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Leveraged Buyouts and Due Diligence
LBOs and Due Diligence
A leveraged buyout — frequently called an LBO — is a popular method used by private equity firms and other buyers to acquire companies primarily with debt. While this financial strategy is often used to acquire multi-billion-dollar public companies, it works equally well for acquisitions of smaller private companies.
The primary benefit of an LBO for current business owners is to provide a vehicle for selling a company to buyers who want to use minimal amounts of cash. For new owners buying a business with a leveraged buyout, benefits include projected net investment returns ranging from 15 to 30 percent or more annually. Actual returns can periodically fail to live up to expectations. The recent financial crisis demonstrated that asset values can depreciate as well as appreciate. You can increase your chances of a good return by performing the right amount of due diligence.
We will reject interesting opportunities rather than over-leverage our balance sheet.— Warren Buffett
Debt is the Key Word
Prospective buyers using a leveraged buyout arrangement often expect to buy a company by paying no more than 10 percent of the total purchase in cash. While this kind of leverage is common when individuals are buying a house, it is less typical when someone is buying a business.
Leveraged buyouts have popularized the use of increased debt levels for corporate acquisitions. Nevertheless, an LBO transaction requires that buyers find a lender or financial sponsor willing to fund the debt portion of the purchase. The debt funding frequently comes from non-bank sources such as corporate bonds.
As with most commercial loan scenarios, a prospective lender such as a bondholder will want to look at financial statements to confirm sufficient cash flow for covering debt payments. Corporate assets will usually be pledged to lenders in a leveraged buyout. Some debt will be viewed as more “senior” than other debt. The primary value of a senior debt classification is that it would be paid off prior to more junior debt and common stock in the event of a bankruptcy.
This is a critical distinction — especially for lenders and investors — because leveraged buyouts do not always work. When they fail, some investors and lenders will lose money. The term "junk bonds" originated several decades ago when leveraged buyouts first became popular with venture capitalists. As you might imagine, a "junk bond" is not an investment grade debt obligation.
The short video (under six minutes long) shown below provides an excellent explanation of a basic LBO transaction between two individuals — one selling their business and the other buying it with 10 percent in cash and 90 percent in debt — with a net annual rate of return (after taxes) of 40 percent.
The truly dangerous thing is asking the wrong questions.— Peter Drucker
Private Equity Firm
If you are looking for a professional firm to help you structure a leveraged buyout, private equity firms are a prudent starting point. Leveraged buyouts are appealing to LBO investors because of expected returns that often exceed 40 percent in a typical transaction. Because something can always go wrong with a highly-leveraged investment, it is desirable for investors to diversify these risks among several different LBOs. Private equity firms accomplish this diversification by participating in a series of leveraged buyouts rather than just one — a portfolio of LBOs.
Observe, record, tabulate, communicate. Use your five senses. Learn to see, learn to hear, learn to feel, learn to smell, and know that by practice alone you can become expert.— William Osler
Management Buyout and Management Buy-In
The current management of a company often bands together to buy a company previously held by other owners such as public stockholders. This version of an LBO is referred to as a management buyout. When managers from outside a company attempt to buy a business via a leveraged buyout, it is called a management buy-in. The only difference between these two LBO strategies is based on the use of existing internal executives for one and new external managers for the other.
Improving the Bottom Line Before or After an LBO
An LBO Exit Strategy
“Ideally, an exit strategy enables financial buyers to realize gains on their investments. Exit strategies most commonly include an outright sale of the company to a strategic buyer or another financial sponsor, an IPO, or a recapitalization. A financial buyer typically expects to realize a return on its LBO investment within 3 to 7 years via one of these strategies.”
— Macabus, Leveraged Buyout Analysis
When one private equity company is selling to another private equity firm, the resulting leveraged buyout is a secondary buyout. In an investment climate that has featured the concept of LBOs, this is a common occurrence. It can be helpful when both buyer and seller are already familiar with how the LBO process works.
Better Business Writing Can Help
Let’s be careful out there.— Sergeant Phil Esterhaus (“Hill Street Blues”)
Let's Be Careful Out There
The fictional Sergeant Phil Esterhaus (“Hill Street Blues”) gave us some timeless wisdom that certainly applies to leveraged buyouts — “Let’s be careful out there.”
If you are thinking about whether to buy a business using an LBO or investing in leveraged buyouts with friends or a private equity firm, don’t make any final decisions without plenty of due diligence first. Large amounts of debt can be both an advantage and disadvantage. The 2008 financial crisis was largely due to everyone forgetting about the potential problems when you use leverage and something goes wrong. Things can and do go wrong with leveraged buyouts. At a minimum, talk to your attorney and accountant before proceeding into LBO territory. When in doubt, remember the words of Phil Esterhaus shown above.
Due Diligence: A Major Component in Being Careful
Some investors probably rush through the due diligence process in an attempt to close the purchase before a deadline. With either specialized transactions like leveraged buyouts or "normal" commercial real estate deals, don't cut corners by reducing the time and effort for a thorough due diligence review.
Risk comes from not knowing what you’re doing.— Warren Buffett
© 2014 Stephen Bush