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LBO Model: Steps & Example

Instructor: Chang Park

Chang has taught college Finance & Accounting courses and has a terminal degree in Finance.

In this lesson, you will learn about leveraged buyout models, their steps and examples. A leveraged buyout (LBO) is financial engineering where a target company is purchased with a combination of small amount of initial equity and most of the debt financing.

Introduction

Hilton Hotel chains, PetSmart, Inc., Georgia-Pacific LLC, and First Data Corp. are some of target companies of the leveraged buyouts from the 1980s through 2000s. The American private equity firm called Kohlberg Kravis Roberts & Co. pulled off the most famous leveraged buyout (LBO) of all time in 1989, the RJR Nabisco deal. The Blackstone Group picked the worst timing when it bought Hilton in a leveraged buyout in 2007 right before the financial crisis. These deals purport to maximize shareholder values, but are usually considered as hostile takeovers since the current management of the targets do not want the deal in the first place.

Definition of a leveraged buyout

When the management of a company and or a financial buyer, such as a private equity fund wants to buy a company or a part of it but does not want to commit too much of their own equity capital, a financing structure called a leveraged buyout is utilized. The bonds issued in the process are usually junk bonds since the bonds are not backed by much cushion called equity. The cash flow of the company being acquired and/or the assets of the acquiring company are often used as collateral for the loans, given the scant amount of equity investment of the acquiring company.

As we saw in the MM Proposition I & II, the use of debt, which has a lower cost of capital than equity, serves to reduce the overall cost of financing the acquisition, thus the name of leveraged buyout.

Types of leveraged buyouts

There are variants of leveraged buyouts such as highly leveraged transactions (HLTs), management buyout (MBO) by the current management, management buy-in (MBI) of outside management, secondary leveraged buyouts of a company that was acquired through an original leveraged buyout, etc. But, they are typically categorized for the following three purposes:

  • Converting a public company into a private one
  • Leveraged buyouts in spin-offs
  • Financing private property sell-off

Public-to-Private

When a financing buyer purchases all of the outstanding stock of a public company and turns the company into a privately one, this particular leveraged buyout is called a public-to-private deal. Depending on the management's point-of-view, these deals could be either friendly or hostile. In a friendly deal, the current management buys the company out for itself with plans to run it. On the other hand, when an outside financing group buys to reorganize and to resell the company, it is called a hostile deal.

Spin-Offs

Companies sometimes need to sell off a segment of their business to pay the investors back. In some cases, the seller may itself have been bought in a leveraged buyout. In these situations, the management of the spun-off segment may initiate the management buyout or may be passive in the transaction. Regardless, the fundamental financial logic of such leveraged buyouts, however, are the same.

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