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1. What is a Leveraged Buyout (LBO)?
In this course, we are modelling the acquisition of a company through a Leverage Buyout. Before we get started, this lesson introduces the case and explains how Leveraged Buyouts work.
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Lesson Goal (00:04)
The goal of this lesson is to learn how a leveraged buyout works and how it can affect the returns on an investment.
Using Debt in Investments (01:12)
An investor will acquire a company if they believe they can receive an adequate return for the risk involved. Leverage, or debt, can be used to finance this transaction. Therefore, a Leveraged Buyout (or LBO) is a company acquisition that uses leverage, or debt, to finance the transaction. Leverage can increase the potential returns on an investment, but also increases the risk.
To understand this principle, we can analyze an investment based on its Money-on-Money multiple. This measures the ratio of the cash an investor receives from an investment to the cash the investor spends on an investment. For example, if an investor buys a property for $500,000, then sells the property several years later for $1,000,000, the money-on-money multiple is 1,000,000 divided by 500,000, which is 2.
If the investor was using debt, they might buy this property using $100,000 cash and a $400,000 loan. Over the next few years, they pay $80,000 interest on the loan, taking their total cash spend on the property to $180,000. They then sell the property for $1,000,000. They use $400,000 to pay off the loan, and keep $600,000 for themselves. In this case, the money-on-money multiple is 600,000 divided by 180,000, which is 3.3. By using debt, the investor increases their return on the same investment.
The downside is that the investment is more risky. If the investor fails to make all their loan repayments, they could lose the property, as well as losing all the cash they spent to that point on the investment. If the investor purchases the property using cash, there is no risk of them losing the property.
Using Debt to Buy a Company (03:08)
In this course, the company MarkerCo is being bought by a private equity company called PrivEq. When a company is purchased in a leveraged buyout, it’s essential that the company has strong projected cashflows, so that they can repay the debt incurred during the transaction.
Using debt amplifies returns on an investment, but does not increase them. To increase returns, companies need to increase earnings or expand market multiples. A company can increase earnings in many ways, such as increasing prices or reducing costs. Expanding multiples is usually dependent on the economic cycle. An investor can achieve high returns by buying at the bottom of a market cycle, when multiples are low, and selling at the top, when multiples are higher.
Welcome to the latest course in our series on Financial Statement Analysis. We began in our first course by examining the historical financial statements of MarkerCo. In the second course, entitled Financial Projections, we learned how to project these financial statements into the future. And in our third course, we learned how to value MarkerCo and calculate the return for an investor, if they chose to purchase MarkerCo for a certain price. In this course, we're going to go one step further down the valuation path that simulates the leveraged buyout of MarkerCo by an external investor PrivEq.
Because MarkerCo currently has no debt on the Balance Sheet, we haven't looked at debt in detail so far. However, in this course, debt will be front and center because PrivEq will be using multiple debt instruments in this transaction.
Indeed this course will focus a lot on the use of debt in financial modelling. Before we launch into Excel, however, it's worth exploring at the beginning how leveraged buyouts work. An investor will acquire a company if she believes that the company is undervalued and that she can receive an adequate return for the associated risk involved. An investor will use leverage or debt to increase potential returns. However, leverage also increases risk. Let's take the example of a house bought for $500,000 in 2012, and the house is bought entirely with cash. In 2016, the house is sold for one million, and so the money-on-money multiple that the investor receives is two, which is a million divided by 500,000.
Now let's take the same house bought with debt. In 2012, the house is bought for 500,000 but only 20% in cash, and the remainder with the loan. From 2012 to 2016, the repayments on the loan are $80,000.
However, in 2016, the house is sold again for a million. The money-on-money multiple is simply the money I receive divide by the money that I paid. The money that I receive is simply the one million, which I sold the house for, minus 400,000, which is the amount of debt.
And the amount that I pay out is the 100,000 initial deposit plus the 80,000 in debt repayments. And this gives me a money-on-money multiple of 3.3. And so debt, in this example, has served to radically improve the returns to an investor. However, if the investor fails to make the debt repayments, the loan may default and he will lose all of his money, including the 20% cash deposit.
In this particular case, PrivEq hopes to use different forms of debt to boast the returns from purchasing MarkerCo. From our analysis, we know that MarkerCo has substantial positive cash flows for the next 5 years.
For a leveraged buyout, this is essential, so that the debt foisted on the company can be repaid. Debt serves to amplify returns, but it does not necessarily increase them. To increase returns, companies can increase earnings or expand market multiples.
To increase earnings, management may increase prices, expand into new markets, reduce costs, launch new products, or even acquire other companies. Unsurprisingly, an increase in earnings nearly always results in an increased value for the company. Expanding market multiples is slightly different and is often more a result of timing than anything else. If you purchase a company at the bottom of a market cycle, for, say, 4 times EBITDA, and sell at the top of the cycle for 8 times EBITDA, then a big return can be achieved by simply timing your entry and exit correctly. It's worth noting that increasing earnings can also increase your market multiple. In the next lesson, we'll examine the process to be followed when building an LBO.