Investment Banking, (Includes Valuation Models + Online Course), 3rd Edition

CHAPTER 4Leveraged Buyouts

A leveraged buyout (LBO) is the acquisition of a company, division, business, or collection of assets (“target”) using debt to finance a large portion of the purchase price. The remaining portion of the purchase price is typically funded with an equity contribution by a financial sponsor (“sponsor”) or equivalent. LBOs are used by sponsors to acquire control of a broad range of businesses, including both public and private companies, as well as their divisions and subsidiaries. The sponsor’s ultimate goal is to realize an acceptable return on its equity investment upon exit, typically through a sale or IPO of the target. Sponsors tend to seek a 15% to 20% annualized return and an investment exit within five years. PE funds range in size from tens of millions to tens of billions of dollars, and some sponsors manage numerous funds.

In a traditional LBO, debt typically comprises 60% to 70% of the financing structure with equity comprising the remaining 30% to 40% (see Exhibit 4.12). The relatively high level of debt incurred by the target is supported by its projected free cash flow¹ and asset base, which enables the sponsor to contribute a small equity investment relative to the purchase price. The ability to leverage the relatively small equity investment is important for sponsors to drive acceptable returns. The use of leverage provides the additional benefit of tax savings realized due to the tax deductibility of interest expense.

Companies with ...