LBOs

What are they?

A Leveraged Buyout (LBO) is a financial transaction in which a company's controlling stake is acquired using a significant amount of borrowed funds. The assets of the company being acquired and of then the acquiring company's assets are used as collateral for the loans. The main goal of an LBO is to allow a company to make a significant acquisition without committing a substantial amount of it's own capital.

Prior to the MBA, I have come across the term a handful of times. Typically, terms such as an "exit" or "IPO" which are both financially driven, but are not strategically as focused as an LBO which falls under private equity in the investment universe.

Why do Private Equity firms complete LBO's?

Private equity firms are known for their unique approach to investing, often implementing leveraged buyouts (LBOs) as a key strategy. The main incentive private equity firms choose to perform an LBO is that LBOs yield significant financial rewards. By acquiring a company with a significant amount of debt, private equity firms can amplify their returns if they are successful in improving the company's operations and profitability.

LBOs also give private equity firms the control, which is highly valued as owning majority stake in an acquired company gives private equity firms the ability to make strategic decisions and drive operational improvements. With controlling power, private equity firms have the control which allows them to implement changes and initiatives that may not have been possible under the previous ownership structure.

LBOs are conducted for three primary reasons:

1. To take a public company private,
2. To spin off* a portion of an existing business by selling itTo transfer private property as is the case with a change in small business ownership.

*A spinoff is a new and separate company that's created when a parent company distributes shares in a subsidiary or business division to the parent company shareholders. It is a type off divesture.

Above is the typical example of an LBO structure, the process, stakeholders and the illustrated purpose.

Three elements which are imperative to the success of any LBO, are listed below. These three elements are tax, legal and financial, but are not limited to other factors that also need to be considered such as risk, return, leverage, strategy and structure.

Tax:

The tax implications of a management buyout will vary depending on the specific details and circumstances of the transaction. It is important to work with experienced tax professionals to ensure that you are aware of all applicable taxes and how they will apply to your situation.

Some of the potential taxes that may be applicable to a management buyout include:

• Capital gains tax, which can be applied to the difference between the sale price of the shares and their original purchase price,
• Value added tax (VAT),
• Stamp duty, on any agreement related to the transaction,
• Corporation tax.

Legal:

Management must perform due diligence, which can cover financial, commercial, and legal concerns. Once the due diligence is complete, the legal paperwork such as the warranties will be negotiated. The right warranties need to be in place to protect them against any future liabilities. 

• Asset Purchase/ Share Agreement
• Tax Deed/ Covenant
• Bank Finance Documentation
• Employment Contracts
• Shareholders Agreement
• Completion of a Management Buyout

Financial:

Ensuring a watertight financial structure, with the use of debt and equity, in addition to minimising risk and maximising return and assessing the leverage is imperative in ensuring that the LBO is financially viable and equitable.

Some factors to assess in an LBO from a financial perspective are:

• Debt Financing (Banks)
• Asset Financing
• Private Equity
• Vendor Loan Notes

Evaluating the Target Company

The decision to move forward with a leveraged buyout should only be made after conducting detailed analysis and due diligence to ensure a sound investment. The assessment includes the following:

1. Financial Health: A thorough and deep financial analysis and overview, including cash flow models, revenue trends and projections, is necessary to understand the company's ability to service any additional debt and to financial longevity.
2. Operational Concerns: Evaluating the company's internal operations, management and overall business model, can help gauge how these factors might aid in servicing any debt obligations, and how much value can be added post any acquisition.
3. Risk Assessment: Understanding the potential risks related to the business, industry, and the acquisition is essential. Reviewing potential regulatory issues, competition, and economic or market downturns.

Exit Strategy Planning

Lastly, before initiating the LBO, it's imperative to consider the exit strategy. This means having a clear picture of how and when to sell the company, or take it public to yield a return on investment (ROI). Other considerations as to whether to opt for a strategic sale, a secondary buyout, or an initial public offering (IPO) will depend on the target company and other factors such as market conditions, the company's performance post acquisition, and the potential returns with each option.

Exit strategies are likely to change over the investment horizon, so creating contingencies and flexibility will allow room to pivot, and thus having a robust scenario planned out will ensure a successful LBO.

These considerations add complexity to the decision-making process, indicating why leveraged buyouts should not be taken lightly and are frequently carried out by experienced investors or firms.