Updated July 3, 2023
Definition of Leveraged Buyout Model
Leveraged Buyout Model refers to a purchase transaction of a company that involves acquiring another company, whereby the payment towards the purchase consideration/cost of acquisition is made by using a substantial amount of borrowed money. In a Leveraged Buyout Model, the debt ratio may go up to 90% of the total acquisition price, with equity being at a minimalist percentage of around 10%.
Explanation
In a financial transaction of acquiring or purchasing a company, the buyer company may entail a loan from a sponsor, bank, or lender to meet the acquisition cost for such a company. In doing so, the assets of the company undergoing acquisition are kept as collateral to borrow money for the acquisition of the company.
- The Leveraged Buyout model is the whole process of acquiring the company with the help of borrowed money. This model also ensures a smooth cash flow in the transaction.
- As attractive as it may sound, the Leveraged Buyout model offers a win-win situation for the lender of money and the buyer investing toward equity.
- The seller receives the full sale consideration, the sponsor lends the money to earn interest and keeps the assets as collateral, and finally, the buyer has control with a low investment amount.
Steps Involved in Building Leveraged Buyout Model
To build a Leveraged Buyout model, you may follow these steps:
- Primarily, assumptions to consider in the transaction are mutually by both parties, with an apt purchase price being decided by the parties involved in the transaction
- The company undergoing acquisition carries out the valuation of the business based on present revenues and earnings
- Once an appropriate valuation arrives, financial projections are made for roughly the next 5 years time frame
- Any adjustments, as may be required, are made to the financial statements and numbers based on new debt and equity being issued.
- After that, the exit value of the selling company shareholders determines.
- Lastly, one computes the internal rate of return considering the date of exit and the purchase value.
Examples
In today’s time, various companies, especially private equity funds, use the Leveraged Buyout model route to buy a company, run it and make it profitable and eventually sell such companies at a profit.
These merger & acquisition (‘M&A’) transactions have been on the rise lately, and the number only seems to grow yearly.
If we dig into history, we can find information about one of the largest Leveraged Buyout model transactions pertaining to an acquisition in 2006 of Hospital Corporation of America. An amount of $33 billion was paid by KKR, Bain & Co., and Merrill Lynch, collectively, towards the acquisition of Hospital Corporation of America.
Assumptions of Leveraged Buyout Model
Assumptions play an important role in a Leveraged Buyout model. Various assumptions are essential to process the transaction in the mentioned model.
Assumptions may pertain to:
- Determination of purchase price,
- Proportion for debt
- Proportion of equity
- The valuation of the company under acquisition
- The number of funds required to carry out the transaction
- Accounting for fees, such as professional fees, statutory fees, legal counsel fees,
- Taking into consideration any charges toward documentation and other transaction-related costs
- Any other key factor which may have an effect on the model
The reader may understand these standard assumptions in a leveraged buyout transaction. The assumptions may vary and require tweaking on case to case basis.
Structure of the Leveraged Buyout Model
When we talk about the structure of Leveraged Buyout, either of the following scenarios is possible:
- An existing entity uses its borrowed funds or debt to acquire the new company; OR
- A new entity with existing shareholders comes into creation which will acquire the company; OR
- A new entity with new investors comes into creation to acquire the company.
The buyer company may either make the target company a subsidiary and add it to its group structure or absorb the company and merge it with one of its existing companies.
Advantages and Disadvantages
Advantages
Below are the advantages:
- Lesser equity means fewer shareholders. Ultimately less co-ordination and effort are required for any shareholder approvals
- Turnaround time for making decisions reduces significantly
- In the case of the sick unit or mismanaged companies, this model helps improves the management of the company
- The buyer gets to claim tax benefits on interest payments on borrowed funds
- Higher rate of return in the hands of equity shareholders
- Also, the Leveraged Buyout model may prove very efficient with high chances of success in a growing economy.
Disadvantages
Below are the disadvantages:
- Lesser risk towards equity shareholders may result in loose management of the company
- Conflict of interest amongst shareholders may lead to struggles in arriving at conclusions and decisions for the good of the company.
- Due to the acquisition, there may be employee lay-offs of the company being acquired.
- In a scenario where targeted returns are unattained such that the returns are even less than the cost of financing, it may lead to bankruptcy.
- If the assets against which one takes the loan are not cash-rich or cash-generating, it may lead to issues in the line of credit, the company’s image, and future prospects.
Conclusion
To conclude the above discussion in a few words, the Leveraged Buyout model is a transaction wherein investors or maybe large companies use borrowed funds or debt or loan to finance the acquisition of another company, keeping the assets of such acquired company as collateral against the borrowed funds. This method has its own share of advantages and disadvantages. Every case requires evaluation in its individuality as to whether this model would be feasible or be an aggressive strategy.
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