Back not too many years ago it was referred to as “bootstrap financing” or simply getting a loan to buy a business. Now referred to by the acronym LBO, the leveraged buyout has become one of the most exciting and popular investment vehicles of the decade.
A leveraged buyout involves financing the acquisition of a business with a small equity investment and substantial debt. The debt financing is obtained and serviced by the assets and cash flow (net income plus depreciation and other non cash expenses) of the the business that is being acquired. Properly structured, an LBO allows an individual or group of investors with limited resources to acquire a business of substantial magnitude.
Leveraged acquisitions have been around for many years and were primarily utilized in the transfer of ownership of closely held businesses. In the later part of the last decade, a few aggressive and creative investment bankers began to apply the same principles to larger transactions. The timing was right, there were many highly publicized deals, a lot of money was made by some and the acronym LBO became a common place term.
The classic debt to equity ratio of a well established business might be one to one (one dollar of debt for each dollar of equity). It is not atypical for the debt to equity ratio in a newly acquired LBO to be ten to one. The key element for a successful LBO is acquired assets and resulting cash flow that are able to support the debt that is being incurred.
The underlining assumption is that, freed from whatever distractions that hindered the previous owners and provided with significant incentives, the experienced management group can maintain a cash flow that will provide for the retirement of the debt. This will result in a dramatically improved debt to equity ratio and the value of the business will increase rapidly.
Opportunities for LBOs exist with both large public companies and private businesses. Larger corporations decide to divest divisions for many reasons. They may be profitable but are requiring too much attention or capital. Perhaps the parent company sees greater opportunities in another direction and wishes to redirect its capital.
A majority of LBOs are smaller transactions that don’t make news headlines. Private investors supporting management groups in acquiring private businesses. Again the reasons for sale are many. The desire for liquidity, estate planning and succession of ownership are frequent sources of opportunity.
Let’s examine the structure, valuation and logic behind the type of deals that make the big headlines. Company X has been valued at $95 million and will be acquired by its current management and a group of outside investors. The buyers intend to finance the acquisition with $10 million in equity (their money, usually the contribution of the outsiders) and $85 million in debt (other peoples money, usually borrowed from large financial institutions).
The objective now becomes to maximize cash flow and reduce debt. The management plans to immediately sell off one of the company’s operating divisions for $35 million. This division in all likely hood will become “son of LBO” as its managers will join with another group of investors and follow the same course as the managers of company X. The proceeds of the sale will be used to reduce the original debt from $85 to $50 million.
After the asset sale the cash flow is estimated to be $9 million per year. It will be the objective of the management to improve that cash flow by a combination of operating efficiencies and modest growth. Despite the cash drain caused by the heavy interest payments, company X anticipates repaying $3 to $5 million a year in debt.
The magic of the mega bucks LBO is seen several years down the road. After about five years, the original investment of $10 million now controls a company with an annual cash flow in excess of $10 million. Conservatively valuing the company at seven times cash flow ($70 million) and after deducting the remaining debt, approximately $30 million, the initial $10 million investment is now worth $40 million after five years.
Actual returns in both large and small leveraged transactions can often result in returns far great than depicted in this example. This accounts for the rise to prominence of the LBO in the investment community.
Because it could be your business, remember the key elements for a successful leveraged buyout and keep an eye out for the right opportunity.