What is LBO?

LBO is the short-form for Leverage Buyout. The other company is acquired by borrowing a large amount of money to meet the acquisition cost. The purpose of these buyouts is to primarily make larger acquisitions without blocking a huge capital and providing assets of the acquiring company for collateral for loans.

It is acquiring a company with small equity (say 5%-10% of the total cost) and using debt to fund the remaining (90%-95%). It implies that the acquisition may primarily use borrowed money, and with this high leverage, the buyer (private equity firmsPrivate Equity FirmsPrivate equity firms are investment managers who invest in many corporations’ private equities using various strategies such as leveraged buyouts, growth capital, and venture capital. The top private equity firms include Apollo Global Management LLC, Blackstone Group LP, Carlyle Group, and KKR & Company LP.read more) hopes to earn a higher return on its investments.

The purpose of leveraged buyouts is to allow companies to make large acquisitions without committing capital.

How does LBO work?

This section of LBO will try to understand how the LBO works using a simple example to clarify the LBO financing.

Let us say that you have a business. It is a great business, and there is no debt now. It generates a pre-tax income of $1.5 million a year. And your net income is $1 million, assuming you are paying a third of what you earn to the government.

  • Now, Mr. B contacts you, praises your enterprise, and desires for buying the company for $10 million. It is a great deal because you have been earning $1 million per year and $10 million looks pretty attractive to you. So, you agree to the buyout.Mr. B, on the other hand, checks his funds and finds out that he can only invest $1 million himself, and the rest he needs to arrange.So, he asks a bank to lend him the rest of the amount. The bank disagrees with lending them money, thinking it would be risky. Then, Mr. B sees that your company has great assets. So, he shows the company’s assets, uses them as collateral, and convinces one of the banks to lend them money at a 10% interest rate per annum.So, Mr. B invests $1 million of his funds, borrows $9 million from the bank, pays you off $10 million, and buys the business. Now, the company does not consist of equity only. There is $1 million in equity and $9 million in debt. So, this would be called a leveraged buyoutLeveraged BuyoutLBO (Leveraged Buyout) analysis helps in determining the maximum value that a financial buyer could pay for the target company and the amount of debt that needs to be raised along with financial considerations like the present and future free cash flows of the target company, equity investors required hurdle rates and interest rates, financing structure and banking agreements that lenders require.read more since debt is used heavily in this whole deal.

We will now check whether this deal is profitable for Mr. B or not. After buying the business, if we assume that the firm still generates $1.5 million in pre-tax income, here’s how we will do the calculation: –

  • Even if the firm generates $1.5 million in pre-tax income, net income will not be $1 million after paying $0.5 million in taxes. Now, Mr. B needs to pay interest on the borrowed funds. He has borrowed $9 million at 10% per annum.That means he needs to pay $900,000 as interest. That means, the company has the pre-tax income of ($1.5 million – $900,000) = $600,000. He will pay the same tax rate as the interest is tax-deductible.He will get a net income of $400,000, assuming he would pay one-third of the pre-tax income as taxes.This $400,000 is a pretty good income if we compare what Mr. B has put in. In addition, He invested $1 million of his own money. That means if the net income remains similar for the next three years, he will get back his invested money and more.

In this example, Mr. B has taken the help of the bank. The company usually targets a competitor and uses a private equity firm in big deals. A private equity firm then goes out, puts in some of its own money, and takes a loan from other financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more.

Summary of LBO

This section of what LBO is summarizes most of the important features of LBO.

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This article is a guide to What is LBO? Here, we explain LBO along with examples. We also look at the leveraged buyouts features in a table summary format. You may learn more about investment banking from the following articles: –

  • Deal OriginationFinancing Acquisitions MeaningInvestment Banking Interview Questions