A LBO is when one company acquires another using both its own equity and a large portion of borrowed money. The “buyer” purchases a business, using funds provided from loans, to pay the “seller.” During a leveraged buyout, the company’s debt ratio is dependent on the level of risk of the buyout to be completed. If the “buyer” is a stable, secure company and it has strong cash flows, then the debt can go as high as 100% of the purchase price. For mid-market companies, the loans used to finance a LBO are quite often around 3.5 times the company’s historical EBITDA.
There are several factors to be aware of before completing a LBO transaction.
- Value of the company: Determine the company’s price on the market. Is the company and industry mature? Is it trading at a higher or lower multiple to free cash flow comparability to a new, fast growing company? The proper value is key to doing a successful LBO.
- Focus your management team: A strong management team with good leadership and expertise that has the capabilities of successfully and efficiently running the business is key. A team that is weak, not cohesive or does not understand the process will get lost in the folds.
- Evaluate the balance sheet: Is your balance sheet strong enough to handle, or “leverage,” this buyout? Are you betting too much on this one big deal at the expense of other growth options for the business? Can you purchase the business with senior debt and apply the free cash flows for the principal and interest expenses without disrupting normal cash flow operations?
- Keep the working capital low and cash flows strong: Emphasize reductions in working capital and escalation of cash flows to give your company the necessary funds it will need to pay down the debt over time. By doing this, a business can be confident about the strength of its equity/total assets ratio and can grow at an accelerated rate.
- Gauge the exit options: If necessary, is it possible to sell the newly acquired business for a price higher than the entry multiple that you initially paid for the company? Does the industry in which you are entering have any previous LBO or IPO precedents?