Leverage buyouts (LBOs) are transactions in which buyers acquire a firm with a significant portion of the purchase price financed by leveraging bank debt. There are various ways to structure the transaction, but as a rule of thumb, banks prefer 30 per cent in equity and 70 per cent of debt.
For example, if the purchase price of a company is $10 million, buyers will need $3 million of equity injection and the remaining $7 million to be financed by a bank loan. Because the balance sheet will now be stripped of retained earnings, the firm’s leverage ratio drastically increases.
By a bank’s definition, “leverage ratio” is ratio of debt and tangible net worth. Put simply, a healthy ratio requires a minimum of 30 cents of equity for every 70 cents of debt.
When the acquisition transpires, it triggers a “goodwill” component on the firm’s balance sheet. Goodwill is the difference between the purchase price and the tangible value of assets. Most banks will treat goodwill as intangible, placing the company into a negative tangible net worth position.
Canadian banks recognize that an absence of bank financing can radically hinder both the buyers and sellers from consummating transactions. Banks don’t want to forgo the opportunity to take on an otherwise lucrative deal. As a result, most banks have learned to disregard the impact of such transactions on the balance sheet, focusing instead on the company’s ability to generate future cash flows.
Thanks to heightening competition among banks and sub-debt lenders, the adoption of cash flow lending in commercial financing has become increasingly popular. Cash flow loans are typically 3.5 times a company’s EBITDA (earnings before interest, taxes, depreciation, and amortization), but this multiple can go higher, depending on the lender’s risk appetite, current industry landscape of the target company, and the firm’s perceived growth prospects.
Private equity firms, also known as “financial buyers,” are extensive users of LBOs during mergers and acquisitions (M&A) because the actual internal rate of return (IRR) — assuming all things are equal — tends to be superior over the use of equity alone.
To illustrate using the same scenario above, let’s say the purchase price is $10 million and the sale price at exit is $20 million. If the acquirer uses only equity to purchase the company, its cash-for-cash return at exit will be $10 million, or two times. If the buyer uses $5 million in equity and $5 million in debt, its cash-for-cash return at exit will be three times, because $20 million in sale price, less the bank debt of $5 million, is equivalent to $15 million. In short, the $5 million investment returned $15 million in cash.
Our example is rather oversimplified given the interest on the bank loan has not been factored into the equation, but it’s sufficient to illustrate the benefit of LBOs and why their use in M&A has become commonplace.
Ideal Acquisition Target
Whether the acquirer is a private equity investor or a strategic buyer, firms that utilize LBOs look for similar characteristics in the acquisition target. These are categorized into two metrics: soft metrics and financial metrics. We will focus on soft metrics that acquirers want to see from a target when making their buying decision.
Above Market Growth Potential
During due diligence, buyers will try to understand the target’s market share relative to the size of the industry and whether its position is defensible. Equally crucial are the firm’s growth prospects, ability to expand to new geographic markets, and potential to disrupt the market by creating fresh demands that incumbents failed to exploit.
Buyers will scrutinize the company’s customer base to see if it can generate meaningful organic growth. They will pore over adjacent markets that the firm can explore. More importantly, buyers will determine if the firm can grow through alliances and partnerships by cross-pollinating with other platforms in their existing portfolio.
Industry Landscape and Attractiveness
Financial and strategic buyers look for sizable returns. Attractive industry trends that the target can substantially profit from enhance their motivation to buy. Changes in demographics, transformation in consumers’ buying patterns, and technological and regulatory shifts are a few examples.
In recent years, IT, biotech, and media have become heavily favoured industries. There also are arguments to be made for innovative companies with robust intellectual properties that create sustainable advantage by staying ahead of the curve in product development.
For strategic buyers in particular, synergies with companies in their current portfolio and the potential to realize operational efficiencies upon investment are excellent motivators. The ability of a target company to leverage the acquirer’s distribution channels, work with the same suppliers to optimize pricing, or use the buyer’s assembly lines to maximize production capacity creates an ideal target.