2022 Comprehensive Guide to LBO Valuation: What, Why, How, Examples
Leveraged buyouts started becoming more and more popular in the late 90s due to the technology boom. They proved their worth when tech stocks boomed in 2001 and 2002.
Before delving into leveraged buyout valuation, let's first define what an LBO is. A leveraged buyout (LBO) is when a private equity firm purchases a company and takes on debt to assist with the purchase. The most common reason for this is that the private equity firm will take on significant amounts of debt to finance the transaction. This way, the equity owners can have a smaller percentage of their money in the transaction.
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What is a Leveraged Buyout?
Leveraged buyouts (LBOs) are a way to acquire a company using private equity. An LBO involves borrowing money from bank lenders and other financial institutions and using that debt to acquire the target company. In an LBO, the amount of debt can range anywhere from 50% to 90% of the purchase price. The rest is financed by equity financing, which would come from within your own company and/or by investors who provide funds in exchange for shares of stock.
The combination of high leverage (debt) along with significant amounts of equity (from yourself or other investors) makes this type of transaction very attractive because it allows you to take over a business without having all the cash required upfront.
Why is LBO Model Important?
One of the main reasons why the LBO model is important is that companies are more profitable than ever.
In 2019, the median operating income margin for S&P 500 companies was 10.2%, compared to 9.3% in 2008 and 6.6% in 2002, according to FactSet data. As a result, company valuations have increased significantly since the 1980s.
For example, Walmart (WMT) had an enterprise value of $46 billion when it went public in 1970; today its market cap is about $230 billion.
The main reason why leveraged buyouts are important is that they allow companies to grow faster than they would be able to without access to additional capital or credit lines. For a company's growth rate to increase, it must be able to raise money to finance its operations. However, this can be difficult when companies are not yet profitable or have negative cash flows which prevent them from raising capital through traditional financing channels such as bond offerings or bank loans. That's where LBOs come in!
The goal of the leveraged buyout is to make a high-yield, tax-deductible return on the debt used to purchase the company. The strategy works because of its ability to use debt to expand a company's earnings potential and earnings growth. Leveraged buyouts are often used when companies need more capital than they can obtain through other means, such as issuing stock or borrowing from banks or investors.
While profitability has been rising over time due to technological innovations and global competition, so too has interest from private equity firms looking to take advantage of those trends by buying undervalued assets at attractive prices through a leveraged buyout strategy (LBO).
How to Perform an LBO Valuation?
Performing an LBO analysis is a lot like performing a cost-benefit analysis for a project. You want to determine whether it makes sense for your company to take on the debt and the risk of an LBO, so you can decide whether it's worth it.
The first step in performing an LBO analysis is to determine the realizable value of a company. The realizable value is the value that can be realized by selling all company's assets, assuming that all contracts are fulfilled, and no new liabilities arise because of selling its assets. To do this, you'll need to know how much equity capital exists in the company and what portion of that equity could be sold without impairing financial performance.
To calculate the realizable value, divide total net assets by total debt. Net assets include cash, short-term investments (such as treasury bills), long-term investments (such as bonds), accounts receivable (unearned revenue), and inventory. You also must account for any other types of assets that may exist such as equipment or buildings.
Debt includes both long-term debt (such as bonds or mortgages) and short-term debt (such as loans). You must also consider liabilities such as deferred taxes, pension obligations, and employee benefits.
Realizable value is the amount of cash left over after you subtract all liabilities from all net assets.
LBO analysis also involves analyzing ratios like net profit margin, return on assets, return on equity, and debt/equity ratio. These numbers are used as indicators of how well a company is doing financially since they affect how much money it has available for investment purposes or how much risk it takes on when borrowing money from investors.
Identify all the variables that will affect your decision. These include things like how much money you have available, what type of debt will be used, who will be providing the money and how much they're offering as an interest rate, who is going to be co-signing on the loan, and when will they get paid back, and so on.
Once you've identified all these variables, you need to figure out what impact each one has on your business’s financial situation. This could mean looking at things like how much money you have available at any given moment or what kind of interest rates are available on different types of loans.
Once you've determined which variables are most important for your company's future success—and which ones aren't—you can use this information to create an approach for analyzing each variable.
Formula Used for LBO Analysis
Leveraged Buyout Structure
The company goes private.
The existing shareholders receive a payout.
Equity is swapped for the new debt and equity.
A new CEO is brought on.
They make cuts and restructure the company, usually through layoffs and the elimination of unprofitable divisions.
