What to Know About Leveraged Buyout Fund Investing

Leveraged buyout fund investing can be a complex and high-risk endeavor, but understanding the basics can help you make informed decisions.

A leveraged buyout fund is a type of private equity fund that uses debt to finance the acquisition of a company. This allows investors to potentially earn higher returns, but also increases the risk of default.

Investors in leveraged buyout funds typically take a long-term view, holding onto their investments for several years to ride out market fluctuations. They also often have a high tolerance for risk, as the potential rewards can be substantial.

Leveraged buyout funds can be a good fit for experienced investors who are comfortable with the risks and have a solid understanding of the market.

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A leveraged buyout (LBO) is the acquisition of one company by another using a significant amount of borrowed money to meet the cost of acquisition.

The borrowed money can be in the form of bonds or loans, and the assets of the company being acquired are often used as collateral for the loans along with the assets of the acquiring company.

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In an LBO, the ratio of debt to equity used for the takeover will be as high as possible, with the exact amount of debt depending on market lending conditions, investor appetite, and the company's expected cash flow after takeover.

The purpose of LBOs is to allow companies to make large acquisitions without having to commit a lot of capital.

Returns are generated in an LBO in three ways: the company pays down its debt, investors improve profit margins by reducing or eliminating unnecessary expenditures and improving sales, and the company is sold at a higher multiple than the investment company paid.

Here are some common ways LBO investments are realized:

Typically, LBO investments are held for between 5 years and 7 years, although there can be shorter or longer holding periods.

Large-scale LBOs experienced a resurgence in the early 2020s, although they're often viewed as a predatory or hostile action.

When acquiring a target company, a leveraged buyout fund typically uses a combination of debt instruments to finance the deal. Bank debt is the cheapest financing instrument, accounting for 50%-80% of an LBO's capital structure.

Bank debt has a lower interest rate than other financing instruments, but comes with covenants and limitations that restrict a company from paying dividends to shareholders, raising additional bank debts, and acquiring other companies while the debt is active. The payback time for bank debt is typically 5 to 10 years.

High yield debt, on the other hand, is unsecured and carries a high interest rate to compensate investors for the risk. It has less restrictive limitations or covenants than bank debt and is typically paid before equity holders in the event of liquidation. The payback period for high yield debt is usually 8 to 10 years.

Mezzanine debt is a hybrid of debt and equity, junior to other debt financing options, and often financed by hedge funds and private equity investors. It comes with a higher interest rate than bank debt and high-yield debt, and allows early repayment options and bullet payments.

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Bank debt, also known as senior debt, is the cheapest financing instrument used to acquire a target company in a leveraged buyout, accounting for 50%-80% of an LBO's capital structure.

It has a lower interest rate than other financing instruments, making it the most preferred by investors. This is likely due to its senior status in the capital structure, ensuring it gets paid back first in case of liquidation.

Bank debts come with covenants and limitations that restrict a company from paying dividends to shareholders, raising additional bank debts, and acquiring other companies while the debt is active.

The payback time for bank debts is typically 5 to 10 years, during which time the company must make regular payments to the bank.

If the company liquidates before the debt is fully paid, bank debts get paid off first, as they have priority in the capital structure.

A debt schedule is used to closely track the following components:

Mezzanine debt is a unique blend of debt and equity that plays a crucial role in the capital structure of a company.

It's often financed by hedge funds and private equity investors, who demand a higher interest rate to compensate for the added risk.

This type of debt is junior or subordinate to other debt financing options, meaning it's paid after other debts have been settled but before equity shareholders are paid.

Mezzanine debt typically takes the form of a high-yield debt with an option to purchase a stock at a specific price in the future, which boosts investor returns.

It allows for early repayment options and bullet payments, just like high-yield debt, giving companies flexibility in their repayment plans.

Mezzanine debt's payback period is not explicitly stated, but it's similar to high-yield debt, which is typically 8 to 10 years.

An LBO model is a method to measure the implied returns on a leveraged buyout transaction, which is a specialized type of acquisition where a substantial percentage of the purchase price is funded using debt. To perform well in private equity interviews, LBO modeling tests, and on the job, understanding the basics of LBO modeling in Excel is necessary.

