5 Minute Leveraged Buyout Deal

In this blog we are going to run through a Leveraged Buyout Transaction in very short form to demonstrate some basics of how an LBO deal is put together.

First of all, as a Leveraged Financier, a Private Equity Firm who is a client of yours has brought you some assumptions around a deal that they want to conduct (in $millions) captured in the table below. As an explanatory note, firstly we are assuming that we are back on 1/1/2010, secondly, each of the Financial Years listed below is for year ended 31/12/2010, and thirdly, last year's EBITDA was $100m:

In practice a Private Equity Firm may look at selling assets or cutting costs to improve EBITDA and Cash Flow Available for Debt Service (CFADS), however for simplicity in this example we are going to stick to basic forecasts listed above.

Lets now assume that companies in the industry of the target generally achieve a 6x EV/LTM EBITDA multiple for acquisition transactions, where LTM stands for Last Twelve Months. This means that the Enterprise Values we are dealing with to buy the company and sell the company are:

Purchase EV Price: $600m

Exit EV Price: $900m

So from this we can see that the anticpated net gain over the transaction period from beginning of 2010 to End 2014 is $300m. Next we need to figure out what initial Equity investment now will receive a 20% IRR by receiving $300m in additional proceeds in 5 years time. This means that if our purchase price is E, then the following equation finds our maximum initial Equity Contribution to achieve our 20% return:

E x (1 + 20%)^5 = E + 300

Therefore 2.48832 E = E + 300

Therefore 1.48832 E = 300

Therefore E = $201.56m

For simplicity lets round this to $200m. This is the most the Private Equity Firm can contribute to the transaction in order to achieve its target return of 20%. This means that to make up the required purchase price to buy-out the company we need to come up with $400m of debt funding to support the transaction at the anticpated required purchase price of $600m. Now we need to quickly look at whether the company can support $400m in Debt. Our cost of Debt is 7% for a 5 year term, which means that annual interest payments will be 7% x $400m = $28m. We can compare this to CFADS throughout the forecast period and see that the company can easily support $28m in interest payments per year. In fact, the NPV of the CFADS is $374m so if the Private Equity Firm can deliver on the forecasts they have provided you, then they could potentially pay down the vast majority of the debt throughout the forecast period.

So, only two things to look at left:

  1. Can you trust the forecasts the PE Firm has brought you? As an analyst working on the LBO you need to conduct a thorough examination to satisfy yourself, your boss and your Credit Executive that the forecasts are achievable and the deal is a good one.
  2. Will the existing shareholders accept the deal? We are going to pay the company $600m initially of which $200m will go to existing debt repayment. This leaves $400m for the equity holders versus an existing Market Cap. of $250m. This represents a 60% premium to the current trading value of the firm. This is a pretty strong premium to pay and in a lot of circumstances will be enough to get existing shareholders over the line.

So based on this we think the deal can be done as we think the existing shareholders, Private Equity Firm and Leveraged Financiers are all getting a return they are happy with.

In practice you will note that there is the potential for much larger returns than 20% under this transaction, as there is a lot of additional cash generated each year above the amount required to satisfy the debt holders.