LBO Flashcards
What is a leveraged buyout, and why does it work?
In a leveraged buyout (LBO), a private equity firm acquires a company using a combination of Debt and Equity, operates it for several years, and then sells the company at the end of the period to realize a return on its investment. During the ownership period, the PE firm uses the company’s cash flows to pay for the interest expense on the Debt and to repay the Debt principal. LBOs work because leverage amplifies returns: if the deal performs well, the PE firm will realize higher returns than if it had bought the company with 100% Equity. But leverage also presents risks because it means the returns will be even worse if the deal
does not perform well.
Why do PE firms use leverage when buying companies?
To amplify their returns. Leverage does NOT “increase returns.” Borrowing money to fund a
deal makes positive returns even more positive and negative returns even more negative.
All PE firms aim for positive returns above a certain IRR, and using leverage makes it easier to
get there… if the deal goes well.
A secondary benefit of leverage is that the PE firm has more capital available to buy other
companies since it will use less of its own capital in each deal.
Walk me through a basic LBO model (without the full financial statements).
“In an LBO model, in Step 1, you make assumptions for the Purchase Price, Debt and Equity,
Interest Rate on Debt, and other variables such as the company’s revenue growth and margins.
In Step 2, you create a Sources & Uses schedule to show how much Investor Equity the PE firm
contributes and how items like the transaction fees and the company’s Cash balance affect this
contribution.
In Step 3, you project the company’s Income Statement and its partial Cash Flow Statement
down to Free Cash Flow.
Then, in Step 4, you use the Free Cash Flow, Beginning Cash, and Minimum Cash to determine
how much Debt principal the company repays each year. You then link the Interest Expense on
this changing Debt balance to the Income Statement so that FCF deducts the Interest.
Finally, in Step 5, you make the exit calculations, usually assuming an EBITDA Exit Multiple, and
you calculate the IRR and Money-on-Money multiple based on the proceeds the PE firm earns
at the end vs. its Investor Equity in the beginning.”
