When it comes to growing your firm, sometimes it helps to have a bit of leverage, and we’re not talking about having the right people on your side (although that always helps!). Instead, we’re talking about leverage in the form of debt, known in the industry as a leveraged buyout (LBO).
An LBO is a phrase that refers to the use of “leverage” to buy out a business. Acquirers are usually private equity firms, although LBOs can also apply to companies, as well as a business’ current management. They occur for either strategic and growth reasons, financial reasons, or all three.
For PEs, leveraged buyouts mean borrowing as much as possible from various lenders and then funding the remaining balance with their own equity, usually at a 90%-10% ratio, respectively. By incorporating LBOs into the firm’s growth strategy, PEs can expect to see greater returns within a shorter time frame. How, exactly? Read on as we dive into the PEs role in an LBO, and the model and metrics to measure to help your firm navigate a successful acquisition.
The PEs Role in an LBO
More often than not, PEs serve as the initiators of any LBO. In contrast to VCs, who typically opt to invest in startups and do not have majority control, the PEs main goal in an LBO is quite the opposite. When purchasing a majority stake of a company they see growth potential in, PEs enter an LBO to be more hands-on and take control.
From management guidance and innovative growth ideas to deep industry expertise, PEs bring new insights and the ability to shift the strategic direction of the newly acquired organization. When pairing that invaluable expertise with the financial leverage to acquire even more resources, PEs can drive rapid expansion for the company, usually within three to five years. This growth would not have been possible otherwise, and due to a fast exit rate, LBOs serve as a time-tested way for PEs to build corporate value over an accelerated time frame.
The LBO Model
Before making an acquisition, PE firms conduct their due diligence through a series of steps, including analyzing a potential company’s assets, cash flows, and capital expenditures. If the deal seems to have potential, the PE firm negotiates a price and outlines a deal structure. Next, they source capital to take ownership of the business, then implement strategic changes and cost-cutting measures to accelerate growth (and revenue).
To determine if a deal is worth pursuing, firms use an LBO model for evaluation, which, as the Corporate Finance Institute explains, can get pretty complicated due to the unique factors that go into such a deal. These include:
- A high degree of leverage
- Multiple tranches of debt financing
- Complex bank covenants
- Issuing of Preferred shares
- Management equity compensation
- Operational improvements targeted in the business
Once evaluating those factors, PEs need to measure key metrics to ensure the deal is favorable, such as:
- Interest Coverage Ratio (EBIT/Interest)
- Debt Service Coverage Ratio (EBITDA – Capex) / (Interest + Principle)
- Fixed Charge Coverage Ratio (EBITDA – Capex – Taxes) / (Interest + Principle)
When analyzing these metrics, PEs should also conduct what’s called a sensitivity analysis. This analysis forecasts LBO outcomes based on different assumptions and scenarios, such as changing the EV/EBITDA acquisition multiple, the EV/EBITDA exit multiple, and the amount of leverage (ie: debt) used.
If using a templated LBO model, it’s essential to keep in mind that certain models use specific assumptions. In Firmex’s templated LBO model, for example, it assumes 100% acquisition of the target company, that the most recent year-end balance sheet is the closing balance sheet, that there are no step-ups in asset values, and that there will be no amortization of goodwill from an acquisition. If these assumptions don’t apply to your deal, factor that in during your analysis.
Put Your Acquisitions on Autopilot
From due diligence tracking and contract negotiations to compiling traditional and alternative data together to determine if a deal will be favorable for your firm, many moving parts go into an LBO.
To centralize the data and communications into one hub, a PE-designed CRM like Altvia can be a differentiator in optimizing your LBO process. To learn how we can help your firm, set up a time to chat with a member of our team.