LBO

Question 1

What is a leveraged buyout, and why does it work?

Answer 1

In a leveraged buyout (LBO), a private equity firm acquires a company using a combination of debt and equity (cash), operates it for several years, possibly makes operational improvements, and then sells the company at the end of the period to realize a return on investment.

During the period of ownership, the PE firm uses the company’s cash flows to pay interest expense from the debt and to pay off debt principal.

1. By using debt, the PE firm reduces the up-front cash payment for the company, which boosts returns.
2. Using the company’s cash flows to repay debt principal and pay debt interest also produces a better return than keeping the cash flows.
3. The PE firm sells the company in the future, which allows it to regain the majority of the funds spent to acquire it in the first place.

Question 2

Why do PE firms use leverage when buying a company?

Answer 2

They use leverage to increase their returns.

Question 3

How do you use an LBO model to value a company, and why do we sometimes say that it sets the “floor valuation” for the company?

Answer 3

You use it to value a company by setting a targeted IRR (for example, 25%) and then back-solving in Excel to determine what purchase price the PE firm could pay to achieve that IRR.

This is sometimes called a “floor valuation” because PE firms almost always pay less for a company than strategic acquirers would.

Question 4

How is an LBO valuation different from a DCF valuation? Don’t they both value the company based on its cash flows?

Answer 4

The difference is that in a DCF you’re saying, “What could this company be worth, based on the present value of its near-future and far-future cash flows?”

But in an LBO you’re saying, “What can we pay for this company if we want to achieve an IRR of, say, 25%, in 5 years?”

So both methodologies are similar, but with the LBO valuation you’re constraining the values based on the returns you’re targeting.