An IPO or trade sale can be used to sell off the company in whole or in parts.
LBO Example and Walkthrough - Acquiring a Company
Edtech company Byju is about to acquire US-based companies Chegg and 2U by taking debt from banks Morgan Stanley and JP Morgan Chase & Co. to finance the acquisition.
Advantages of a Leveraged Buyout
Leveraged buyouts are useful for acquiring companies, restructuring companies, selling companies, exiting a company, and creating a holding company.
It allows an investor to acquire a company with less equity than would otherwise be required for direct purchase. Because most private companies require investors to contribute equity, investors who want to avoid this requirement can use leverage instead.
LBOs can help companies grow faster than they would if they stayed public by allowing them access to additional funds from new creditors who have invested in their businesses.
The use of debt, rather than equity, can be more attractive because it allows the buyer to cover all or part of the purchase price with borrowed funds provided by lenders. The debt load created by this leverage helps spread out risk among multiple lenders, reduces cash flow concerns, and increases profit margins as leverage inherently increases returns on capital invested into the leveraged buyout. A deal financed with debt usually has higher interest payments than one financed with equity (in some cases up to double).
They allow for more creative ways of expanding the company's business model and enhancing its brand name.
An LBO provides a substantial financial benefit to existing shareholders, who may receive equity-like returns on their investment and the opportunity for continued participation in management through earnings. The primary benefit to lenders is the potential for significant returns on their investment capital if they participate in an LBO transaction.
For the investor, there are tax benefits as well as appreciation potential in the target's stock.
For managers and shareholders who want to sell their shares, there is liquidity and value appreciation potential concerning the market price at which they can be sold (and receive cash).
For employees who want to cash out their shares, there are often significant liquidity gains such as dividend payments or share sales at higher prices than they paid for their shares.
They can be used to reduce debt when selling companies. If you don't need to pay interest on your debt, it frees up cash flow for other uses and reduces your tax liability.
They can provide a quick infusion of cash to improve shareholder value and increase asset values. A good LBO provides capital that can be used to boost sales by improving the product line or marketing campaigns and/or purchasing new equipment or technology that will help your business grow in the future.
They allow you to buy out shares at a premium (sometimes as much as 5% or 10%). This is because investors who might otherwise have been interested in buying shares have been attracted by an increase in stock price caused by an LBO offer.
Disadvantages of a Leveraged Buyout
Because debt is used as an accelerator during an LBO, lenders must bear all the risk associated with credit default swaps and collateralized debt obligations associated with their investment for it to be successful.
Financial risk: The financial investor bears the risk of losses on their investment. The LBO firm is generally required to post collateral to cover any potential losses.
Financing costs: To obtain funding for the LBO, the LBO firm may have to pay interest on borrowed money. This can be expensive, especially if the company has high-interest rates and low credit ratings.
Tax planning: The tax consequences of an LBO may differ significantly from those of other forms of financing. The buyer's share in profits will usually be taxed at lower rates than those typically paid by corporations, but they may also owe additional taxes on dividends or bonuses paid to employees or directors.
Leveraged buyouts often involve complex financial structures that are hard for outsiders such as investors to understand. And because LBOs don't give investors much control over management decisions, it's common for the people who run companies after a buyout not to be the same ones who led them before. All this can result in bad decisions made by people with little incentive to make them good ones.
Management often becomes more focused on meeting quarterly earnings targets than on building long-term value for shareholders or customers. In some cases, management teams might shift strategy after being acquired by an acquirer whose interests may not align with those of existing shareholders or customers.
Conclusion
A leveraged buyout is an acquisition of a company where the buyer uses significant amounts of debt to finance the purchase. This allows the buyer to pay less than the market value for the business because he does not have to use all his own money for his purchase. Since this type of transaction involves lots of debt (which can be risky) and because it's often done by private equity firms that aren't required to report their financial results publicly (making them hard to analyze), there's some debate about how effective these deals are over time.
Leveraged buyouts are not for every investor, but they do offer several benefits to the private equity firms which employ them. Hopefully, this primer on LBOs has provided you with a better understanding of how to use them effectively and efficiently.
Key Takeaways
LBOs are typically done by private equity firms that seek to purchase a firm's assets and then invest in it over several years to turn around the business and sell it for a profit.
The point of doing this type of transaction is that it allows an investor or management team (usually both) to purchase all outstanding shares or assets from either one person or multiple people who own them.