Question

1.   What are the key elements of a LBO?

2.   What is the debt to equity ratio in this example and how does this ratio relate to risk?

Answer 1

1. Leveraged buyout (LBO) is an acquisition / segment of a company funded primarily with debt.

Some key elements to consider in LBO :

Industry characteristics:

• Type of industry
• Competitive environment
• Cyclicality
• Extraneous factors like politics

Company characteristics:

• Market share
• Growth scope
• Operating leverage
• Sustainability of operating margins
• Level of maintenance CapEx vs. growth CapEx
• Working capital requirements
• Ability to operate effectively in levered situation

Market conditions:

• Accessibility and cost of bank and high yield debt
• Expected equity returns

Characteristics of a Good LBO Candidate

The following characteristics define the ideal candidate for a leveraged buyout.

• Strong, predictable operating cash flows with which the leveraged company can relieve acquisition debt
• Mature, steady (non-cyclical)
• Well-established business
• Moderate CapEx and product development (R&D) requirements so that cash flows are not diverted from the principle goal of debt repayment
• Limited working capital requirements
• Strong tangible asset coverage
• Strong management team
• Viable exit strategy in the case of mess up

Returns

In LBO transactions, buyers want to generate high returns on the equity investments and use financial leverage (debt) to increase these potential returns. They evaluate investment opportunities by analyzing expected internal rates of return (IRRs), which measure returns on invested equity.

The returns in an LBO are driven mainly by three factors

• De-levering (paying down debt)
• Operational improvement (e.g. margin expansion, revenue growth)
• Multiple expansion (buying low and selling high)

2.

In a leveraged buyout (LBO), there is usually a ratio of 80% to 90% of debt and the balance in equity.

There are certain risks associated with LBOs.Success of the LBOs depend on the ability to-

a) improve performance of the Company.

b) manage and contain its business risks.

c) exercise cost controls, and

d) liquidate disposable assets.

If these issues are not addressed properly, high fixed costs may jeopardize the venture. Also, since there is a high amount of leverage, interest costs form a major part of the fixed costs and can force company into default if not paid. For the debt holders, there is a probability that the risk of default might not give full returns for their investments.