You may have heard the term ‘leveraged buyout’ (or ‘LBO’) be thrown around by Elon Musk in regards to Tesla or by Mark Dell in regards to Dell Inc. But what does it actually mean and is it reserved for tech giants? Read on to find out what leveraged buyouts are and also how they work.
What Is A Leveraged Buyout?
A Leveraged Buyout (LBO) is the process of buying a business using a combination of equity (i.e. assets and cash flow) and borrowed funds (i.e. debt). In a traditional leveraged buyouts, debt comprises approximately 60%-70% of the purchase price. The remaining 30%-40% of the purchase price are attributed to equity.
The purpose of an LBO is to allow a company to make an acquisition without committing a whole lot of capital. Further, an LBO allows the target company’s assets and future cash flow to pay off the debt.
Who Are the Key Players in a LBO?
An LBO transaction involves many moving parts and a number of participants to see it through. Before we get into the nitty-gritty, it is important to become familiar with the key players.
Financial Sponsor
The buyer in the LBO transaction and the person who provides the capital portion of the purchase price.
Target Company
The seller in the LBO transaction.
Investment Banks
Advise both the buyer and seller in the LBO transaction. They assist in creating the optimal financing structure. Moreover, they will provide a financing commitment to support the sponsor’s bid.
Banks and Institutional Lenders
Collectively provide the debt portion of the purchase price.
Why Buy A Company Through A LBO?
Leveraged buyouts are generally cheaper, faster, and less risky than building a business from scratch. It can provide the resources to increase both cost savings and growth opportunities.
Through an LBO you are able to leverage the established business model, infrastructure, and also customer base of the target company. This can be integrated to complement or expand an existing product line. Moreover, it can help develop the company’s geographic reach.
During due diligence, be sure to check compliance with anti-trust laws. Anti-trust laws operate to prevent a company from gaining too much share in a given market. If this is the case, you may have to pass on that particular opportunity.
What Makes A Good LBO Candidate?
An LBO is only beneficial if the target company can create value for the financial sponsor(s). Common traits among LBO candidates include:
Strong cash flow generation
Demonstrates the ability to support periodic interest payment and also debt repayments.
Leading and defensible market position
Supports the stability and predictability of the target company’s cash flow.
Growth opportunities
Increases the likelihood of (1) the target company’s enterprise value going up and (2) generating greater returns.
Low capital expenditure requirements
The lower the capital expenditure, the higher the free cash flow and ability to meet periodic payment obligations.
Strong asset base
Serves as collateral and makes securing loans easier and cheaper.
Proven management team
Strong leadership provides the expertise required to navigate the complexities of the transition period and beyond.
Advantages
- Tax shield – interest expense on debt is tax-deductible.
- Improved managerial performance. This is because financial gain is tied to improving the company’s performance.
Disadvantages
- The target company will be operating in a high-risk zone during the transition period
- Interest payments and debt repayments are reliant on steady cash flows. If vulnerable to market volatility, the company may go bankrupt.
Conclusion
To conclude, the next time you come across a business with great potential, consider seizing the opportunity with a leveraged buyout. A LBO looks to the potential of the target company to generate greater revenue as opposed to your ability to buy upfront.
It is important that you engage in due diligence prior to engaging in a LBO. This will involve bringing in both your financial and legal advisors to assess your position. If you would like more information or advice regarding LBOs, please reach out to a Mergers and Acquisitions Lawyer.
