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Leveraged Buy-out (LBO) analysis

1.1. Introduction

Leveraged buy-outs (LBOs) are a very common way of acquiring companies. The practice was
pioneered by houses such as Kohlberg, Kravis & Roberts (KKR) in the 1970s and over the last two
to three decades LBOs have assumed an ever-greater importance.

LBOs are characterised by the significant debt levels relative to total capital employed.

The attractive returns that financial buyers have been able to generate by using LBO structures has
led, in recent years, to a proliferation in the number of financial buyers and a significant increase in
the size of funds they have available to invest in acquisition opportunities. As a result, competition
for suitable acquisitions is intense. This factor, combined with the significant reduction in European
and US interest rates during the 1990s, has meant that financial buyers are prepared to pay full
prices, often even outbidding trade buyers who can extract significant synergies from a target or who
are prepared to pay a strategic premium for the business.

1.2. Rationale

A highly leveraged entity has a number of advantages for an equity investor, including the
following:
n Interest on debt is tax deductible and the cost of debt is generally lower that the cost of equity. As
a result, increasing a company’s gearing should reduce its cost of capital. In other words, given
the effect of taxes, debt is cheaper than equity
n In a highly leveraged company, a relatively small increase in the company’s enterprise value can
lead to a substantial increase in the value of its equity. In a bull market, the attractiveness of an
LBO will therefore increase. Of course, the gearing effect also means that high gearing increases
an equity investor’s risk, since a relatively small decline in enterprise value could severely impact
the value of the equity investment. Moreover, high interest charges increase the risk of default by
the company
n High gearing tends to be a discipline on management, since a company’s cash flow is usually
quite tight due to the necessary pay-down of interest and debt. Management is therefore likely to
focus on driving down costs and controlling capital expenditure
n Many LBOs are structured so that managers have substantial incentives to increase the value of
the business. In these acquisitions, management will subscribe for a small proportion of the
equity. A ‘ratchet’ will often be put into place which will give management an increased share of
the company’s equity in circumstances where the returns accruing to shareholders are greater than
a pre-determined level. Whilst the ratchet allows management to benefit disproportionately
compared with other equity investors, other investors usually recognise the additional value for
them

However, given the risks associated with high gearing, financial buyers demand high projected
returns on any investment they make. The key consideration is the expected internal rate of return
(or IRR) of the investment. This is the discount rate which is required to make the net present value
of all future cash flows of the business equal to zero and effectively represents the opportunity cost
of capital to the buyer. In order to maximise returns a financial buyer will seek the highest IRR
possible and, in considering any potential transaction, will usually require an IRR of at least 25%.

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1.3. Suitable LBO candidates

Not all companies are suitable targets for an LBO. A financial buyer will only look at companies
which exhibit many of the following characteristics:
n Strong and stable (free) cash flows . Since the LBO will be highly geared, significant interest
and capital repayments will need to be made out of its cash flows. The target’s cash flows need to
be stable enough to support these payments. This is often regarded as the key criteria
n Leading market position/brand or clearly defined niche market. This established strength in a
particular market would act as comport for a financial buyer as there is greater certainty (or cash
flows), relatively less capex is required to generate growth, and it provides a platform on which to
leverage its position (often with an established management team in place)
n Low capital expenditure requirements. Reduced capex will increase the cash flows available
and increase the debt levels, which the company can bear. As a result, an LBO is often not
suitable for high growth companies
n Low working capital requirements
n Good historical track record
n Scope for margin improvement/cost reduction potential. This is true even if historically the
business has not been well run since a financial buyer may be interested if margins can be
improved to the levels of its major competitors
n Strong/successful/proven management. However, it is not uncommon for new management to
take over the running of the business (though the new management are likely to have proven track
records)
n Acquisition oppor tunities. A financial buyer may be prepared to use the target as a platform for
growth, or as part of industry consolidation
n Exit. A financial buyer will need to be convinced that a suitable exit can be found. This will
normally occur by way of trade sale or IPO. A buyer will typically have a time horizon of
between three and five years, although a number of financial buyers target longer or shorter
periods

As a result, issues to beware of would include:

n Limited and/or volatile free cash flow generation (key issue)
n Weak market position
n Emerging markets risks
n Questionable management team – new/inexperienced/indicted
n Small size
n The business is in a ‘turnaround situation’

1.4. Types of financing

In a leveraged transaction, the majority of a company’s capitalisation is debt financed, which enables
financial sponsors to achieve their IRR targets and corporates to acquire larger companies. The
equity is provided by the buyer and is frequently 30% – 40% of the total capitalisations.

