A Practical Guide to a Leveraged Buyout (LBO)

Posted at August 11, 2020 » By : » Categories : Business Management »
leveraged buyout

Leveraged buyouts (LBOs) have gathered a lot of notorious press. However, according to economists, a leveraged buyout is still an important company acquisition tool.

The leveraged buyout model is an interesting one and something that all investors should know about.

Although potentially profitable, leveraged buyouts also come with a high level of risk. Therefore, it is important to find out everything you can about this unique acquisition method before taking action. Otherwise, you may lose assets rather than build them.

If you want to get savvy about leveraged buyouts, keep reading for a practical guide to LBOs.

What Is a Leveraged Buyout (LBO)?

So what is a leveraged buyout?

A leveraged buyout is the acquisition of a company through the use of borrowed funds. High leverage is utilized, generally 90% and above. The assets of the company are often given as collateral for an asset-based loan.

The loan repayments are paid back by the company.

This has a unique advantage that the borrower does not need to provide collateral or much capital. What’s more, the company is responsible for meeting the loan payments.

However, the drawback to the leveraged buyout model is that such high leverage also involves a certain amount of risk. If any problems occur while running the business, and cash flow issues develop, the company may not be able to make the loan payments. If the company defaults on the loan that bought it, its assets may be seized, causing a loss to the investor.

The History of Leveraged Buyouts

Leveraged buyouts underwent a surge of popularity in the 1970s. During this time favorable economic factors made it easy for investors to secure leveraged loans.

During this time, and on into the 1980s, large corporations ate up smaller companies on this wave of easy credit. Combined with the history of junk bonds and leveraged buyouts, this caused many to view LBOs as an unsavory acquisition method.

Added to this was the fact that some investors saw an opportunity to split up acquired companies and sell the pieces for a profit. This was generally of detriment to the company, impacted jobs, and was only good for the investor’s pocket.

However, leveraged buyouts are not just a corporate raiding mechanism. In fact, some of the most successful, well known, and trusted brands today, such as Heinz, were acquired through an LBO.

Leveraged Buyouts Today

In favorable economic periods, leveraged buyouts are still abused in some cases today. However, they are also a legitimate acquisition method.

What’s more, leveraged buyouts are not only used for large companies. An LBO can also be used to effectively acquire and improve smaller companies.

Let’s now take a look at the basic steps to completing a leveraged buyout.

How to Do a Leveraged Buyout

Leveraged buyouts are typically complex procedures. However, the basic method for going about an LBO is simple.

The first step is to vet out potential companies to acquire. These companies need to be analyzed carefully, funding needs to be found, and a financial structure needs to be chosen for the LBO.

Look at Potential Companies to Purchase

Initially, a list of companies that have the potential for an LBO needs to be compiled. To satisfy lending requirements, companies need to have a specific ratio between cash flow, assets, and asking price.

Firstly, for a company to be suitable for a leveraged buyout, it needs to have sufficient cash flow to cover the debt payments. In many cases, the cash flow will need to be used to service senior debt, junior debt, subordinated debt.

What’s more, the assets the company holds need to be enough to underpin the loan (as these serve as the collateral).

Lastly, the price of the company also needs to be justified by the company’s assets and cash flow. Furthermore, investors may have specific criteria for which companies they want to acquire.

Some investors may wish to focus on companies in distress that can be rapidly improved. Others may wish to acquire within a certain sector, or only invest in businesses that are running soundly.

Analyze Cash Flows

To effectively analyze a company’s cash flow, investors need to look at operating cash flow and working capital.

Working capital is calculated by deducting current liabilities (such as loan payments and accounts payable) against current assets (such as accounts receivable and inventory).

Operating capital is measured by combining net income with non-cash expenses and changes in working capital. It is very important to look at these company metrics, as any disruption in cash flow could quickly compromise an LBO.

Estimate a Reasonable Offer

As mentioned above, it is essential that the offer amount in a leveraged buyout be in line with a company’s assets and cash flow. If the offer amount is too high, this can cause the loan repayment to be too large for the company to meet.

Some investors will want to look at getting a minimum return on their investment. Others may wish to secure a maximum payback period. This model aims to regain their money within a set timeframe.

Decide on a Financing Structure

Another important step is to decide on a financing structure. Financing structures for leveraged buyouts are typically complex, especially in larger acquisitions. If this is unfamiliar territory for you, you will want to speak to your CFO and discuss the advantages of multiple layers of financing versus a single layer.

Do You Need Capital for a Leveraged Buyout?

Are you contemplating a leveraged buyout? If so, not only will you need the right company with a balance between cash flow, assets, and price—you’ll also need good financing options at your disposal.

If you are in need of financing, take a look at our business loan types to find one that fits your needs. Start by filling out our 90-second online application. Once this is done you will quickly be matched with tailored loan offers from competing lenders.

If you have any questions about the process contact us directly and we will be eager to help.