Leveraged Buyout (LBO) Definition | Example
A leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company.
In a leveraged buyout (LBO), there is usually a ratio of 90% debt to 10% equity. Because of this high debt/equity ratio, the bonds issued in the buyout are usually are not investment grade and are referred to as junk bonds. Further, many people regard LBOs as an especially ruthless, predatory tactic. This is because it isn’t usually sanctioned by the target company. It is also seen as ironic in that a company’s success, in terms of assets on the balance sheet, can be used against it as collateral by a hostile company.
LBOs are conducted for three main reasons. The first is to take a public company private; the second is to spin-off a portion of an existing business by selling it; and the third is to transfer private property, as is the case with a change in small business ownership. However, it is usually a requirement that the acquired company or entity, in each scenario, is profitable and growing.
Leveraged Buyout (LBO)
What Is A Leveraged Buyout | Example
Leveraged buyouts have had a notorious history, especially in the 1980s, when several prominent buyouts led to the eventual bankruptcy of the acquired companies. This was mainly due to the fact that the leverage ratio was nearly 100% and the interest payments were so large that the company’s operating cash flows were unable to meet the obligation.
One of the largest LBOs on record was the acquisition of Hospital Corporation of America (HCA) by Kohlberg Kravis Roberts & Co. (KKR), Bain & Co., and Merrill Lynch in 2006. The three companies paid around $33 billion for the acquisition of HCA.
LBOs are often complicated and take a while to complete. For example, JAB Holding Company, a private firm that invests in luxury goods, coffee and healthcare companies, initiated an LBO of Krispy Kreme Doughnuts, Inc. in May 2016. JAB was slated to purchase the company for $1.5 billion, which included a $350 million leveraged loan and a $150 million revolving credit facility provided by the Barclays investment bank.
However, Krispy Kreme had debt on its balance sheet that needed to be sold, and Barclays was required to add an additional 0.5% interest rate in order to make it more attractive. This made the LBO more complicated and it almost didn’t close. However, as of July 12, 2016, the deal went through.
Why Leveraged Buyout
- A leveraged buyout is the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition.
- One of the largest LBOs on record was the acquisition of Hospital Corporation of America (HCA) by Kohlberg Kravis Roberts & Co. (KKR), Bain & Co., and Merrill Lynch in 2006.
- In a leveraged buyout (LBO), there is usually a ratio of 90% debt to 10% equity.
Leveraged Buyout Model | Leveraged Buyout
An LBO model is built in excel to evaluate a leveraged buyout (LBO) transaction, which is the acquisition of a company that is funded using a significant amount of debt. The assets of the company being acquired and those of the acquiring company are used as collateral for the loans. The buyer typically wishes to invest the smallest possible amount of equity and fund the remainder of the purchase price with debt or other non-equity sources. The aim of the LBO model is to enable investors to properly assess the transaction and earn the highest possible risk-adjusted internal rate of return (IRR). Learn more in CFI’s LBO Modeling Course!
In an LBO model, the purpose of the investing company or buyer is to make high returns on their equity investments and using debt to increase the potential returns. The acquiring firm determines if an investment is worth pursuing by calculating the expected internal rate of return (IRR), where the minimum is 30% and above. The IRR rate may sometimes be as low as 20% for larger deals or when the economy is unfavorable. After the acquisition, the debt/equity ratio is usually greater than 1-2x since the debt constitutes 50-90% of the purchase price. The company’s cash flow is used to pay the outstanding debt
Structure of an LBO Model
In a leveraged buyout, the new investors (private equity or LBO Firm) form a new entity that they use to acquire the target company. After a buyout, the target becomes a subsidiary of the new company, or they merge to form one company.
Capital Structure in an LBO Model
Capital structure in a Leveraged Buyout (LBO) refers to the components of financing that are used in purchasing a target company. Although each LBO is structured differently, the capital structure is almost similar in most newly-purchased companies, with the largest percentage of LBO financing being debt. The typical capital structure is financing with the cheapest and less risky first, followed by other available options.
