At some point, a company may decide to perform a LBO. But, what is it and how can it help the company? First and foremost, a leveraged buyout is when one business uses a large portion of borrowed funds and a substantial portion of its own equity to acquire another business. The business making the acquisition makes the purchase using loans it gets from outside resources or agreements made between the buyer and seller as a promissory note to be paid over time. An LBO structure allows for more deal making in the market, due to the abundant use of borrowed money. It provides greater liquidity to the M&A markets and allows sellers to have more exit options. Furthermore, it allows purchasers to achieve higher returns, should the company be successful, retire its debt and sell at a higher valuation. There are some important characteristics of an LBO that a company should be aware of:
- The Company: Companies that have stable cash flow in defensive industries make strong candidates for LBO’s. Some of the most successful LBO’s of all time have been in basic industries where product life cycles change slowly and where companies have strong market shares. Good LBO candidates are companies with mature products and low capital intensity.
- The Management Team: The quality of the management team is the single biggest determining factor in a LBO. Mediocre companies with great management teams will still achieve acceptable LBO returns. Great companies with mediocre management teams will likely not be successful.
- Cash Flow Focus – the focus of a LBO is pay down the debt as quickly as possible. Management must manage for cash and focus on reducing costs and increasing working capital efficiency. Often, strategic divestment of non-core assets can product extra cash that can be used to reduce the debt.
- Need for Lender Cooperation – Usually in a LBO, there will be several tiers of loans ranging from bank loans, to mezzanine loans to high yield loans. The new owners and management team of the company must ensure that all lenders are well informed and cooperative with the company over the life of the deal.
- Risk Mitigation – due to the level of debt on the balance sheet, Companies need to have well defined course of action to get through a tough economic stretch. If a recession hits, the Company must react quickly and make hard decisions to ensure continued profitability.