There are a number of types of financing which can be used in an LBO. These include, for example,
the following (in order of risk):
n Senior debt . This is debt which ranks ahead of all other debt and equity capital in the business.
Bank loans are typically structured in up to three tranches : ‘A’, ‘B’ and ‘C’. The debt is usually
secured on specific assets of the company, which means the lender can automatically acquire these

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 assets if the company breaches its obligations under the relevant loan agreement; therefore it has
the lowest cost of debt. These obligations are usually quite stringent though senior debt is often
not subject to reporting requirements as they are usually unrated. The bank loans are usually held
by a syndicate of banks and specialised funds. Typically, the terms of senior debt in an LBO will
require repayment of the debt in equal annual instalments over a period of approximately 7 years.
Senior debt is prepayable and has a floating rate of interest. From the lender’s perspective, this is
the most secure form of financing
n A financial buyer will usually want the LBO to be financed by as much senior debt as possible as
it provides the ‘platform’ for the debt financing, since it is the lowest cost form of financing.
However, the providers of senior debt will be reluctant to accept very high levels of senior debt
(which may affect their security) or may impose conditions which are unacceptable to the equity
investor. As a result senior debt will often only form about 50% of the total financing

Typical terms in Europe

Arranging fee Interest Final maturity Average life Repayment

A 2.25% upfront LIBOR + 2.25% 7 years 4 – 5 years In semi-annual instalments

B 2.25% upfront LIBOR + 2.75% 8 years 8 years In the last year
C 2.25% upfront LIBOR + 3.25% 9 years 9 years In the last year

Size
n Senior debt multiples are usually 3.0x – 4.0x times historic EBITDA of target
n Deutsche Bank’s target transaction size begins with senior debt of E200 million and will typically
include high yield or mezzanine in the capital structure

Pros and cons for the issuer?

Pros Cons

ü Usually offers the lowest cost of funding û Requires periodic amortisation out of free cash flows.
ü Prepayable at no or little cost û Therefore this instrument may not be suitable for
ü Deep established market in Europe which can companies consuming cash for some years
accommodate large transactions û Strict maintenance covenants are tightly monitored,
ü Private market and therefore less exposed to volatile usually on a quarterly basis (eg total leverage, interest
market conditions cover, fixed charge cover ratio, etc)
ü No equity dilution û Full security required in most cases

n Subordinated debt. This debt ranks behind senior debt in order of priority on any liquidation.
The terms of the subordinated debt are usually less stringent than senior debt. Repayment is
usually required in one ‘bullet’ payment at the end of the term. Since subordinated debt gives the
lender less security than senior debt, lending costs are typically higher. An increasingly important
form of subordinated debt is the high yield bond, often listed on US markets. High yield bonds
can either be senior or subordinated securities (though they tend to be the latter in Europe and
typically rank structurally and contractually below senior secured debt) that are publicly placed
with institutional investors and are rated by Moody’s and S&P. They are fixed rate, publicly
traded, long-term securities with a looser covenant package than senior debt though they are
subject to stringent reporting requirements. High yield bonds are not prepayable for the first five
years and after that, they are prepayable at a premium

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Typical terms

Underwriting fee Interest Final maturity Repayment

2.5 – 3.0% 8 – 13% per year 7 – 10 years A single payment at maturity

payable upfront (fixed rate)

Size
n Minimum size typically E100 million
n High yield bridges can be used as temporary funding for an acquisition until a high yield bond is
issued. It is not usually possible to issue high yield bonds at closing because of the time required
to prepare offer documents, organise roadshows, etc. The size of high yield bridges are estimated
to be the amount achievable from the high yield bond that will replace it. However, such bridges
are expensive and the cost ‘explodes’ if not replaced with a high yield bond in the expected
timeframe (usually twelve months) because they are risky instruments for the underwriter
n Mezzanine finance. This is usually high risk subordinated debt (prepayable at a pre mium), and is
regarded as a type of intermediate financing between debt and equity and an alternative to high
yield bonds. An enhanced return is made available to lenders by the grant of an ‘equity kicker’
(eg warrants, options and shares), which crystallises upon an exit. A form of this is called a PIK,
which reflects interest ‘paid in kind’, or rolled up into the principal, and generally includes an
attached equity warrant (for larger financings)

