
 Mezzanine finance exit IRR
3) Estimate Equity Required:
The equity required in simplistic terms, the costs of
acquiring the company less its debt capacity.
The total cost of the company comprises both the
purchase price and transaction expenses.
(4) Estimate the Exit Price
(5) Calculate the IRR
 A. Advantages of LBO
 With the help of LBO system, a new company is
created to procure the debt capital as well as other
resource of finance required for the acquisition, the
volatility of earning of that new created company,
popularly known as special purpose vehicle d
 The newly created company can enjoy tax benefits
in operating the business for a considerable time
period of five to six years.
 The LBO system help stimulating the cross border
acquisition since this system ensures the supply of
required amount of capital needed for large
acquisitions.
Stages of LBO
1st stage : Arrangement of finance
 The first stage of the operation consists of raising the

cash required for the buy outs and working out a

management system.
 The new firm consists around 10 % of cash put by the

company’s top management or buy out specialists.

 Outside investors like merchant banker, venture

capitalists and commercial bank arrange to provide

the remaining equity.
 Usually 50 % of the cash is raised by borrowing

against company assets in secured bank acquisition

loans from commercial bank.
2nd stage: Going Private
The organising or sponsoring group purchase all the
outstanding shares of the target company and takes
it private through stock purchase format of purchase
all assets through assets purchasing format.
3rd stage: Restructuring: The new management would
try to enhance the generation of profit and cash
flows by reducing certain operations costs and
changing the marketing strategy.
Consilidation and reorganisation of the existing
production facilities.
Changing