The LBO model estimates the implied returns from the buyout of a target company by a financial sponsor, or private equity firm, in which a significant portion of the purchase price is funded with debt capital. Following the leveraged buyout (LBO), the financial sponsor operates the post-LBO company for around five to seven years – with the free cash flows (FCFs) of the company used to pay down more debt each year.

The LBO model must derive the following pieces of information to analyze a potential investment opportunity:

The LBO model can be broken down into several key components, including:

Here's a summary of the key components of an LBO model:

A leveraged buyout fund relies heavily on financial analysis to determine the feasibility of a deal. This involves analyzing the business's financial performance and determining the maximum purchase price that can be paid.

The LBO analysis is a crucial step in this process, and it typically involves developing operating assumptions and projections for the standalone company. This helps arrive at EBITDA and cash flow available for debt repayment over the investment horizon, which is usually 3 to 7 years.

To achieve realistic financial coverage and credit statistics, key leverage levels and capital structure must be determined. This includes senior and subordinated debt, mezzanine financing, and other forms of financing.

The sponsor's expected exit multiple is also estimated, which should generally be similar to the entry multiple. This helps calculate equity returns (IRRs) to the financial sponsor.

The LBO analysis also involves solving for the price that can be paid to meet the above parameters. This can be done by sensitiing the results to a range of leverage and exit multiples, as well as investment horizons.

Here are the key steps in the LBO analysis:

By following these steps, a leveraged buyout fund can determine the maximum purchase price for a business and ensure that the deal is financially viable.

Exit Strategies are a crucial part of a leveraged buyout fund's success, enabling financial buyers to realize gains on their investments.

Ideally, a financial buyer expects to realize a return on its LBO investment within 3 to 7 years via one of these strategies.

An outright sale of the company to a strategic buyer or another financial sponsor is a common exit strategy, where the buyer can sell the company at a higher price than the original purchase price.

An IPO, or initial public offering, is another option, where the company goes public and the financial buyer can sell its shares on the open market.

A recapitalization is also a viable exit strategy, where the financial buyer can restructure the company's debt and equity to achieve a better return on investment.

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Financial buyers in LBO transactions seek high returns on equity investments, often using financial leverage to increase potential returns. Historically, financial sponsors' hurdle rates have been in excess of 30%, but may be as low as 15-20% for particular deals under adverse economic conditions.

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To measure success, sponsors use metrics like cash-on-cash (CoC), which is calculated as the final value of the equity investment at exit divided by the initial equity investment, and is expressed as a multiple. Typical LBO investments return 2.0x – 5.0x cash-on-cash.

Equity holders assume significant financial leverage risk, which can lead to default if interest costs are not paid. Small changes in enterprise value can have a magnified effect on equity value when a company is highly levered.

Debt holders, on the other hand, bear the risk of default but are likely to realize a partial, if not full, return on their investments, even in bankruptcy.

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Returns are a key consideration for financial buyers in LBO transactions. They seek to generate high returns on their equity investments by using financial leverage to increase potential returns.

Financial buyers evaluate investment opportunities by analyzing expected internal rates of return (IRRs), which measure returns on invested equity. Historically, financial sponsors' hurdle rates have been in excess of 30%, but may be as low as 15-20% for particular deals under adverse economic conditions.

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Sponsors also measure the success of an LBO investment using a metric called "cash-on-cash" (CoC). Typical LBO investments return 2.0x – 5.0x cash-on-cash.

The returns in an LBO are driven by three key factors: de-levering (paying down debt), operational improvement (e.g. margin expansion, revenue growth), and multiple expansion (buying low and selling high).

Here are some general guidelines on typical LBO investment returns:

It's worth noting that hurdle rates for larger deals tend to be a bit lower than hurdle rates for smaller deals.

Risk is a major consideration for both equity holders and debt holders. Equity holders bear the risk of significant financial leverage, which can lead to default if interest costs are not paid.

This is because substantial amounts of debt result in "fixed costs" that can force a company into default if not paid. The value of debt remains constant, while small changes in the enterprise value of a company can have a magnified effect on the equity value.

Debt holders, on the other hand, bear the risk of default, but they have the most senior claims on the assets of the company. This means they are likely to realize a partial, if not full, return on their investments, even in bankruptcy.

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