OE - Basic Leveraged Buyouts (LBO) Flashcards
Explain an LBO in the simplest possible language.
Analogous to buying a house with a mortgage and renting it out. A house (firm) is bought; significant leverage is put on to reduce the necessary equity injection. Over time, cash flows from rent (earnings) go to paydown the debt and increase the value of the equity.
Explain an LBO in the in the simplest possible language.
Analogous to buying a house with a mortgage and renting it out. A house (firm) is bought; significant leverage is put on to reduce the necessary equity injection. Over time, cash flows from rent (earnings) go to pay down the debt and increase the value of the equity.
What makes a good target for an LBO?
Stable and predictable cash flows:
- Important determinant to the amount of leverage a company can take on
- Sign of future financial performance and ability to pay down debt
Low EV / EBITDA multiple:
- An indicator of how easily the cash flows will be able to cover the purchase price
Large amount of tangible assets:
- Tangible assets can be used as collateral for loans and help increase the amount of leverage the acquiring firm can get
Limited working capital and capital expenditure requirements:
- Increases in working capital and capex result in a reduction in FCFF, which would have otherwise been used to pay down debt. Capex should be reduced to cover maintenance capex only, unless the sponsor is looking to grow the enterprise as well.
Strong and defensible market position:
- Makes cash flows less risky
- Want to be sure market has medium to high barriers to entry for competitors
Ability to reduce costs and increase margins:
- Increases cash available to pay down debt
Undervalued Business or Assets:
- Having divestible assets can be an effective means to reduce a debt burden of the buyout
Viable Exit Strategy:
- The realized ROE in an LBO comes from sale of the business. Without a viable exit in sight (typically through a sale to a strategic, another sponsor, or an IPO), an LBO most likely will not go through
What makes a good target for an LBO?
Stable and predictable cash flows:
- Important determinant to the amount of leverage a company can take on
- Sign of future financial performance and ability to pay down debt
Low EV / EBITDA multiple:
- An indicator of how easily the cash flows will be able to cover the purchase price
Large amount of tangible assets:
- Tangible assets can be used as collateral for loans and help increase the amount of leverage the acquiring firm can get
Limited working capital and capital expenditure requirements:
- Increases in working capital and capex result in a reduction in FCFF, which would have otherwise been used to pay down debt. Capex should be reduced to cover maintenance capex only, unless the sponsor is looking to grow the enterprise as well.
Strong and defensible market position:
- Makes cash flows less risky
- Want to be sure market has medium to high barriers to entry for competitors
How do LBOs increase the value of a company?
They create value in several ways:
- By reducing the firm’s WACC by adding debt that is cheaper on an after-tax basis
- By realizing operational efficiencies
- By increasing ROE through financial leverage
- Reduction of public listing costs because a firm is now private
- Private ownership allows for long-term strategic thinking
Walk me through how an LBO impacts the financial statements.
Income statement: An LBO drastically increases interest expense
Cash flow statement: Any leftover cash after operating and investing activities is used to pay down debt (CFF)
Balance sheet: Existing debt, equity, and goodwill is wiped out; a new capital structure is put in place with sponsor equity and new debt. Debt balance is gradually paid down with cash generated from operations.
What is the plug in an LBO model?
The sponsor’s equity check is the plug in an LBO model. Given a fixed IRR, the most you can spend will be the equity.
Why is historical interest expense not meaningful when building an LBO model?
The prior interest expense is not relevant because the target company will be recapitalized with a new capital structure and associated debt terms.
How is purchase price determined for a public target? For a private target?
For a public company, the purchase price is calculated by multiplying the fully diluted shares outstanding by the offer price; net debt is then added to get to the enterprise value. For a private company, you multiply LTM EBITDA by a purchase multiple to arrive at enterprise value.
