Leveraged Buyout (LBO) Primer
Key Takeaways
Leveraged buyouts (LBO) are a type of acquisition where investors finance the purchase of a target company via debt financing (usually 50-60% is debt financing and 40-50% is equity).
In a LBO, the investors seek to increase the target company’s revenue and EBITDA in order to pay down debt and increase the total value of the Company to drive outsized increases in equity value before selling the company or executing an IPO.
LBOs have several benefits, such as: allowing firms to acquire larger companies than they could with equity alone, facilitating ownership transitions, allowing founders/owners to retain a stake and participate in future value creation, and strong returns for equity investors. However, they also carry significant risks, such as high interest rates, risk of credit default, and less cash available for other activities, including growth.
A successful LBO requires experienced advisors who understand the importance of a suitable target company, current market conditions, and how to navigate the complicated process.
Volume and Percentage of LBO Transactions
Source: Pitchbook, 2024 represents YTD through 06.30.2024
What is a Leveraged Buyout?
A leveraged buyout (LBO) is a type of corporate acquisition where the buyer, usually a financial investor or a group of investors, funds a significant portion of the purchase using debt capital. The buyer typically borrows 50-60% of the purchase price, using the target company’s assets as collateral for the borrowed capital and the cash flow from the target to repay the debt over time. The buyer contributes the remaining 40-50% of the purchase price as equity capital.
The acquired company (often referred to as the “target” of the LBO) may include public and private companies, family-owned businesses, or divisions of larger firms with stable cash flows, strong market positions, high growth potential, and a proven management team. The buyer will look for the target company to have a clear exit strategy within three to five years. The investment thesis for a LBO buyer is that, as an investor, they can earn a financial return by boosting the equity value of the target company through debt reduction and earnings growth. Equity investor targets for a LBO are often as high as 18%+ annual or internal rate of return (“IRR”) and 2.0+ times cash-on-cash return.
Investors generally have a three- to five-year holding period and then seek to monetize their investment by selling the target company, recapitalizing through the payment of dividends, or through a public stock offering called an Initial Public Offering (IPO). Typically, LBO buyers are investors who rely on low borrowing costs and a have a much higher equity capital cost. As such, buyout investors are the most active when interest rates are low and corporate valuations are moderate.
How Do Leveraged Buyouts Work?
The process of a LBO transaction is similar to that of other types of acquisitions. It requires due diligence and agreements between all parties involved. One key difference is that other acquisitions typically involve two parties: a seller and a buyer. In a leveraged buyout scenario, the buyer has to borrow the debt capital from a lender, which adds a third party to the transaction.
Here are the general steps taken in a LBO – from the initial interest in the target LBO company to dispersing funds after the target LBO company is sold:
Identification of the Target LBO Company: The acquiring company or investor identifies a potential target LBO company. The primary requirement for a target LBO company is the ability to support debt repayment. Good indicators of a suitable target are a company with stable cash flows, a strong market position, quantifiable growth potential, and a capable management team.
Structuring the Deal: Once the buyer has identified the target, they approach lenders to secure debt financing. Each acquisition is unique, and the deal's structure will depend on several factors. Typically, 50-60% of the purchase price is funded through debt. The buyer funds the remaining portion of the purchase price as equity from private equity funds or the investors’ resources (family office, sovereign wealth fund, etc.).
Acquisition and Ownership: The investors acquire the target LBO company using the combined funds from debt and equity. After the acquisition, the investors may choose to reorganize the company to improve efficiency, cut costs or implement strategic changes, though this is not always the case.
Creating Value for Repayment: As the target LBO company generates cash flow from operations, investors use a portion of the cash flow for debt repayment, thereby increasing the target LBO company's equity value. Investors may also implement operational improvements and other strategic changes to accelerate growth, improve margins and otherwise add value to the target LBO company.
Exit Strategy and Returning Funds: Investors aim to exit the target LBO company in three to five years, although it often takes longer, by selling it to another buyer, taking it public through an IPO or conducting dividend recapitalizations. Once the company is sold or there is another liquidity event as described above, funds are returned to investors.
