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What Is LBO?

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LBO Explained

LBO or leveraged buyout is the process in which one company buys another. The acquiring company uses borrowed funds for the acquisition, and its assets are used as collateral against the loan.

The borrowed money may be a bond issue or loan among the various steps of an LBO. But in the process, the acquired company’s assets act as leverage against it. It is considered a forceful acquisition process. To finance the acquisition cost, the acquiring company prefers debt with a lower price than equity, thus reducing the financing cost. The interest payments on loans also help in reducing tax liability

The steps of an LBO is most prevalent in private institutions. The value of assets used as collateral to get the loan and the future prospects of the target company determines how much fund the banks agree to provide for the acquisition.

Types

Let us look at the various types of LBO.

Privatize a public company – In this process, the acquirer uses a loan fund, purchases the outstanding stocks of the public entity, and makes it private. The aim is to go for an Initial Public Offer.
Split Up – The target company is divided into parts, and the acquirer sells them reasonably. This helps the target company grow. This is what makes a good LBO.
The savior – The management takes a loan to save the company from failure. However, without restructuring and makeover, success is difficult.
Restructure portfolio – The company acquires a competitor to get a portfolio makeover. This helps businesses expand, reach a better market, and increase share prices.

Thus, the above lists out the different types of LBO.

Example

This section of LBO will try to understand how the what is LBO model using a simple example to clarify the LBO financing.

Let us say that there is a business with no debt now. It generates a pre-tax income of $1.5 million a year. And the net income is $1 million, assuming the owner is paying a third of the earning to the government.

Now, Mr. B desires to buy the company for $10 million. It is an excellent deal because earning $1 million per year and $10 million looks pretty attractive. So, there is a buyout agreement.
Mr. B, on the other hand, checks his funds and finds out that he can only invest $1 million, and the rest he needs to arrange.
So, he asks a bank to lend him the remaining amount. The bank disagrees with lending them money, thinking it would be risky. Then, Mr. B sees that the company has excellent assets. So, he shows the company’s assets, uses them as collateral and convinces one of the banks to lend them money at a 10% interest rate per annum.
So, Mr. B invests $1 million of his funds, borrows $9 million from the bank, pays off $10 million, and buys the business. Now, the company does not consist of equity only. There is $1 million in equity and $9 million in debt. So, this would be called a leveraged buyout since debt is used heavily in this whole deal.

We will now check whether this deal is profitable for Mr. B. After buying the business, if we assume that the firm still generates $1.5 million in pre-tax income, here's how we will do the calculation: -We will now check whether this deal is really what makes a good LBO or not. In other words, is it profitable for Mr. B or not? We will now check whether this deal is beneficial for Mr. B. After buying the business, if we assume that the firm still generates $1.5 million in pre-tax income, here's how we will do the calculation: -

Even if the firm generates $1.5 million in pre-tax income, net income will not be $1 million after paying $0.5 million in taxes. Now, Mr. B needs to pay interest on the borrowed funds. He has borrowed $9 million at 10% per annum.
That means he needs to pay $900,000 as interest. That means the company has a pre-tax income of ($1.5 million – $900,000) = $600,000. He will pay the same tax rate as the interest is tax-deductible.
He will get a net income of $400,000, assuming he would pay one-third of the pre-tax income as taxes.
This $400,000 is a pretty good income if we compare what Mr. B has put in. In addition, He invested $1 million of his own money. That means if the net income remains similar for the next three years, he will get back his invested money and more.

In this example, Mr. B has taken the help of the bank. The company usually targets a competitor and uses a private equity firm in big deals. A private equity firm then goes out, puts in some of its own money, and takes a loan from other financial institutions. The above example explains clearly what is LBO model.

Summary Of Features

This section of what LBO is summarizes most of the important features of LBO.

Parameters	Range
Returns	Generally, between 20%-30%
Exit Time Horizon	3 years-5 years
Capital Structure	A mixture of debt (high) and equity (low)
Debt Payment	Bank debt is usually paid in 6 years-8 years. Higher yield debt is paid in 10 years to 12 years.
EXIT Multiples	EBITDA, PE, EV/EBITDA
Potential exits	Sale, IPO, Recapitalization

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Frequently Asked Questions (FAQs)

1. What is a paper LBO?

A paper LBO, or a hypothetical LBO or simulated LBO, is a financial modeling exercise where an analyst creates a model to simulate the financial structure and performance of a leveraged buyout (LBO) transaction. It allows analysts to assess an LBO's potential returns and feasibility without actually executing the transaction.

2. What is LBO analysis?

LBO analysis is a financial evaluation method used to assess a leveraged buyout transaction's financial viability and potential returns. It involves creating a detailed financial model that incorporates assumptions about the purchase price, financing structure, cash flows, debt repayments, and exit strategy to determine the LBO's financial performance and potential profitability.

3. What makes a good LBO?

A good LBO typically involves several factors, including a target company with stable cash flows, strong growth potential, and opportunities for operational improvements. A suitable capital structure, where the debt portion is reasonably sized and the interest and principal payments are manageable, is also important. Additionally, a well-defined exit strategy that allows for an attractive return on investment is crucial for a successful LBO.