Leveraged Buyout in simple terms means purchasing a company or an asset with the combination of Equity and Debt capital, with a significant portion of Debt in the total capital. The debt capital ranges between 70%-80% of the total capital. Because of this, it is known as Leveraged Buyout since the company leverages itself by way of borrowed funds.
The purpose of a buyout can be different as it depends on the purpose of purchasing a company. If the company wants to expand its current operations or increase its scale of business then it is a strategic buyout and is done by way of Mergers & Acquisition. On the other hand if a company or an Institution is just targeting to buy a company only for the sole purpose of generating returns then it is called a Financial Buyout. This is known as Leveraged Buyout
One question which can come to anybody’s mind is why a Financial Institution will be interested in buying a company. This can be portrayed through a simple example referred below.
This company has an EBIDTA of $100 million. The EV/EBIDTA multiple in this case is 6.0 times. So that creates a value of the company to be $600 million.
The Financial Institution funds this transaction in the following way:-
Now the Institution can generate the value on this Investment/Transaction:
1. Improvement in acquired company’s performance through improving the EBIDTA
2. Improvement in Industry outlook and hence increase in the multiple
3. Selling assets of the acquired company.
An explanation on how an Institution can generate returns can be understood by referring the video on “Why LBO?”
There can also be a case when the Institution cannot generate returns from the any of the three mentioned in the above cases. Does that mean that the Institution should not invest in the company? Not really.
Consider a Hypothetical Scenario where the Institution exits after 5 years.
We see that the Enterprise value remains same after 5 years and all the values remains the same. The only figure changed in the 5 years is the Capital Structure.
We see that at exit, the Equity value has increased from $200 million to $500 million and the debt has reduced drastically from $400 million to $100 million.
How did this happen?
The company used its positive free cash flows gained over the five years to pay off the debt the Institution raised at the time of Buyout.
This provides a fundamental reason for Institutions to invest in a company through a Leveraged Buyout.