Leveraged Buyout Deal Volume and Market Share
As shown in the graph above, leveraged buyouts make up the majority of private equity transactions, averaging around 50% of the total market with a range from a low of 33% of total deal activity in Q2 of 2020, when add-ons acquisitions were much higher than usual (add-ons are acquisitions by an existing target LBO company that are meant to accelerate growth / value creation and are also often funded with debt), to a high of 63% in Q2 of 2019 when the cost of debt was low.
Private Equity Leveraged Buyout
Private equity (PE) firms frequently use leverage to enhance equity returns for their fund investors, similar to how investors buy stock on margin or purchase real estate utilizing debt or a mortgage. PE firms form fixed-life limited partnerships (“Funds”) that pool committed capital from limited partners such as pension funds, high-net-worth individuals, family offices, endowments, and other institutional investors. These funds use leverage to amplify returns while managing financial risks through reliable cash flows.
A typical private equity fund has a ten-year term:
Initial four to six years: This is the “investment period,” when firms acquire target companies, leveraging their experience and expertise to restructure, grow, and enhance the value of the companies in their investment portfolio.
Subsequent four to five years: After the investment period is the “harvest period.” During this time, the private equity firm monetizes its investment portfolio via recapitalizations, selling to other buyers, executing an IPO, or through a secondary stock sale. Upon a liquidity event, proceeds are returned to the limited partners who contributed to the private equity fund.
Private Equity Fundraising
Source: Pitchbook, 2024 represents YTD through 06.30.2024
PE firms are compensated primarily via annual management fees (~2%), a share of profits on their investment portfolio (~20%), and any associated transaction or monitoring fees. Funds often focus on specific investment sizes, industries of expertise, or specific corporate growth stages where they can leverage specialized knowledge to identify and execute LBOs, thereby maximizing returns for investors.
Family Offices (Direct Investing)
Single-family and multi-family offices are often limited partners in private equity funds, but they are increasingly becoming more active in directly investing in LBOs. When participating as direct investors in these transactions, family offices often do not have defined guidelines on the timing of capital returns (the three to five years as detailed above), allowing for a longer-term investment horizon. These offices often specialize in industries where the family has experience, deep knowledge or history. Additionally, family offices have been early adopters of investing in mission-driven and impact-focused businesses.
Types of Leveraged Buyouts
There are different types of LBOs, all of which have different goals, investors, and financing structures. Some common types of LBOs are management buyouts, secondary buyouts, and hostile takeovers.
Leveraged Management Buyout
A management buyout (MBO) is a financial transaction in which an individual from the corporate management team or the entire team purchases the business from the original owner using a mix of borrowed capital, personal resources, and private equity investors. Buyers utilize this type of buyout to take a publicly traded company private or to acquire a private company from existing owners. The appeal of MBOs is that they provide management with more control of the business and greater opportunities for financial rewards.
Secondary Buyout
A secondary buyout occurs when one investment firm acquires a target LBO company from another investment firm that initially acquired the company via a LBO. Secondary buyouts are attractive because they provide the seller firm with instant liquidity and make room for other M&A activities. Historically perceived in a negative light, secondary buyouts are a good option when the seller firm has already realized significant gains from the investment and/or the target company would improve under a different firm’s management.
Hostile Takeover
A hostile takeover occurs when a company or group of investors seek to purchase a controlling stake in a publicly traded target company without the knowledge or favor of the target company’s management team. In hostile takeovers, investors need to secure approval from more than 50% of the voting shares issued by the company. A hostile takeover that involves a significant amount of debt financing would be considered a “take-private” or LBO. These are relatively rare.
The Advantages of Leveraged Buyouts
LBOs offer several advantages, primarily centered around financial efficiency and value creation. By using debt to finance a significant portion of the acquisition, investors can amplify their potential returns on equity, making LBOs a powerful tool for enhancing investment performance. Using leverage allows firms to acquire larger companies than they could with equity alone, enabling access to valuable assets and markets. Additionally, the debt obligations create a disciplined management environment focused on cash flow and operational efficiency, often leading to cost reductions and improved profitability. LBOs also provide opportunities for restructuring and strategic realignment, unlocking hidden value and driving long-term growth. For investors, LBOs offer the potential for high returns while diversifying their portfolios with substantial, asset-backed investments.
