What is Leveraged Buyout (LBO)?
A leveraged buyout (an LBO) is an acquisition of a company or a segment of a company by a financial sponsor using significant amounts of debt. A financial buyer invests a small amount of equity and uses leverage to fund the remainder of the consideration paid to the seller. Internal rate of return (IRR) of a company can be calculated by evaluating an LBO transaction. equity investment upon exit versus the amount invested at the entry of the company is compared by IRR and it also and calculates an annualized return on the investment.
Stable cash flows and low fixed costs, Potential for operational improvements and an attractive valuation upon entry and present a clear exit strategy are the specialities of Target Company.
Applications of the LBO Analysis
LBO helps to determine the maximum purchase price for a business that can be paid based on certain leverage or debt levels and equity return parameters. It is also calculated to develop a view of the leverage and equity characteristics of a leveraged transaction at a given price. It also calculates to the minimum valuation for a company since, in the absence of strategic buyers, an LBO firm should be a willing buyer at a price that delivers an expected equity return that meets the firm’s hurdle rate.
In LBO transactions, financial buyers want to generate high returns on equity investments and use financial leverage (debt) to increase these potential returns. Financial buyers evaluate investment opportunities by analysing expected internal rates of return (IRRs), which measure returns on invested equity.
The financial sponsors’ minimum required IRRs rate have been more than 30%, but maybe as low as 15-20% for particular deals under adverse economic conditions. This rate for larger deals tends to be a bit lower than rates for smaller deals.
The success of an LBO investment can be measured by the sponsor using a metric called “cash-on-cash” (CoC).
De-levering (paying down debt), Operational improvement (e.g. margin expansion, revenue growth) and Multiple expansion (buying low and selling high) are the factors which drive the returns in LBO.