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Equity Valuation: Models from Leading Investment Banks by Armin Varmaz, Thorsten Poddig, Jan Viebig

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30

Leveraged Buyouts

A leverage buyout (LBO) is an acquisition of a target company which is predominantly financed by debt. The purpose of an LBO is to gain control of a target company without committing a large amount of equity capital. The equity capital is usually provided by private equity funds. The debt capital employed usually consists of a combination of senior debt in the form of bank loans, high yield debt (“junk bonds”), and mezzanine debt. The use of financial leverage allows equity investors to earn higher returns on equity but also makes the transaction more risky. The assets of acquired companies are usually used as collateral and their cash flows repay debt. Private equity investors expect their capital to be committed to the company only for a limited period of time, typically three to five years. Often, they realize high rates of return on their capital when they sell the acquired company to new investors either in one transaction or in stages. Given the leverage, a private equity sponsor will attempt to reduce overall risk by lowering operating risk. UBS estimates that 31% of LBO exits over the period 2003 to August 2006 were by way of initial public offering (IPO), as compared with 26% via a secondary buyout and 44% via a sale to a trade (corporate) buyer.

Figure 30.1 explains the basic principles of an LBO deal. Let us assume that a private equity fund buys company A for an enterprise value, or EV, of EUR 20 billion at the end of 2007. The company generated ...

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