Risks Associated with Leveraged Buyouts
While the LBO model has several benefits, there are also significant risks. Potential investors should evaluate the current market conditions and their capacity to take on debt. Some of the risks include:
High-interest payments are associated with the high-yield debt and mezzanine (a hybrid debt and equity financing option) financing of LBOs. Lenders often charge higher rates to offset the increased risk of leveraged buyouts.
Pressure on cash flow due to substantial debt repayment obligations can reduce operating flexibility and limit a target LBO company’s ability to capitalize on growth opportunities. These pressures can be exacerbated by changes in market, competitive and economic conditions.
Excessive debt can lead to a lower credit rating, making it challenging to secure new financing. This can potentially hinder the target company’s ability to undertake new projects or expand its portfolio.
To justify a LBO, the target LBO company must demonstrate strong cash flow and profitability, ensuring that the anticipated profits from the acquisition will outweigh the costs of high-interest loans. Proactive planning and contingency measures are essential to mitigate these risks and manage the financial burden effectively.
Leveraged Buyout Example
Below is an example of a leveraged buyout transaction (the “Illustrative LBO”), demonstrating the typical structure and mechanics in a conventional leveraged buyout scenario. The Illustrative LBO assumes a company with $25 of earnings before interest, taxes, depreciation and amortization (“EBITDA”) is acquired for 8.0 times EBITDA, implying a total transaction value of $200. The $200 transaction value is funded with $120 of new debt (representing 4.8 times EBITDA and 60% of the total purchase price) and $80 of new investor equity (40% of the total purchase price). Investors use proceeds to repay the existing debt of the target company, and the remaining $180 is used to purchase all of the equity interests from existing shareholders.
Note: Buyout Investors often require management and, in some cases, existing investors to roll over a portion of their existing equity interest into a new equity investment.
In this example, the investors focus on strategies to grow revenue and EBITDA and then target the end of year five to exit the company. During years one through five, the target grows revenue and EBITDA. The buyers use cash from operations to pay interest expense and principal on the $120 of debt to fund the purchase.
In Year 5, the company, which is now generating $31.9 of EBITDA, is sold at an 8.0 times EBITDA multiple, valuing it at $254.8. After repaying $68.2 of the remaining debt, the remaining equity value is $186.6.
Based on an initial investment of $80, the equity holders have earned a 2.3x “cash-on-cash” return (implied equity value / initial investment) and a compound annual return or internal rate of return (“IRR”) of 18.5%.
NOTE: This is an example scenario and does not represent any Keene Advisors’ clients or other organizations
The Bottom Line
Leveraged buyouts can be a good strategy if the conditions are right and the investors have done their due diligence to ensure the target LBO company meets specific requirements. A LBO is also a possible exit strategy for startups and founder-owned businesses that have previously raised venture capital funding or have been self-funded. Understanding an LBO's mechanics, benefits, and risks can yield positive results. They also require strong advisors who can educate management teams on the risks and rewards of an LBO, detail subsequent operational and cash flow requirements, and handle the due diligence and management of the acquisition process.
Keene Advisors is a Full-Service Strategy Consulting and Investment Banking Advisory firm with over $40 billion in successful mergers and acquisitions, leveraged buyouts, capital raising, and restructuring advisory transactions. We are dedicated to transparent communication and seamless guidance throughout every stage of the process, always aiming to align short-term needs with long-term goals.
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Disclaimer: This commentary is intended for general informational purposes only. Keene Advisors does not render or offer to render personalized financial, investment, tax, legal or accounting advice through this report. The information provided herein is not directed at any investor or category of investors and is provided solely as general information. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action. Keene Advisors does not provide securities related services or recommendations to retail investors. Nothing in this report should be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product. Securities offered through Burch & Company, Inc., member FINRA/SIPC.