LBO Guide

Leveraged Buyout (LBO) is another pillar of the financial world. Carried out by Private Equity firms, this process certainly has its ethical question marks. Essentially, PE firms buy a company with a fraction of their own money the rest is financed by debt. The debt is repaid by the acquired business which will then be flipped for profit. This process is less formulaic than its other counterparts,  however, I have compiled a general structure then analysed a few famous LBO deals.

Structure

1)        Target Identification

2)        Planning Financing

3)        Acquisition & Operation

4)        Exit

1)        Companies targeted in LBO are stable and mature in their development. Earnings are predictable, they will have very good cash flow and stable assets. Crucially, the company must be low risk with minimal debt, so it won’t be overloaded with future debt repayments

2)        Next, PE firms decided how to finance the acquisition. Typically, LBO deals are financed with a maximum of 70-90% debt with the rest equity. Critically, despite being acquired, the target company is responsible for servicing all debt. The debt payment ends up on their balance sheet. PE firms ‘leverage’ the acquired firm’s assets, ‘pledging them as collateral’ if the total debt is not serviced ie lenders can seize their assets. Usually PE firms require a 20-30% IRR (internal Rate of Return). The annual rate of return after all debts have been serviced from year of acquisition.

3)        The actual acquisition occurs once all finances are sorted. PE firms expect the target company to service all debts, make profit and then they flip it normally 5-7 years after. more profit. Here the real ethical issues commence. PE firms are renowned for being ruthless and making profit by any means. Their role now is to ‘streamline operations.’ This can involve cost cutting by removing ‘unnecessary divisions’ leading to many losing jobs. Worst case scenario, the company is not able to service the debts and the entire company goes under.

4)        The PE firm then sells the acquired firm making profit in the process. Alternatively, the target company defaults on its assets, potentially even goes bankrupt but the PE firm only loses its equity investment. For them, it is just another investment but for many acquired companies it’s an entire livelihood. Generally, a 3x MOIC (Multiple on Invested Capital) is desired.

Toys “R” Us

One of the most infamous LBO cases. In 2005, the company was acquired by KKR, Bain Capital and Vornado Realty Trust for $6.6B with $5B debt. The firm struggled heavily with the rise of online shopping and was essentially squeezed out of the market by e-commerce giants such as Amazon. The firm filed for bankruptcy in the U.S in 2017. While the PE firms only lost their equity investment, it’s reported over 30,000 people lost their job. A brutal example of the dangers of LBO’s.

This wraps up the end of my mini-series on all valuation techniques. Planning a few pieces on M&A deals and Macro to Markets in the coming weeks. Check out the rest of my work here.