Typical terms

Arranging fee Interest Final maturity Repayment

3.0% payable upfront LIBOR +4.0% (normal Up to 10 years Single payment at maturity
cash interest) – +4.5%
(PIK)
Warrants are usually
added on top of this
Total target IRR by
holders of 17.0% - 18.0%

Size
n Around 1.0x historic EBITDA (on top of bank debt)
n Very low minimum size (EUR10 million)
n Loan stock. This can be a form of equity financing if it is convertible into equity capital. The
question of whether loan stock is tax deductible should be investigated thoroughly with the
company’s advisers
n Preference shares. This forms part of a company’s share capital and usually gives preference
shareholders a fixed dividend and fixed share of the company’s equity (subject to there being
sufficient available profits)
n Ordinary shares. This is the riskiest part of an LBOs capital structure. However, ordinary
shareholders will enjoy the majority of the upside if the company is successful

Only some of these forms of financing will be used in a transaction, unless the transaction is
extremely complex. Furthermore, this list is a very general summary and many of these categories
comprise a number of different products . There are also certain types of financing which do not fall
within these categories.

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1.5. Building an LBO model

A basic LBO model is similar in many respects to a stand alone DCF model in that exactly the same
methodology is used to derive the company’s financial statements. The major difference is that an
LBO analysis, unlike a DCF, takes account of interest charges and debt repayments. As a result, the
financial statements need to be adjusted to include these payments.

The key steps in completing an LBO model are as follows:

1.5.1. Forecast cash flows

Projected cash flows should be modelled in exactly the same manner as for a DCF valuation. The
forecast period should end no earlier than the latest date on which an exit is expected or the latest
date on which the debt is expected to be repaid in full (whichever is later). While a DCF valuation
requires the unlevered free cash flows to be discounted to provide enterprise value, an LBO uses free
cash flows to derive IRRs .

1.5.2. Estimate debt capacity

The next step is to estimate the amount of debt that the company can take on. The financial
statements should make provisions for interest and debt costs. The company can only bear debt to
the extent that it has available cash flows. Note that all existing debt will need to be refinanced.

When modelling, consult your team about the financing assumptions to be used. These will vary
according to market conditions, industry characteristic and company specific issues . Consultation
with the leveraged finance team or the financial sponsors group is advisable, since they have more
day-to-day exp erience about the current parameters in the marketplace.

Set out below are some parameters that will influence financing considerations for the model:
n Minimum interest cover (times)
n Total debt/EBITDA (times)
n Senior debt repayment (in years)
n Mezzanine debt repayment (in years)
n Senior debt interest rate
n Subordinated interest rate
n Mezzanine finance exit IRR

It may also be appropriate to model the potential sale of non-core assets in order to ensure maximum
leverage.

Note that, when modelling interest charges, a circular reference is likely to be encountered resulting
from calculating interest payable as the average of the debt at the start and end of the relevant period.
This is to be expected and iterations can be used to resolve the circular reference. The best way to
avoid this is to copy the formula to another cell and delete the cells generating the circular reference
before making any amendments to the model. When all changes have been made, you can copy the
formula back into the relevant cells.

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1.5.3. Estimate equity required

The equity required is, in simplistic terms, the cost of acquiring the company (including existing
debt) less its debt capacity. The total cost of the company comprises both the purchase price and
transaction expenses. The level of transaction costs should not be underestimated – these can often
amount to approximately 3% of the purchase price, particularly for smaller transactions.

1.5.4. Estimate the exit price

A financial buyer will typically wish to exit within 3 – 5 years. The exp ected value of the company
at that time is critically important to the buyer. Therefore, an estimate of the value of the business
should be made, usually as a multiple of EBIT or EBITDA, at the end of that period. As a base case,
the multiple should normally be no more than the multiple paid for the business by the financial
buyer. Furthermore, a discount of 10 – 15% should be included if an IPO is the most likely exit
route.

1.5.5. Calculate the IRR

There is an Excel function which can be used to estimate the IRR. It is advisable to run sensitivities
for the IRR in different years and for different exit multiples.

1.6. Management investment

In order to provide an incentive to management, managers are often asked to invest in the business.
They will usually be asked to invest an amount which, although immaterial in the context of the
transaction, is significant to the manager in a personal context . The returns to the managers if the
LBO proves successful are usually far greater than the returns made by institutional shareholders.
Furthermore, if the IRR is exceptional and exceeds a certain level (agreed at the time of the LBO), a
ratchet will usually kick in, which will multiply the returns achieved by management according to a
set formula.

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