What Does Leveraged Buyout Analysis Mean?
The leveraged buyout (LBO) analysis seeks to determine the price which could be paid by a financial buyer for a target. This analysis is useful in determining the maximum price that could be paid for a company, with financing in the current debt markets, that would generate an appropriate return to a financial buyer.
The highest purchase price that can be justified in an LBO will primarily be a function of:
- The target company’s current and projected free cash flows;
- The required hurdle rate by equity investors; and
- The financing structure, interest rates and banking covenants required by lenders.
Due to the financial risk inherent in a leveraged buyout transaction, equity investors generally look for a minimum internal rate of return (IRR) on their investment of 25% to 35%. To calculate this return, the equity value of the target when the buyer exits the investment needs to be calculated.
Divestopedia Explains Leveraged Buyout Analysis
The steps in the LBO analysis are:
- Figure out how the acquisition of the business will be financed. Talk to an investment banker and ask what the current level of debt to equity is on M&A deals. Using that ratio, apply it to your value expectations. Assume you have a $22 million value expectation and an appropriate debt to equity ratio in the current M&A environment was 50% debt and 50% equity. Then, the acquisition of the business could be financed with $11 million in debt and $11 million in equity.
- Determine the free cash flow of the business over the next five years including the cost to service the debt amount used in the acquisition.
- Calculate the equity remaining for the buyer assuming that the company will be sold after five years at a conservative multiple of EBITDA (usually the same as the entry multiple).
- Use the initial equity investment dreamed in #1 above, the free cash flow after debt servicing in #2, and the equity remaining for a buyer upon a subsequent sale in #3 to calculate the potential IRR on their investment.
The LBO analysis doesn't take into consideration a premium that a strategic buyer might pay for your business due to synergies, but it will provide a "floor" valuation for the company.