The basics of an LBO.
An LBO (or Leveraged Buyout) is a combination of two words; Leverage & Buyout. Let’s try to look at these two words separately and then we will patch them together to arrive at LBO.
In finance, Leverage is a common term, which basically means to use debt to multiply the potential returns from a project. While leverage multiplies the potential returns, we should also note, it also multiplies the potential losses. There are two types of leverage: Financial & Operational. For the discussion on LBO, we will focus only on Financial leverage. To understand the power of leverage, let’s go through an example:
Let’s assume that there are 2 companies, one A and the other B and both are looking at purchasing company C that is valued at INR 1000 Cr. Although the target company is the same, the financial structuring of A & B is different. Now, to purchase this firm, A uses a Debt to Equity ratio of 4:1 i.e. a highly levered company while B uses a Debt: Equity ratio of 1:9 i.e. not a highly levered company. In the future, if company C gets sold at INR 1200 Cr., then A will generate a 72% Return on Equity (ROE) while B will generate only 21% ROE. Alternatively, if company C gets sold for INR 800 Cr., then A will report a -128% ROE, and B will report -23% ROE.
So, on the upside, leverage amplifies your gains while on the downside, it also amplifies your losses.
Now, the meaning of Buyout is pretty straightforward and means, “to purchase a controlling share in a company.
So, an LBO...
is a type of transaction where a pool of investors finances the acquisition of a firm by borrowing against the firm’s expected future cash flows. In most cases, this whole financing is done (usually) by using a cocktail of secured bank debt and unsecured subordinated debt. Effectively, an LBO redistributes the risks and rewards among the capital holders. Another benefit of LBO stems from the large tax shields which are generated because of this highly levered structure.
But, probably, the most distinct characteristic of an LBO is that it secures this mammoth of an acquisition debt against the acquired company itself. Meaning, in our above example, if company A takes over C using LBO, then, company C will continue to keep paying the interest payment to the debtors and not company A.
We get to see an LBO, usually when…
- a firm tries to privatize a publicly-traded company.
- a firm is trying to restructure itself via asset disposition. Usually happens when a large company wants to detach a unit/division for lack of fit but is unable to source buyers.
- an informed LBO acquirer buys the firm as a part of their platform strategy, meaning, the acquirer will then carry out subsequent “add-on acquisitions” for value addition and then goes ahead and consolidates all the add-ons with the platform to generate higher value.
- an informed LBO acquirer buys the firm as an add-on for their already assorted portfolio.
So, what type of exit options are there?
There are 3 primary exit options: M&A, IPO & Recaps.
Mergers & Acquisitions
The desired exit in an LBO acquisition is by M&A deals where an exit multiple based on the EBITDA is arrived at; meaning that some other firm buys that company at that exit multiple. But, it doesn’t happen all the time due to various reasons spanning from risk to unwillingness of the market to acquire such a huge stake in an LBO company, and other modes come into the picture here. But, the IRR % is the highest in this mode.
IPO
In an IPO-type exit, the gestation period of the investment is longer as it’s not possible for the firm to sell off 100% of their holdings of that company instantaneously. Hence, a phased sale happens which drags the return for a long time as we see a lower IRR (or Internal Rate of Return).
Dividend Recapitalization
The other type of exit that we look at here is the Dividend Recapitalization type where the acquirer holds on to his stake in the company and the company keeps on issuing dividends from its Cash Flows till the time, the shares are held onto. But, the problem here is that, since the dividend is a residual payout mechanism, the returns would be far too low and unpredictable, depending on the business performance, that the IRR would suffer. But, it’s not the case all the time, because if the firm company grows at a breakneck speed, the realizations are much faster and higher.
